Streetwise Professor

Western European utilities are pressuring Russia and Qatar to eliminate long term gas supply contracts with prices tied to crude oil in favor of a spot market mechanism:

Russia and Qatar are under growing pressure from Europe’s biggest utilities to scrap a 40-year-old system that links natural-gas prices to oil after Brent crude’s 23 percent surge this year.

As delegates from countries that hold two-thirds of the world’s reserves gather in Cairo tomorrow for a one-day meeting of the Gas Exporting Countries Forum, customers from France’s GDF Suez SA to EON AG of Germany are urging producers to link prices to spot markets instead of insisting on long-term contracts that shadow the fluctuations of oil. Contract prices will rise about 15 percent in the next quarter alone, according to Wood Mackenzie Ltd., an Edinburgh-based energy consultant.

“The European contract price of gas is going up,” said Thierry Bros, a senior analyst at Societe Generale SA in Paris. “Utilities won’t sign new oil-linked contracts.”

But Gazprom says nyet, no, never!:

Spot markets don’t have enough trading to ensure adequate supply, Alexander Medvedev, deputy chief executive officer of Russia’s OAO Gazprom, the world’s biggest producer, said May 13.

“There has never been any transition to spot-priced market structure, and never will be, because spot market liquidity is insufficient,” Medvedev said in Slovakia’s capital, Bratislava. As soon as economies began to recover from the financial crisis, “it became clear that the market will work as before.”

The Other Medvedev is either an ignoramus or a liar.  Check that–he’s probably both.  Regardless of the explanation, his “analysis” is bunk.

First, there has been an extremely successful transition to a spot market structure: in the US, in the 1990s.

Second, the liquidity of the spot market is endogenous.  Believe me, the elimination or even phasing out of oil-linked contract terms would lead in very short order to the development of a robust spot pricing mechanism.  The ability to trade gas spot, and the reliance on spot prices to index contracts will initiate a virtuous cycle that will result in spiraling liquidity.  Just as occurred in the US with the elimination and phase-out of take-or-pay contracts and the elimination of gas price controls.  Just as occurred in oil in the late-1970s when OPEC abrogated oil equity contracts: there was no spot market in oil to speak of before that, but once OPEC transitioned to a different pricing mechanism, the oil spot market developed quickly.  (Note the launch of the NYMEX crude contract followed the elimination of equity contracts in oil by less than three years.)

There is no reason why, in the current environment, with current technology, that a robust spot price in gas cannot and will not develop in Europe.  The existing pricing mechanism is an anachronism rooted in a very different legal and regulatory environment, and one that is plainly unnecessary in light of the development of vibrant spot markets in myriad types of energy since the late-1970s.

Gazprom–surprise, surprise–is just talking its book.  Oil and gas prices have diverged, with oil prices rising and gas prices remaining stagnant or even falling since the end of the financial crisis.  Thus, the pricing mechanism provides a windfall to Gazprom in the existing environment.  Note TOM’s linking of “the market will work as before” to the end of the crisis.  Oil prices plummeted during the crisis, making the linking mechanism less profitable for Gazprom, but with the rise of oil prices, that mechanism works very well for the company.

But very poorly for its customers.  The linked article mentions the woes of E.ON, RWE, and GDF Suez.  Those woes will only become worse with the craven decision of the Merkel government in Germany to shutter the country’s nuclear power plants.  Merkel will soon be in a difficult position, between the Russians she habitually appeases (often at the behest of German companies, including, ironically, E.ON and RWE) and German companies, notably the just-mentioned utilities.   She has jumped from the greenie frying pan into the energy fire.

The current situation is not sustainable.   Wide divergences between prices and values like those seen between the contract price of gas and the spot price of gas cause contract disputes and market breakdowns.  Something will have to give.  Gazprom insists it won’t.  But if the divergences remain wide or even widen, it may find itself without customers and forced to give.

Here’s hoping.

Russia’s grain harvest is looking fine this year, in contrast to last year’s drought ravaged one, so the country is canceling its export ban as of 1 July.  So line right up buyers!  Russia is open for grain business.  15 million tons–maybe 20 million tons–available!  Step right up.

Uhm, not so fast.  Customers are taking a once burned, twice shy attitude:

“Russia will return once again but it will be dealt with cautiously,” Nomani Nomani, the vice chairman of Egypt’s General Authority for Supply Commodities, told Reuters in an interview.

“We do not want to fall into the same problem we fell into last year,” he said.

Egypt was forced to scramble to replace more than 500,000 tonnes of Russian wheat purchases when Moscow imposed the ban.

WATCH AND WAIT

The government could yet clamp down if domestic supplies start looking short or inflation accelerates in a crucial political year when parliamentary elections are due in December and a presidential poll in March.

“If issues of price increases arise, we will use means of customs and tariff regulation,” Deputy Prime Minister Viktor Zubkov, who recommended Putin end the ban, told the prime minister on Saturday.

Russia’s farm lobbies, traders and analysts had proposed a more conservative three month export window from July 1 to relieve a stock buildup in the south and help domestic prices off of lows to encourage investment in next year’s crop.

Many senior industry figures had also expected a system of quotas or protective export tariffs to be imposed in order to control the outflows.

“They will track the pace of export growth, the international market dynamics, the pace of retail price growth, and eventually they may still impose export duties,” Andrei Sizov, managing director of the SovEcon think tank, said.

Russia’s central bank, which left key lending rates on hold on Monday in its struggle to restrain inflation without killing off growth, said the decision over the weekend to lift the grain export ban posed the single biggest threat to prices.

Russian inflation is running at an annual 9.7 percent.

“This is the only significant risk factor,” central bank chief Sergei Ignatyev said after the bank raised its key deposit rate, referring to the decision to lift the ban.

With the political odds stacked against unfettered exports, traders said they did not fully believe that free shipments could continue for long.

“Will Russia really open its gates in a lasting way and without any export restrictions? I want a clear and precise confirmation,” a European grain trader said.

I especially like the part about how if prices do spike, Russia won’t ban exports–it will just make them uneconomical using customs and tariff regulations.  That makes it so much better!

Note well, newly nominated US ambassador to Russia, Michael McFaul, who claims to have been the “sherpa” for Russia joining the the WTO.  This is what you are so anxious to help?  Do you think anything will really change?

Russia did its already not too stellar reputation serious damage with the grain export ban.  Just as it did damage with the various gas shenanigans over the past years.  It talks the WTO talk, but walks the protectionist walk.  That’s unlikely to change soon, and indeed is likely to get worse as Medvedev fades to black and Putin the Protectionist and natural state balancer reasserts even greater control.  That grain trader will wait a long time for a “clear and precise confirmation” of anything different.

FT Alphaville has an interesting post on metals warehousing that resonates with my earlier post on the subject.   They call attention to a BBC report on commodities.

Recall that I dismissed the concerns about leveraging market power, and said that the crucial issue was information.  Given the availability of statistics on metals inventories, I downplayed the information advantage that warehouse owners have, but the Alphaville post suggests I was hasty in that judgment:

MR [BBC reporter Michael Robinson]: Steinweg is the last independent warehouse. Does it give them [the banks which own warehouses] an unfair advantage?

MR: John van der Lek told me he’s relieved that the Steinweg group is still independent, he says he’d like to avoid any suspicion of conflict of interest.

MR: “But what’s wrong with a bank owning a warehouse?”

ST [Warehouse operator Steinweg’s head of metals John van der Lek]: “I don’t know why they want to own warehouses. There must be a reason for that. But I don’t know why they do.”

MR: “Is it good business for a bank?”

ST: “Could be, but I don’t know, I don’t think so. I don’t have an idea what their feeling for taking over a warehouse.”

MR: “The danger is pretty obvious. That the bank has more information than other traders because it owns a warehouse?”

ST: “Yeah. That is to a danger for the traders. Maybe so we’re in a situation where people get more information out of the warehouses, but we are here independent and we would like to keep it that way. And we hope our customers appreciate that.”

All that said, trading is about information flows, and integration of traders into physical assets is ubiquitous–and has been for a long time–for exactly that reason.  Again, recall that major grain merchants did–and still do–operate the main delivery warehouses for CBOT/CME Group contracts.  Banks have been going into physical asset ownership in energy in recent years.  BP always viewed its asset ownership as a key to its trading operations.  That’s the way the game is played.

Anybody who owns the physical assets like storage facilities will have an information advantage when it comes to trading.  The relatively recent move of financial institutions into this area reflects a complementarity between access to this information flow and the ability to operate and finance trading operations.

In other words, it’s not about leveraging market power.  It’s about putting information and capital together.  That’s the essence of trading.  It’s the financial equivalent of a Reese’s Peanut Butter Cup.

The CFTC made all the front pages by filing manipulation charges against Parnon Energy, Arcadia Petroleum LTD and Arcadia Energy (Suisse), all affiliates of the trading firm Arcadia.

Let me say at the outset that I am in favor of addressing manipulation by ex post actions like those filed by the CFTC, and have long made that argument.  Let me also say that in 2002, Arcadia was accused of manipulation of Brent crude, and price patterns at the time were symptomatic of a corner, and per public reports, Arcadia’s trading was consistent with an attempt to corner.  Thus, I have no objection to the type of action the CFTC has brought, and don’t put it beyond Arcadia or a company like Arcadia to engage in manipulative conduct.  Indeed, I wish that the CFTC would rely more on ex post actions and less on things like position limits or ex ante jawboning to reduce the frequency and severity of market manipulation.

That said, based on the complaint, I conclude that the CFTC case is a tenuous one.  It is tenuous because of the novel nature of the claim, and the weak support for that claim provided by the price and trading data cited in the complaint.

The CFTC does not allege a corner.  Instead, it claims that Arcadia engaged in deceptive conduct.  It bought cash WTI forward contracts it did not need, then sold those contracts in the last three trading days of the WTI “cash window.”  The CFTC alleges that the buying deceived the market by suggesting buying interest that was not there, creating a false perception of market tightness.  This perception of increased tightness caused backwardation to increase.

Arcadia’s subsequent sales allegedly disabused the market of its (allegedly false) belief, causing backwardation to fall.  Arcadia allegedly lost money on these cash WTI purchases and sales, but made up for it through first buying and selling nearby spreads, and once the front month contract stopped trading on NYMEX, shorting the (new) nearby spread.  The creation of the perception and subsequent destruction of the perception of tightness, the CFTC alleges, generated profits for those spread positions.

Thus, the CFTC alleges a trade impact manipulation, rather than a corner.  These are always a greater challenge to prove, and the proof the CFTC adduces is hardly convincing.

In particular, the price data do not provide strong support for the allegation.  Consider the first alleged episode, in January, 2008.  Per the complaint, Arcadia bought 4.1 million barrels of February WTI cash crude.  During this period, it was also buying the February-March spread.  But in the 3 January-8 January period, when this trading–notably the cash trading, per the complaint–was allegedly creating an artificial perception of tightness in the market, (a) front month cash WTI fell by about $3.30/bbl, (b) the February-March (GH8) backwardation actually fell by 4 cents, and (c) front month WTI fell relative to front month WTS and LLS.  The spread did jump up 25 cents between the 8th and the 10th, and the WTI-LLS front month spread jumped by over a dollar, but this is after Arcadia’s purchase of the cash WTI contracts, and the purchase of the bulk of the GH8 spreads.  So to believe the CFTC, one has to believe that the market only became aware of the impending tightness with a lag–which is hard to reconcile with its assertion that it became aware that the demand was chimerical immediately on the sale of Arcadia’s cash position.

Moreover, by 15 January the GH8 spread had fallen to a level below its value prior to the commencement of Arcadia’s buying.  Then, when Arcadia began to sell the GH8 spread, the spread actually began to widen, going from 17 cents to 64 cents during the period that Arcadia was selling it. February WTI actually rose relative to February WTS during these days of selling February WTI as well.

This is all very hard to square with any assertion that the market was responding to Arcadia’s trading activity.  After all, NYMEX February futures and WTI cash forwards are effectively perfect substitutes, both allowing the buyer to take delivery of 1000 barrels of WTI in Cushing during February, 2008.  The market was showing greater signs of tightness at the very time Arcadia was reducing its demand for February WTI.  It will be devilish hard for CFTC to argue that purchases of near perfect substitutes have different price impacts, and for it to argue that the market was very sensitive to Arcadia’s trading of February WTI when its sales are associated with rising backwardation and its purchases are associated with falling backwardation.

The GH8 cash WTI spread did indeed go from backwardation to contango during the cash window of 25-28 January, when Arcadia was doing its selling of Feb cash WTI.  But February WTI actually rose during this period, and indeed rose on 28 January when Arcadia did most of its selling.  Again, this is not symptomatic of a market that was suddenly convinced that demand tightness had declined.

It must also be noted that the collapse in the February-March cash spread was equally large for LLS ($.985), and more than twice as large for WTS ($2.335).  Thus, the spread collapse was not limited to the product that Arcadia was trading.

Perhaps CFTC will argue that Arcadia’s deceptive buying had lifted and then crushed LLS and WTS spreads as well, but any manipulative buying should have a larger impact on the commodity actually bought, and the 25 January-28 January spread moves are not consistent with that.

What’s more, making this argument would present the CFTC with an acute problem.  It defines “market dominance” based on the size of Arcadia’s position relative to the WTI market.  If LLS and WTS are such close substitutes for WTI that buying one impacts the prices of the others because they are effectively one market, then for the purpose of determining market dominance Arcadia’s position must be measured relative to that market–WTI, WTS, and LLS, plus any other close substitutes.  It would be much harder to prove market dominance under such an expanded market definition.

In brief, the price and trading patterns for the January episode are not consistent with the CFTC allegations.  Prices fell throughout, even after Arcadia allegedly fooled the market into believing that conditions were tight.  Prices and backwardation did not rise when Arcadia was buying.  Backwardation was rising when Arcadia was actually selling the spread.  The spread collapse during the cash window that the CFTC apparently believes is its “Gotcha” piece of evidence was mirrored by collapses as large or larger in other types of oil.

I also note that the CFTC has provide no evidence that any of the price and spread moves were statistically significant.

The spread and trading co-movements are more equivocal during the March, 2008 episode.  The April-May (JK8) spread did rise when Arcadia bought it, and during the period it commenced buying April cash WTI.  But the biggest move in the spread, from $1.16 to $1.94 occurred when Arcadia sold its JK8 NYMEX spreads.  It was buying 3.5 mm bbl of April cash during this 14-19 March period,  but it was selling 14.4 mm bbl of JK8 spreads–meaning that it sold 10.9 million more barrels of April WTI than it bought during this period–so how could this contribute to an explosion in the perceived tightness of WTI–as indicated by the 78 cent increase in the backwardation? Note too that the WTI April cash flat price was falling $5.73 during the period it was buying the 3.5 mm bbl of April cash crude–another thing that is hard to square with a perception of increased tightness.

Furthermore, the April-May LLS spread fell by more during the cash window ($2.29) than did the WTI spread ($2.015).  This is very hard to square with any coherent manipulative theory, and as noted before, any story in which sales of WTI cause declines in the price of LLS would require a market definition under which it would likely be very hard for CFTC to prove market dominance.

I should also mention that even ignoring this problem, the CFTC’s market definition is suspect.  It compares Arcadia’s position to the company’s estimate of flows of WTI in Cushing during the delivery month.  But this ignores stocks of oil in Cushing, which were about 17 mm bbl during this period.  Now some of these barrels were not WTI, but some if not most of these barrels should be included in any calculation of the size of Arcadia’s purchases relative to the size of the market.

Corner manipulation cases are hard: the CFTC has never won one.  Trade impact manipulation cases in which it is alleged that buying or selling created false perceptions of demand are even harder to analyze and prove.  Thus, just based on the nature of the allegation alone, the CFTC has filed a very challenging case.  When one looks at the evidence the CFTC presents in its complaint, the odds become even higher.  For the January episode in particular, the most straightforward interpretation of the evidence cuts squarely against the allegations.  This will be a very difficult case for the agency to win.

There’s another lesson here that has been lost in all of the hue and cry over the filing of the complaint.  CFTC has been examining the oil market with a fine tooth comb going back to 2005 if memory serves.  If this is the best case they can find after all that, the oil market must be pretty damn clean.

FT Alphaville reports that the UK Parliament’s Science and Technology Committee is all hot and bothered about bank ownership, and particularly JP Morgan’s ownership, of LME delivery warehouses:

79. We heard that there were large companies dealing metals within the UK and an allegation was made by the MMTA that a company through a subsidiary may be behaving in an anti-competitive manner: on the London Metal Exchange there are four very large companies that own the very warehouses that people deliver metal into, J.P. Morgan is one of them.

They own a company called Henry Bath. They are, therefore, a ring-dealing member of the exchange and they also own the warehouse. That is restrictive. They were also reported, at one point, to have had 50% of the stock of the metal on the London Metal Exchange.[113] 80.

We would be concerned if the ownership of metals storage warehouses by a dominant dealer on the London Metals Exchange were to be anti-competitive. We would also be concerned if a dealer who had the resources to own over 50% of stock on the London Metals Exchange impeded the correct functioning of the market.

81. We use this report to bring the alleged activities of large dealers on the London Metals Exchange to the attention of the Office of Fair Trading. We would be concerned if a dealer were undermining the effective functioning of the market and we look for assurance that the market is functioning satisfactorily.

The confusion about the anti-competitive effects–or, more correctly, the lack thereof–of vertical integration is pervasive.  This is just another example.   JPM ownership of a delivery warehouse is not per se anti-competitive, and indeed, it is difficult to see how it could be a way of leveraging market power as the Committee insinuates.

Insofar as ownership of 50% plus of deliverable supply is concerned, that is a completely separate issue.  Sumitomo never owned any delivery warehouses, but it (and its pilot fish) cornered the market with abandon in the 1990s.  To my knowledge, none of the other frequent squeezes on the LME in recent years have been facilitated by ownership of warehouses.  What’s more, it’s most effective to attack corners and squeezes directly, rather than through restrictions on asset ownership.

I’ve also written from time to time on how ownership of physical assets is an important part of many commodity trading firms’ strategies.  In particular, commodity trading firms can optimize use of physical assets based on their access to information and their ability to exploit the option value of these assets.

With respect to delivery warehouses in particular, come on.  In the grain markets in Chicago, big merchants like Cargill, Continental, and ADM long owned delivery houses.  They did so for the exact same reason that many energy and metals traders today own physical assets like storage.

Where ownership of physical assets may be somewhat problematic is when it gives the owners privileged access to information.  By trading on that information, the asset owners create an adverse selection problem that reduces market liquidity.

Perhaps the most famous example of this occurred in the Chicago grain markets in the 1860s.  At that time, there was a veritable war between grain brokers and traders and the owners of the grain elevators in Chicago.  The Chicago Board of Trade was the representative of the interests of the brokers and traders, and fought hammer and tong against the “piratical” elevators.

The elevator operators had information about the quantity and quality of grain in store.  This information advantage allowed them to trade profitably.  For instance, elevator operators from time to time learned that grain was getting out of condition–“heating.”  Given this knowledge, they would go short, and cover their positions at a profit when news of the spoilage became public.

This is akin to inside trading, and has deleterious effects on market liquidity: it transfers wealth from the uninformed to the informed.

The elevator operators also allegedly operated a cartel that fixed storage rates at supercompetitive levels.  This again harmed grain merchants–and also farmers.   Elevators also took advantage of their ability to mix grain down to the minimum required to meet grade.  This effectively transferred wealth from those who stored above average quality grain into the warehousemen’s pockets.

The CBOT tried mightily to get the elevator operators to report information about the quality and quantity of grain in their facilities, and to charge reasonable rates.  The elevators basically told them to pound sand.  The CBOT had little leverage over the elevators: the brokers and merchants needed the elevators, but the elevators didn’t need to the CBOT, so threats of expulsion had little effect.

Eventually, the CBOT prevailed on the legislature of Illinois to regulate grain warehouses.  This is actually an extremely important event in American legal and regulatory history, for one of the elevator operators, Ira Munn, challenged the Illinois regulation.  He appealed all the way to the Supreme Court, which decided in favor of the state, thereby establishing the power of states–and the federal government–to regulate business “in the public interest.”  The regulatory state in the US traces its roots to that decision in Munn v. Illinois.

One of my favorite papers discusses this episode in more detail.  You can find it here.

Going back to the hyperventilating Parliamentary Science and Technology Committee and JP Morgan’s ownership of a delivery warehouse, the things that were arguably inefficient in 1867 Chicago are completely absent in 2011 Bath.  The LME announces stocks held in warehouses on a daily basis, meaning that elevator operators don’t have privileged information on quantities in store.  Quality is monitored by independent inspectors.  The fears of vertical integration resulting in a leveraging of market power are neurotic.  Merchant ownership of delivery and storage facilities is a virtually universal feature of the commodity landscape.

In other words: Move along.  Nothing to see here.

Chicago finance prof Luigi Zingales has written a short oped on OTC derivatives markets.  Considering the source, it is very disappointing, not to say embarrassing.

Indeed, it seems that Luigi is on the same frequency as Kenneth Griffin of Citadel: their arguments, such as they are, are virtually indistinguishable.

Zingales’s basic argument is that the OTC derivatives market is oligopolistic, and that all sorts of bad things flow from that structure:

Indeed, today the market for derivatives is oligopolistic, with a few banks running huge profit margins. And, regardless of whatever political motivations might lie behind the latest investigations, this market concentration is a real problem. According to a 2009 study by the European Central Bank, the five largest CDS dealers were party to almost half of the total outstanding notional amounts, while the 10 largest CDS dealers accounted for 72% of the trades. The markets for other derivatives are not much better.

As is usual in assertions of dealer oligopoly, there is seldom any comparison to other markets.  The concentration figures Zingales cites are hardly exceptional when compared to other industries, and I daresay to the markets for groceries or gasoline in Chicago.

But worse, Luigi’s argument is very anti-Chicago.  Long, long ago, dating back to the 1960s and 1970s, Chicago eviscerated the structure-conduct-performance paradigm associated with Harvard (and Joe Bain in particular).  Folks like Harold Demsetz and Sam Peltzman pointed out that market structure is endogenous, that concentration can result from the exploitation of cost advantages, that prices can be close to marginal cost even in concentrated markets, and that large profits in such markets are not prima facie evidence of weak or absent competition.

This means that rather than taking the concentration data (as benign as they are by comparison with other industries) and making the leap that this concentration indicates a lack of competition, Zingales should ask why the structure is what it is, what forces generated it, and whether concentration is actually symptomatic of an inefficient, non-competitive market structure.  Put differently, concentration is neither sufficient nor necessary condition for a non-competitive outcome. Regurgitating concentration statistics and proclaiming “QED” is bad economics.

That’s all bad enough, but then he really goes off the rails:

A high degree of concentration distorts the market in several ways. First, when they transact among themselves, large players do not insist on an adequate amount of collateral, relying on the counterparty’s generic creditworthiness (and on the implicit guarantees that governments provided to large firms). Not only does this severely undermine the ability of small firms to compete, but it also contributes to systemic instability of the type that we experienced in 2008, thus increasing the likelihood that taxpayers will have to step in. Market concentration renders mostly illusory the beneficent risk-spreading role that is claimed for derivatives, because the bulk of the risk is borne by very few players.

The point about implicit guarantees is fine–but that’s a policy error that can’t be fixed by jiggering with the market structure.  But the criticism that banks don’t collateralize trades but rely on generalized creditworthiness is wide of the mark for many reasons.  For one, under standard credit support annexes, dealers don’t post independent amounts with one another, but do collateralize via variation margins on a daily basis.  Hence, inter-dealer credit is limited to one-day moves.

For another, Zingales is overlooking the fungibility of credit: initial margins/independent amounts could be funded by borrowing–and banks kind of have access to a lot of borrowing channels.  And since dealers typically rehypothecate collateral, what’s the point of interdealer independent amounts anyways?: with hypothecation A can give collateral to B who can effectively turn around and give it back to A; the actual money flows are a little more complicated, but rehypothecation effectively allows banks to lend each other the collateral that they post with one another.  What’s the point of that?

For yet another, regarding the “undermining the ability of small firms to compete”–can he be serious?  Because of the borrowing point I just made, no doubt if independent amounts on all inter-dealer trades were somehow mandated, who do you think would have the lower cost of funding these margins, the big incumbent banks, or small firms?  I would wager that mandated collateralization would actually favor bigger, more creditworthy firms.

Moreover, Zingales also overlooks other potential scale and scope advantages in derivatives dealing: yes, some of these may be artificial because they arise from TBTF subsidies, but again, that is a problem that needs to be tackled directly.

Zingales then trots out the conventional arguments regarding opacity:

Over-the-counter trading also contributes to the opacity of derivatives markets, further reducing competition and increasing the margin enjoyed by the traders – and the prices that final users (mostly industrial firms) must pay. The combined profits of the key players in this market total $80 billion, which represents a massive tax on the real economy.

To fix this problem, we need to move the bulk of derivative trading onto organized exchanges, where daily collateral requirements would guarantee systemic stability, and price transparency would force competition, reduce margins, and increase the market’s depth. In the United States, the Dodd-Frank Act moves some of the way in this direction, and similar efforts are underway in Europe.

I’ve been over this ground so many times, so I’ll try to keep it brief (for me, anyways).  Zingales presents no evidence that margins are excessive.  End users have choices, including very close exchange-traded substitutes for many OTC derivatives, but they choose to trade OTC instead: like others who have made similar criticisms, Zingales apparently believes that end users are suffering from Stockholm Syndrome or Battered Spouse Syndrome.  When touting exchanges as an alternative, he also overlooks the very real possibility that face-to-face OTC dealings reduce adverse selection costs that end users incur, but would incur on anonymous exchanges.

Moreover, apropos the earlier point about anti-Chicago, if margins are so wide and profits are so fat, why doesn’t entry occur?  Why doesn’t competition work to erode margins and profits here, like in other markets?  Perhaps there’s a story, but Luigi sure doesn’t tell one–and he is far from alone in this.  The statement about profits being a tax is so embarrassing I will pass over it in silence.  The profit number itself is completely contextless; his statements about profits based on absolute magnitude (“boy, that’s big”) remind me of the periodic attacks on oil industry profits that are similarly without any context, or attempt to control for capital deployed, risk, etc.  Given that he alludes to the concentrated riskiness of derivatives positions, perhaps he should at least entertain the possibility that the profits are in fact compensation for risk:  indeed, large profits in “normal” times interspersed with periods of big losses is characteristic of the risk-reward profile associated with tail risk.

As for his proposed “solution,” I can only stand and wonder.  The hook for the entire piece is the EC’s antitrust investigation of the OTC market:

the existence of political motivations does not undermine the legitimacy of the new EU investigations, which will be conducted alongside an ongoing inquiry by the United States Justice Department into anti-competitive practices in the trading, clearing, and pricing of CDS in the US

He starts out his critique of the OTC market by focusing on concentration in the OTC market, and concludes that high concentration is symptomatic of a lack of competition.

Uhm, has he looked at concentration in the exchange space? Is he aware that virtually every major exchange-traded derivatives contract is a monopoly?  Has he looked at concentration trends in exchanges?  Has he noticed the major consolidation wave that has been going on in exchanges since about 2005, and which as picked up again after tailing off during the crisis?

To go on: Is he aware that OTC markets also engage in “daily collateralization”, particularly among dealers?  Is he aware that such daily collateralization is not necessarily stability enhancing, as he asserts? Is he aware that “price transparency” already exists, though in a different form, on OTC markets?  Is he aware that the price transparency on exchanges is accompanied by counterparty opacity that can actually increase trading costs for the uninformed end user due to adverse selection?  And again: if the advantages of exchange trading are so great for end users, why haven’t exchanges made greater inroads in attracting their business, and why have end users in fact gravitated more towards OTC markets where he claims they are getting shafted?

Luigi is a very accomplished economist.  He can do much better than uncritically recycling stale and unpersuasive conventional wisdom.

Please, Luigi: adjust the frequency on your receiver.

It’s hard to know whether to laugh or cry when reading day after day the expression of newly recognized concerns about the possible consequences of clearing mandates and other efforts to re-engineer the very complex derivatives markets.  All around the world, it is dawning on this Sorcerer’s Apprentice or that one that gee, a wave of the legislative or regulatory wand may just unleash forces that they did not intend with results they may not like.  Newly recognized by some, that is.

For instance, for quite a while now I’ve pointed out that the economies of scale and scope in clearing mean that it will be highly unlikely that this sector is going to be highly competitive.  There are strong natural monopoly elements.  This is an inherent part of the economics of risk and clearing.

One Apprentice awakes to this realization:

Over-the-counter (OTC) derivatives into clearing houses must not reinforce monopolies in the clearing business, otherwise the wider economy will suffer, a British government minister has warned.

. . . .

Mr Hoban said: “But we must not allow new standards for CCPs, combined with a legal obligation to clear derivative products, to embed monopolies in clearing that will result in costs passing back to the wider economy.”

But then he proceeds to bugger up the economics completely (sorry about the language, but he is a Brit):

The comments, by Mark Hoban, financial secretary to the Treasury, are a sign of growing unease in London over a trend gathering pace globally for exchanges to have their own clearing houses in a so-called vertical silo.

. . . .

“To prevent this, our view is that, while linked structures – so called vertical silos – can be effective, they must be subject to fair and open access requirements,” he told a conference organised by Markit, a derivatives data company.

Proponents of vertical silos, which include Deutsche Börse and CME Group, the US exchange operator, say that vertical silos are efficient and that derivatives traders like the fact that they offer a single pool of liquidity in key derivatives contracts, offering more opportunities to get deals done at keener prices.

In the latest draft of Emir, circulating among EU member states, a clearing house that has been authorised to clear [OTC] derivative contracts “shall accept clearing such contracts on a non-discriminatory, and transparent, basis, regardless of the venue of execution”.

Mr Hoban said: “Market participants should be offered a meaningful choice of using all or part of a vertical structure.”

This is getting tiresome.  Again: the very fact that there are strong natural monopoly elements in both execution and clearing is exactly why vertical integration–the dreaded silo–is so common, and in fact is becoming more so (e.g., LME’s recent mooting of setting up its own clearinghouse, following similar efforts by ICE and EuroNextLIFFE).  Straightforward transactions costs economics and even some straightforward neoclassical economics (double marginalization) provide a strong rationale for integration of execution and clearing venues.

Scope economies are the only thing that really push against this.  To the extent that there are greater scope economies in clearing than in execution, vertical integration can be more costly as it means that scope economies are not fully exploited.

But the fact remains that scale and scope economies and transactions costs and double marginalization effects are going to lead to industry structures that are likely to involve a lot of concentration and a lot of integration (in part because there’s a lot of concentration).  Forcing greater use of clearing and exchange-like execution venues is only going to intensify these effects.

Bloviating about mandating “meaningful choice” doesn’t change the fundamental economic drivers.  People who regulate and legislate in blissful disregard of these drivers, and then express Shock!, Shock! that the results they engender are not what they desired are annoying beyond belief. Annoying and pathetic.

The commodity markets have been volatile of late.  The tumult started in silver, which sold off dramatically after reaching post-Hunt highs.  Last week the sell-off broadened to a good chunk of the commodities markets, with oil especially hard hit.  In response to the roiling markets, the CME raised margins sharply on silver, and today on oil and the rest of the energy complex.

This raises the question of the effect of margin changes on prices.  The CME’s head of clearing, Kim Taylor, vigorously defended the CME’s margin increases in silver (and would presumably make the same defense of today’s moves).  Kim’s justification characterizes the clearinghouse’s move as a response to changed market conditions:

Changes to margin requirements are a routine part of market surveillance at CME Clearing, the risk management and compliance unit at CME Group Inc. (CME), which owns Nymex. So far this year, CME has issued over 57 margin change notices.

“I don’t agree that the margin change was a trigger for changes in the market,” said Kim Taylor, president of CME Clearing. Taylor leads a team of sever hundred risk management and compliance professionals who monitor CME’s markets around the clock.

“The market is well tuned so that if there’s a market move that approaches or exceeds our volatility limits” participants know to expect an increase in margin requirements, she said.

The decision to alter trading margins on a contract typically involves risk management professionals involved in day-to-day monitoring of the specific market as well as senior management of the clearing house. The team looks at a variety of quantitative factors like rising volatility and qualitative factors like seasonality and relevant news events in making margin decisions.

“We try to make changes in a way that we can telegraph to the market, so that participants have notice. We try to be routine and predictable and provide no surprises,” Taylor said.

The trading margins are designed to cover around 95% of expected losses, and act as a pre-payment on the coming day’s market move.

“When market conditions become more volatile we would increase margins in anticipation of that, and when volatility decreases we don’t want to create unnecessary capital costs,” Taylor said.

In past instances, CME Clearing has often raised trading margins ahead of certain events in an attempt to damp their impact on trading. For example, the exchange-operator increased trading margins on several products, including crude oil, ahead of Hurricane Katrina to ensure traders were prepared for higher volatility .

“We try to be proactive with either something we can measure or something we can judge to likely effect our markets,”

This is sensible, in a way that I’ll explain in a moment, and the way that CCPs usually act.  Taylor tries to emphasize that the changes are predictable, and in some respects they are, but this is not sufficient to relieve CME of the charge that margin changes can cause market movements.

The changes that CME made, and which Kim explains, are sensible in a microprudential sense.  They help ensure that the CME has a sufficient buffer to absorb defaults by traders.  CCPs try to work on the “loser pays” model, and with more volatility, there are bigger losers–so margins have to be higher to ensure they can pay.

But the implicit assumption here is there isn’t feedback between margins and prices.*  Indeed, that’s the gravamen of Taylor’s argument (“I don’t agree that the margin change was a trigger for changes in the market”).  That is the essence of a microprudential approach.  That assumption, however, is quite tenuous, and almost certainly untrue.  This is particularly the case for big margin changes during unsettled market conditions.

That is, when setting margins, CCPs (and participants in bilateral markets too) typically act as if they are price (and volatility) takers, when in fact they are big enough and their decisions are material enough to be price and volatility makers.  Acting microprudentially, they typically fail to take into account the feedback between their decisions and market prices, or at least do not do so completely.

The feedback mechanism works because frequently market participants will respond to margin changes by liquidating positions.  Those who have already lost money as a result of big price moves are the most likely to liquidate, which tends to exacerbate the original moves.  That’s one reason why you can see bigger than expected moves (as occurred in oil last week) to fundamental shocks.

This is why CCP policies that are prudent in some sense can be macroprudentially dangerous.  Silver, and perhaps oil and other commodities, may be providing an object lesson of what is in store when clearing is extended to vast new markets.  When OTC clearing mandates kick in, the scope for these destabilizing feedbacks will expand dramatically.

Kim suggests that predictability mitigates these impacts, but CCPs are not that predictable, and margin methods are not necessarily that transparent.  So market participants cannot foresee the changes perfectly.  And even if they could, all this means is that they will likely react in anticipation of margin changes. The timing of the response may depend on predictability, but not the existence of the response.

This can create some really strange dynamics and non-linearities.  There’s a big selloff.  Longs anticipate that in response, CCPs will raise margins.  Those that have lost a lot of money know they can’t afford the higher margins, so they preemptively liquidate, exacerbating the selloff.  The bigger price move induces the CCPs to raise margins more than they would have without the preemptive liquidations.

This is exactly the kind of feedback mechanism that can induce chaos (in the technical and conversational senses of the word) in a tightly coupled system like a financial market. This mechanism is particularly prone to chaos if the CCP setting margin doesn’t take into account, or cannot predict accurately, the feedback between its margin changes and the trading of market participants.  And how could it know this effect with any accuracy?

This is a classic example of the tension between microprudential and macroprudential policies that I discussed in some earlier blog posts, and which is a major theme in my forthcoming white paper/discussion paper on clearing.  (This should be available within a week to ten days, if all goes well: final edits and approvals are in the works.)  The information and incentive structures tend to induce microprudentially sensible actions based on the price/volatility taking assumption.  But those actions can be destabilizing. CCPs acting in their own self-interest, and those of their clearing members, may not choose the systemically optimal actions.

It’s worth noting that the CFTC’s Proposed Risk Management Standards for Designated Clearing Organizations effectively codifies this sort of behavior.  Its proposed rule (a) requires that CCPs set margins “actual coverage of the initial margin requirements produced by such models, along with projected measures of the models’ performance, shall meet an established confidence level of at least 99%”, (b) determine the adequacy of margins on a daily basis, (c) backtest the adequacy of margins on a daily basis for products experiencing “significant market volatility,” and (d) backtest the adequacy of margins for all products at least monthly.  Similarly, both the Federal Reserve’s and the SEC’s proposed regulations require the use of risk-based models and at least monthly review of margin levels.

All of these requirements are microprudentially sensible, but will result in margin increases during periods of heightened market volatility.  As just noted, this can create destabilizing feedback effects, particularly during periods of extreme market volatility.

In contrast, the Committee on the Global Financial System recommended the use of a “through-the-cycle approach employing data from a long time series of market movements” when setting initial margins, precisely to reduce the procyclicality in margin that results from adjusting it frequently based on changes in market risks.

Which means don’t look at last week’s commodity mini-crash, or the earlier bigger crash in silver, as historical events.  Look at them as harbingers, as warnings.  Just the normal operation of a tight, mechanical variation margin process can be destabilizing.  Changes in initial and maintenance margins adopted in response to big price moves can destabilize things more.  The financial system can shake off such an occurrence in a market as small as silver, or even one the size of oil.  When it’s a bigger market–and especially when it’s a much bigger market, like some of the huge OTC markets–these changes will shake the markets, perhaps by more than they can withstand.

*Failures to account for feedback between one’s behavior and market prices is a common element in many market crises.  For instance, LTCM’s risk models–like most models in finance–presumed that the hedge fund was a price taker.  But once it became huge, it was no longer a price taker; its trades moved prices and affected liquidity.  Similarly, portfolio insurance strategies took price processes as exogenous, when in fact the strategies themselves affected prices.

The LME has announced that it is considering severing its clearing relationship with LCH.Clearnet (a relationship that goes back to the Tin Crisis of the 1980s) and setting up its own clearinghouse.  This is a perfect illustration of the disconnect between market participants on the one hand, and regulators on the other.  Regulators are extremely suspicious of the “vertical silo” model, but exchanges are migrating in that direction: recently, ICE, EuronextLIFFE, and LSE have set up or moved to set up integrated clearing operations.

As I wrote years ago, both on the blog and in some academic work, vertical integration makes sense for exchanges on transaction costs grounds, even though it involves the sacrifice of some margining and netting economies, especially for relatively narrow exchanges like the LME or ICE (less so for multi-asset class exchanges like CME or Deutsche Borse).  Regulators seem a little slow on the uptake about this point, being instead haunted by hobgloblins screeching that integrated CCPs are anti-competitive (and thereby ignoring well-understood economics).

Moreover, this brings home a point I made in some things I’ve written over the past couple of years about the uncertainties of the evolution of market structure in the aftermath of Dodd-Frank and EMIR.  For instance, in the Journal of Applied Corporate Finance I wrote that “strategic considerations will influence decisively the way that the industry develops.”  By that I meant exactly that transactions-cost driven decisions regarding CCP ownership would play an important role in the industry evolution.  What’s more, these decisions will have implications for the costs and benefits of clearing, and the systemic risk effects of clearing mandates.

The financial markets are an extremely complex system.  Market participants will make decisions regarding things like clearing arrangements based on private costs and benefits, even though those will have systemic effects not internalized by the decision makers.  Legislators and regulators overlooked this almost entirely when deciding that clearing was the magic solution to counterparty risk.  As a result, they have unleashed a process that will have unintended consequences that will in turn spark regulatory and legislative responses.

This process has just begun.  It’s already complicated, and will get more complicated in very short order as dreamy regulators and legislators butt up against commercial reality.

The CFTC and SEC have released their swap definitions. Among other things, the CFTC rule excludes commodity forward contracts from the swap definition.

The CFTC proposed rule is 300 pages long.  Do you believe that such a massive attempt at definition will not have ambiguities and uncertainties that will require clarification?  Do you believe that market participants will not try to write contracts to take advantage of exclusions and exemptions, and that these attempts will not result in litigation?  Do you believe that a rulemaking that is far broader in its application than pre-CFMA laws and regulations  will not result in the growth of a thicket of decisions, interpretive letters, no action letters, etc., that will be more confusing and more contradictory than that which developed prior to 2000 (before the passage of the CFMA) to clarify the distinction between “futures” that had to be traded on exchanges and commodity forward contracts that didn’t?

If so, have a nice dream.  Reality will be waiting for you when you wake up.

The Commission also voted out a proposal for a hybrid margin segregation mechanism, where customer funds would be segregated operationally (i.e., held in a single account), but would not be at risk to a the default of another customer.

This is a victory for BlackRock and other big money managers who lobbied hard for it.  And yes, they are winners.  But make no mistake, the main effect of this rule is redistributive, meaning that there are losers.  And to the extent that it affects efficiency, the effect is negative because mandatory segregation encourages moral hazard: clearing member customers now have zero incentive to monitor their clearing members.

The distributive effect arises from the fact that removing customers from default risk mutualization means that default losses are just shifted elsewhere, e.g., CCP equity or the CCP’s default fund.  Alternatively, CCPs may choose to up margins to reduce default fund exposure to customer defaults.

The costs of default don’t go away.  They are mainly shifted around.  Low default risk firms (e.g., BlackRock, pension funds) will no longer be at risk and will benefit.  But somebody else will pay.

A much preferable approach would be to establish omnibus segregation as a default standard, but permit clearing members and their clients contract for individually segregated accounts .  This would permit those who value segregation more highly than it costs clearing members to segregate to negotiate mutually beneficial arrangements with clearing firms.  Such contracts would reflect information available only to the contracting parties, but which regulators could not know when setting a one-size-fits-all standard.

This would internalize (i.e., price) many of the costs of segregation which  under the CFTC proposal would be shifted to default fund participants (i.e., other clearing members) and from some customers (the BlackRocks of the world) to others.

For instance, if a large money manager and a clearing member negotiate a segregation arrangement, this would shift risk to the member’s other customers, and to the CCP default fund. The shift in risk to other customers would tend to reduce their demand for the member’s services, leading this firm to internalize some, and perhaps all, of the effects of this risk transfer.

However, the risk transferred to the default fund would not necessarily be priced.  This problem could be addressed by allowing the CCP to set default fund contributions based on segregation, with members with larger sums in segregated accounts being required to make a larger default fund contribution.

I don’t understand the mania for one-size-fits-all rules when private contracting can result in efficient outcomes that take into account individual differences.  Derivatives market participants are by and large quite sophisticated, and capable of trading off the costs and benefits of alternative arrangements, including alternative segregation arrangements.  Permitting individualized negotiation which prices these costs and benefits–which differ among market participants–is the most efficient and effective way of ensuring they optimize that trade off, and do so in ways that reflect differences among them.  Let CCP members who participate in the default fund come up with methods that internalize the potential spillover between segregation and the default fund.

One size fits all rules create a tremendous incentive for affected parties to influence the rulemaking process for their benefit.  BlackRock, Pimco, some big pension funds, etc., seem to have done that in this instance.  They’ve secured a rule that protects them from some risks–by shifting those risks to others, not by reducing them (in fact the overall risk likely has increased due to moral hazard).  The outcome is affected by the costs and benefits of exercising influence, not by the economic costs and benefits of alternative segregation mechanisms.

This is another example–as if we needed more–of a prescriptive regulation dictating an allocation of resources that is perfectly amenable to private contracting.  And one where there are no obvious barriers to private contracting, and where as a result such contracting would lead to an allocation that balances efficiently costs and benefits.