Streetwise Professor

Can you say that any more?  Well, even if use of the word “retarded” is increasingly frowned upon, there are some special cases in which its use is so evocative, and hence so appropriate, that it should be blessed.

The compromise on the Lincoln amendment is one such case:

The bill also includes a provision, authored by Sen. Blanche Lincoln (D., Ark), which would limit the ability of federally insured banks to trade derivatives. This provision almost derailed the bill following vehement objections from New York Democrats. Ms. Lincoln worked out a deal in the early hours of Friday morning that would allow banks to trade interest-rate swaps, certain credit derivatives and others—in other words the kind of standard safeguards a bank would take to hedge its own risk.

Banks, however, would have to set up separately capitalized affiliates to trade derivatives in areas lawmakers perceived as riskier, including metals, energy swaps, and agriculture commodities, among other things.

Under any modern understanding of what “risk” means, this makes no sense.  Ever heard of diversification, or the fact that “risk” of a particular position is attributable to its contribution to the payoff distribution of the entire portfolio of risks, not anything inherent to the position itself?  (Meaning that even if energy prices are volatile, doing energy swaps may not be that risky in a portfolio context.)  Under any modern understanding of the economics of financial intermediation (in which information about counterparties is vital) this makes no sense either.  (Meaning that the costs of intermediation are lower if information obtained in trading one instrument with a counterparty can be used when dealing in other instruments.)  Under any modern understanding of counterparty risk, where maximizing netting opportunities can be quite valuable, this makes no sense; splitting up businesses in an arbitrary fashion like this reduces scope economies from netting and other things.  It also makes no sense even on its own terms, because yes, banks use interest rate and credit derivatives to manage their own risks, but from my understanding of the provision, banks will still be able to be dealers in these products, and the whole basis of Lincoln’s proposal (to the extent that it had one) is that dealing is a particularly risky activity.  Not that I am buying into that argument; I’m only pointing out that is that’s what you believe, this provision is contrary to that belief.

This is transparently a compromise to save the face of a senator in over her head, who made a wild legislative proposal to stave off a primary challenge.  The banks were willing to throw a couple of bones in order to save their biggest books; metals, energy, and ags are small potatoes compared to interest rates and credit.  Lincoln gets to do what senators do best–pose.  The banks largely escape major damage.

Even by sausage making standards, this is revolting.  It is good that the most egregious parts of the Lincoln proposal have been jettisoned.  It is bad news, however, for liquidity and hedging in the disfavored products, especially commodities.  This, along with the position limit measure in the bill, and the clearing mandate, will increase the costs of managing commodity price risks in particular.

All pain, no gain: the only thing that can be said is the pain could have been a lot worse.

Igor Sechin is on a charm campaign.

Let me repeat that.   Igor Sechin is on a charm campaign.

There is a long piece about him in a recent FT:

As Russia seeks to shake off an economic crisis that wiped out layer after layer of the oil-fuelled gains of the Putin era, Mr Sechin – viewed with fear and awe for overseeing the state takeover of the strategic heights of the economy – is striking a new, surprisingly accommodating tone. The Kremlin, taken aback by how vulnerable Russia’s oil and gas-driven economy proved to be to the global financial crisis and recession, has started to change its tune.

I said Sechin is trying to be charming.  I didn’t say that he had gone so far as to actually tell the truth, or anything.  In fact, he makes a couple of complete howlers.  One relates to how Rosneft, and other Russian state  energy companies, came by some of their prize assets:

In his first public comments on how the reinvigorated Putin state managed to recover important energy assets from oligarchs who picked them up cheaply during chaotic post-Soviet privatisations, Mr Sechin says these properties were not “repossessed”. It was, he insists, a legal process where state companies paid market prices for assets that are now managed no differently from private ones.

Riiiiigggghhhhtttt.  Legal process.  Market prices.  Uh huh.  Tell me another one, Igor.

So he obliges:

Russia’s state-controlled companies cannot use their resources as political weapons, or “instruments to put pressure on consumers” as he puts it. The likes of Rosneft and Gazprom are, he adds, “normal public companies, working under international laws, and this makes it impossible for them to break their obligations to consumers”.

Stop it, you’re killing me!

But he can’t stop:

Russian companies are not subject to state fiat in the same way as national oil companies set up by the world’s other big producers.

“When we speak with our colleagues from Opec, they say that Russia should operate quotas just like they do. I tell them that unfortunately we have no such instruments, because Russian oil companies are private companies. Even those that are partly state-owned are private companies. They are working in the conditions of the market and have obligations to their partners which do not allow them to take unilateral decisions.”

Sechin has been peddling this line going back to late-2008, when he was playing Lucy and the football with OPEC.  As I wrote then, and in early-2009, it is complete tripe.  Not that I WANT Russia to cooperate with OPEC, but even given that it has some “private” companies rather than completely nationalized oil sectors, Russia can control exports at a whim, and has the policy tool to do so: its export duty.  By raising the export duty, Russia would reduce export volumes, just as by reducing output national oil companies can reduce export volumes; both actions raise the world oil price.  Russia tweaks its oil export duty all the time.  It adjusts other export duties as well, in order to achieve policy objectives.

In brief: if Russian (and Sechin) wanted to coordinate output with OPEC, it would have no difficulty in doing so via the export duty.  The truth is, it doesn’t want to coordinate output with OPEC; it doesn’t want to cut Russian output.  Quite rationally, Russia wants OPEC to bear all the costs of supporting world oil prices by cutting OPEC output, and to reap the benefit by producing as much as it can.  That’s what Russia has done.  Like I say, as a net short, I (and the US) benefits from Russia’s action; the world is a better place for it.  But it doesn’t do Sechin’s credibility any good for him to tell such laughable falsehoods.

Perhaps Sechin’s choir boy act indicates that finally, Russia has learned that you catch more flies with sugar than gall.  Perhaps.

But I wouldn’t consider this to be a sincere conversion.  It is, at best, a pragmatic trimming in response to changed economic and political conditions.  And if and when those conditions change again, don’t be surprised if the Old Igor, the Bad Igor, returns, fangs bared.

Whether it is with Sechin or Lavrov or Putin or Medvedev: anyone who puts their faith in their more moderate statements does so at their peril.  For as Sechin demonstrates, even when he tries to act nice, he does so with a stream of falsehoods.

I’ve been incommunicado for several days, up in the Austrian Tyrol, where the internet is but a rumor, for the most part.  (Yes, TRex, there are parts of Europe where internet access is difficult, at best.)

The weather was appalling, but the valleys I visited were stunning.  Even though the highest peaks were shrouded in heavy cloud, and I had only glimpses of the rocky and glaciated summits, the views were spectacular.  Makes me wish I was a skier, although some of the slopes look downright suicidal.

Like I say, the weather was bad.  Under 10C in the valleys, with a constant drizzle: exactly freezing at 2000m, an elevation I reached via a ski lift.  There was snow both evenings at elevation: today starting about 1800m there was about 10 cm of wet, heavy snow.

Not exactly what I was expecting on the first days of summer, but that’s life in the mountains.  Enough to whet my appetite for a return visit.

The trip to the area south of the Inn followed a very enjoyable three days of teaching in Geneva, at HEC (Hautes Etudes Commerciales) of the University of Geneve, in Geneva, Switzerland.  I taught a specialized course on commodity price modeling for a masters program in commodity markets and trading, with 17 students from all parts of the commodity business and all types of commodity firms.  It is a pleasure having self-selected students who have an intense interest–and career prospects–in the rather arcane subject I teach.  The students were enthusiastic and active.  I look forward to repeating the experience next year.

I’m now in Nurnberg, Germany, on my way north to participate in a ceremony in a street will be named for one of Mrs. SWP’s great-grandfathers in a little town called Rotenberg am der Fulda.  Ironically, one of my GGGFs came from the same area–Kassel.  Then off to see the areas from whence the Pirrongs (or Pirrungs or earlier than that, Pierrons) lived before seeing the light and decamping to the US: namely, the countryside east of Saarbrucken.  Then perhaps a side trip to Strasbourg.

Matt Leising and Shannon Harrington report that smaller firms are accusing the big dealers of blocking access to clearinghouses:

Rules intended to lessen the risk of a systemwide failure are “working to restrict access to only the incumbent dealers,” the Swaps and Derivatives Market Association said in a statement sent today to Theo Lubke, senior vice president at the Federal Reserve Bank of New York. The group of more than 20 brokers including Jefferies & Co., Imperial Capital LLC and Newedge USA LLC formed in February to lobby Congress and regulators for access to derivatives clearing.

Intercontinental Exchange Inc., CME Group Inc. and other companies that operate clearinghouses for the $615 trillion privately negotiated derivatives markets enforce capital requirements and trading rules intended to bolster the ability of the clearinghouses to withstand losses. Those requirements, though, prevent all but the world’s largest banks, including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Barclays Plc, from sending trades to the clearinghouses, according to the statement by the brokers group.

“The effort to protect clearing, however, is actually a proxy war to limit competition to the incumbent dealers’ $100 billion in profits for derivatives execution,” the brokers group said. Mike Hisler, a spokesman for the association, and Ray Zorovich, the group’s policy assistant, are listed as contacts on the statement. Hisler also is a partner at New York- based Hexagon Securities LLC, a member of the association.

This was only a matter of time.  I’ve written academic articles dating back well into the 1990s that in the presence of large scale economies in a particular service (e.g., trading), including scale economies arising from network effects, a suboptimally small coalition of suppliers can form a cooperative firm that offers this service (see, for instance, my 1999 J. of Financial Markets and 2002 J. of Law, Econ., and Org. articles).  The cooperative is smaller than optimal, but just big enough that no competing coalition can form because it cannot achieve the same scale economies.  Because it is suboptimally small, and faces no competition, the members of the dominant coalition/cooperative firm earn rents.

I applied this argument to clearing in the early-2000s, and again in a couple of papers done in 2007 and 2008.  So, what Matt and Shannon report is no surprise to me.  None whatsoever.  It was a direct implication of the work I’ve done for going on 15 years.

Indeed, when many asked me whether dealer opposition to clearing was motivated by their desire to limit competition, I would often reply that forming a clearinghouse that limited entry was perhaps the best way to cartelize the industry, and make even more profits.

But that’s not the end of the story.  I’ve also written that there are good economic reasons to limit entry into a clearinghouse.  In particular, rigorous financial requirements are necessary to ensure the safety and soundness of the CCP.  Moreover, I’ve also written that the transaction costs/organizational costs of operating a clearinghouse will be greater, the more heterogeneous the membership: this provides further justification for limiting membership to a relatively homogeneous group of firms.  Setting margin, capital levels, etc. is more difficult, and the process more rancorous, the more heterogeneous the membership.  (The effects of heterogeneity on governance was the focus of my 2000 JLE piece on exchange organization.)

In brief: just as is the case in virtually all trading services, market structure issues in clearing are extremely, extremely knotty because of the pervasive scale and scope economies.  The pronounced scope and scale economies create opportunities for the exercise of market power, most notably by the formation of cooperative firms that restrict entry and face no competition.  This is the way that exchanges earned rents for their members for years, and years, and years.  At the same, time, open entry is particularly problematic for CCPs given the effects of heterogeneity on governance costs, and the extreme importance of financial stability.

Battles over market structure in securities have been raging for decades, due in large part to similar considerations.  Ditto recently in futures markets.  (Note the battles that raged over the CME-CBT and CME-NYMEX mergers.)

Note that this battle over entry is going to create serious legislative and regulatory conflicts because, as I have pointed out ad nauseum (including in a forthcoming Policy Paper for Cato) there is a fundamental tension between enhancing competition and reducing systemic risk in CCPs.  Conventional political economy considerations are going to play out here.  The pressure of the SDMA and other firms will inevitably lead to regulatory interventions that will open up entry and access, and thereby threaten to compromise the financial soundness of CCPs.

The irony is almost too much to take.

There are no free lunches.  None.  Only very difficult trade-offs.

Is their any evidence that any legislator or regulator has given serious consideration to this problem?  Not that I’ve seen.  But now, with clearing mandates on the horizon, there will be years of knock down-drag out fights over CCP rules, membership requirements, etc.  At every turn, there will be a tension between the systemic risk issues and the competition issues.  The results will not be pretty: they will be driven by the political economy considerations that dominate all such issues.  Economic efficiency and the soundness of the financial system will take a back seat, a distant back seat, to rent seeking.  We know how that usually works out.

No regulator or legislator can say that s/he wasn’t warned.  They just weren’t paying attention, or thinking seriously about the subject.  Oh yes, they said: just mandate clearing and we can go live on the big rock candy mountain.  As if.

For some reason Mark 6:4 just popped into my head.

I think I’ve made the analogy before on SWP, but it bears repeating.  There’s an old story about the Indian village that is beset by mice, and brings in cats to get rid of them.  The village is soon overrun by the cats, so they bring in dogs to scare off the cats, but then the dogs become a plague, so they bring in the elephants . . . and then realize that mice weren’t such a bad problem after all, so they bring back the mice to scare off the elephants.  The moral: short sighted “solutions” to a problem adopted without consideration of all of the consequences can lead to worse problems than you started with.

The criticism of CCP membership problems is just a harbinger of things to come: after too long, the mice might look pretty good by comparison.

Apparently Gazprom’s Alexei Miller didn’t get Putin’s memo on spot markets as the cure to all your commodity contracting ills:

Addressing the annual European Business Congress in France for the first time since 2008 – when he predicted oil prices would soar to $250 per barrel – Mr Miller said sales had recovered in the first few months of 2010, “but the month of May has seen the positive trend reversed. As we see, financial turmoil in the eurozone has started to affect energy markets”.

Swiping at those pressing for linkage to spot prices, Mr Miller said this price could soon rise as demand recovered, while Gazprom’s long term contracts offered greater stability.

“In several cases we have agreed to take into account the spot market component,” he said. “But please note: when in a couple of years the market bounces back, do not ask us to revert to previous price practices.”

Tying gas prices to oil made some sense when (a) these things were closer substitutes, and (b) there was absolutely no spot market in gas, but a well-developed oil spot market.  The case, on transaction cost grounds, for utilizing oil as a pricing benchmark for European gas is far, far weaker when there is a growing (organically) spot market for gas in Europe.

Miller is, surprise, surprise, talking his rather large, and underperforming, book.  With weak demand and surging supply for gas, the relation between gas values and oil prices is far weaker than it was only a couple of years ago.  Miller wants to live in the past, and keep on pricing like it’s 2007.  But it’s not, and it’s not likely to be for a long, long time.  Demand looks to be weak for an extended period, especially given Europe’s current economic ferment, and the supply situation has been turned upside down by shale gas and its concomitant effects on LNG flows.  Oil and gas have diverged, and not in a way that is favorable to Gazprom.  Miller way want to hold back the tide, but the pressures on the existing pricing mechanism are likely to grow over time, and rapidly.

Perhaps recognizing this, Miller tries to rain on the shale parade:

In his speech, Mr Miller also sought to dispel what he said were “myths” that a recent surge of LNG and the rapid development of shale gas in the US could threaten Gazprom’s position on global markets.

Citing high investment requirements for developing shale gas deposits and “low output at wellheads”, Mr Miller said shale gas could only serve as a replacement for the depletion of local traditional gas production. “There are no reasons to crown it and elevate it to the throne,” he said.

Hmm.  Then why is Gazprom moving into shale?  And more importantly: the markets apparently think quite differently.

And speaking of “depletion of local traditional gas production”: where is Gazprom going to replace its depleting local traditional gas production?

Last August, I wrote a post titled “Not Tall Enough to Regulate” in which I skewered CFTC Commissioner Bart Chilton.  He was very peeved.  He’s not going to be any happier about this post, because he hasn’t changed his mind, nor have I.

This weekend’s WSJ has a semi-fawning story on Chilton, focusing on his advocacy of position limits–and the endorsement thereof in the House and Senate bills currently in conference.  The article gives Chilton an opportunity to explain his position.  His utter failure to do so, which implicitly implicates the entire position limits initiative both at the CFTC and in Congress, speaks volumes about the intellectual bankruptcy of the pro-limits side.

Here’s what the article says (emphasis added):

The volatile summer of 2008, when $145-a-barrel oil led to $4-a-gallon prices at the pump, was the pivotal moment for the Midwesterner. Mr. Chilton says he largely ignores prices, but the surging cost of oil changed his mind. “I’ve seen nobody who can justify $147 [a barrel for crude oil]. It doesn’t mean the massive passives are the sole culprit. I think they’re having an impact. As regulators, it’s our job to be asking these questions,” he says. Mr. Chilton pushed the CFTC to propose position limits that would prevent traders from having a large concentration in energy contracts for four of the most highly traded commodities at the center of the global energy market.

“Position limits that are reasonable,” Mr. Chilton says, “would end the possibility of large concentrations in individual markets that could inordinately influence price.”

. . . .

In July 2008, the CFTC staff issued a report saying that financial traders weren’t driving oil prices higher. Mr. Chilton was infuriated and publicly called the report “deeply flawed.” Today, he charges the report was “political” and done to appease Republicans.

Mr. [Dr.] Harris says, “There was no political pressure from any party. We looked but we couldn’t find any smoking gun. There were a lot of people working hard to find out what was going on. We had dedicated economists and their reputation was more important than political pressure.”

Possibility.  Could.  I think.  A refusal to take seriously empirical evidence, or to critique it rigorously, and a complete failure to provide any of his own.  Ad hominem accusations of politicization when competent economists–which Chilton certainly is not–did not give the answer he wanted.  (This is particularly rich from a political lifer who owes his position to long service as a Senate staffer.)

This is the basis for major policy changes that could have serious effects on the market?

I have a piece on position limits coming out in Regulation titled “No Theory?  No Evidence?  No Problem!”  That’s Chilton (and to a large extent, Gensler, and most of the Senate) in a nutshell.  Any cogent–or even coherent–theory of how speculators are influencing prices?  No.  In particular, any cogent/coherent theory of how passive traders–buy and hold traders so beloved in securities markets–cause prices to increase 100 percent in a period of months?  Surely you jest.  Any empirical evidence to support the claims that speculation and/or passive traders have distorted prices?  See above slander of CFTC economists, along with the CFTC position limit NOPR, for illustrations of the “we don’t got to show you no steekin’ evidence” attitude of Chilton et al.  He just “thinks” it’s “possibly” true–that’s enough, dontcha know.

Here’s a guy who has never been in the markets, and who has never seriously studied markets (“he largely ignores prices”), declaring that prices are somehow wrong.  He wants to restrict the market in order protect against the theoretical possibility (and a theoretically ungrounded theoretical possibility at that), but does not give serious consideration to the far more realistic and likely deleterious effects of the limits on liquidity, hedging, and price discovery.  His justification for the “crowding out” provisions are particularly inane, and not based on any serious economics analysis.

As I point out in the Regulation piece, markets aggregate massive amounts of dispersed information, so it is impossible to explain–“justify”–exactly why prices are what they are.  If it were possible, we wouldn’t need markets to discover prices. That’s why debates over speculation never end: you can’t prove or disprove that the price was right.  Bob Barker doesn’t give you the answer just before going to commercial.

But we know that people spend tremendous time and resources to develop information about values–arguably too much time and resources–and that through trading decisions, this information is embedded in prices.  Moreover, since prices guide the allocation of resources, distortions in prices should result in distortions in quantities–something which (as I point out in the Regulation piece)  were not observed in the commodity price boom and bust.  Commodities are different than say, internet stocks: they are consumed and produced every minute of every day, and distortions in prices will distort those decisions–and such distortions are noticeable.  And if speculators are overpaying–they’ll end up owning the stuff.  None of that happened, and Chilton and others have failed even to acknowledge the issue, let alone confront it.

There should be a pretty high bar to overturn the operation of markets.  Any such action should be based on serious economic reasoning and sound empirical evidence.  And no, deep musings during guitar picking sessions or boat trips to restaurants don’t count.

Yesterday Putin did his best King Canute impression, and ordered a group of financial regulators, including the finance ministry, to draft plans for an exchange to trade steel, coal, coking coal, and other metals.  By 1 August.  Putin believes the exchange will, in the words of the Moscow Times article just linked to, “avert price rows between producers and industry.”

In other words, even though no exchange anywhere has created successful spot or futures markets for steel and coking coal, and really for thermal coal either, in the 150 odd years since the advent of modern futures trading, Putin has commanded that Russia, which has never really created a successful commodity exchange for anything ever, do it in less than 2 months.

Yeah.  Right.

My reference to Canute was a slight to Canute, of course.  The Danish (English/Norwegian/Swedish) king knew that he couldn’t make the waves cease their beating: he just wanted to make the point to court sycophants.  Putin, by contrast, apparently thinks that his command will make it so.  I can just imagine the furtive and panicked looks between those in Putin’s audience charged with implementing the (impossible) task.  I can also imagine the “jump? how high boss?” responses to his command.

This is another case of Putin, Man in a Hurry, as I dubbed him soon after I began this blog.  It is clear that he has tired of the squabbling between the upstream and downstream firms in the Russian ferrous metals sector.  He evidently believes (or at least hopes) that a command that a market magically appear will relieve him of mediating this conflict to maintain the equilibrium in the natural state.

Ain’t gonna happen.  Markets don’t just magically appear.  As has been documented in the academic literature, most notably by Dennis Carlton, auction type futures markets are devilishly hard to start.  Far more contracts fail than succeed, despite the concerted efforts of experienced exchanges to identify the most promising candidates, to work to design contracts that will suit the needs of the target industry, and to build industry support through favorable fees, liquidity support programs, etc.

Steel and coking coal are particularly challenging for a variety of reasons.  “Steel” is not a homogeneous product, but consists of a dizzying array of differing physical types and shapes.  Some kinds of steel, e.g., scrap, are fairly standardized and traded, but its prices don’t necessarily track the prices and values of other types of steel.  Coking coal is also characterized by substantial differences in grades and uses.  Moreover, for coal in particular, location matters because it is relatively expensive to ship.

Industry structure matters too.  Futures markets tend to work best with relatively disaggregated value chains, where the same product is often bought and sold repeatedly, and where there is relatively little concentration on either the buy or sell sides.  (Structure is not independent of product characteristics, of course.  Relatively homogeneous goods tend to have a larger number of buyers and sellers, and greater turnover, than more specialized goods unique to one producer or tailored to fit the needs of a particular consumer.)

Firms in an industry will not necessarily support the introduction of more transparent pricing mechanisms, either, as Carlton points out in another paper.  The steel industry has been quite outspoken in criticizing plans for steel and iron ore derivatives markets.  (India’s Tata Group is a good example of this.)

I would imagine all these factors go double in Russia–if not more than double.  With central planning, the absence of a free pricing mechanism, and a preference for giganticism, Soviet firms tended to be few in number and dependent on a small number of suppliers and customers.  Moreover, just as was the case with the US electricity business prior to deregulation, integration and price regulation led to patterns of investment in plant and equipment that tended to create holdup problems; Steel plant S was highly dependent on coking coal from mine M because the lack of freely negotiated prices meant that outside options weren’t that valuable in constraining opportunism.  (In US electricity, firms that supplied both generation and transmission didn’t worry about holdups between these two stages of the value chain, and hence created generation and transmission infrastructures that were subject to bilateral monopoly problems when the products were unbundled in deregulation.)  Russia inherited this structure, but then eliminated the central planning and price control that was necessary to keep transaction costs  in check.  Hence Putin’s pricing problems.

In Russia, the holdup problems inherent in the mismatch between the pattern of capital investments made when government control over prices suppressed (but didn’t eliminate) pricing disputes, and the pattern that firms would choose if they had to worry about opportunism problems, has exacerbated the price conflicts that are vexing Putin.  But the problem is that saying “presto, change0, make me an exchange-0” doesn’t make these fundamental problems go away.  Indeed, they are antithetical to the effective operation of a centralized spot or futures market.  And what’s more, the prices for the stuff not traded on exchange–which would be most of the steel and coal products actually produced and consumed in Russia–would still have to be negotiated between the parties.  Yes, centralized market prices would provide some information about the underlying fundamentals that affect the values of steel, etc., but there would still be considerable room for dispute about the price relationships between the standardized and non-standardized products.  As a result, there would still be considerable potential for holdup.

I would imagine this plan will go nowhere, as it is as futile as commanding the tides to stop.  It is futile because it ignores all of the transaction- and product-specific features of the products in question, and the necessity of structuring transactions in ways that respect these features.  Putin is apparently like Gary Gensler, who thinks that auction markets should be good for everything, when experience (and economics) shows that they are really good for very few things indeed and pretty much unworkable for everything else.

Putin’s heavy metal headache is a fitting curse for a Sovietophile who is enamored with raw materials and basic industries and who has been the enemy of property rights and the rule of law.  He is suffering this malady in large part because of (a) an industrial structure inherited from Soviet times, and (b) the inability of Russia to move beyond its resource focused development, which (c) which reflects in no small part the fact that the precariousness of property and legal rights in Putin’s natural state is an anathema to entrepreneurship and tends to favor the persistence of oligarchic structures because oligarchs can bargain with the state on relatively equal terms, and can thereby protect themselves against expropriation without having to rely on courts.  Putin’s problem, then, is inherent in Putinism.

Irony can be a real b*tch.

So, good luck with that steel exchange thing, VV.  And don’t say I didn’t tell you so.

I find the whole upstream-downstream dispute in the metals markets in Russia very fascinating.  To watch the operation of a slice of the natural state is to understand the whole.  Putin’s role in these events is particularly illuminating.

Putin held a meeting with the head of Russia’s Federal Antimonopoly Service, Igor Artemyev, at which he gave a soliloquy telling how it was going to be.  Most notably, Putin advocated the return to a system of long term contracts with fixed prices (or prices based on a formula—press accounts vary):

The largest producers and consumers of metal could return to the practice of long-term contracts with a fixed price formula, which would rule out the possibility of price hikes. He said that the government believes that the supplies of metal, iron ore and coke to the domestic market should be viewed as a priority.

But as some bank analysts point out, this doesn’t solve the problem.  Fixed prices  are almost always wrong, out of alignment with current market conditions.  Sometimes they are too low, other times they are too high.  One party of the other has a reason to squawk that current prices are out of line.  And with commodities (the role of which in the Russian economy Putin’s soliloquy emphasizes with pride, in a very revealing counterpoint to Medvedev’s embarrassment at Russia’s commodity-centric economy), since prices are very volatile, misalignments are frequently large.

The key thing is that as any good transactions cost economist knows, contracts are first and foremost a part of a mechanism to govern the relationship between the contracting parties.  They provide some structure to the relationship between the parties.  But these contracts are necessarily incomplete, and need a mechanism to respond to developments not anticipated in the contract

Putin gets this, sort of, in an intuitive way:

Disagreements over prices should not lead to the unilateral termination of deliveries or failure to pay, and commercial dispute over contracts must be resolved through talks or arbitration tribunals, without driving partners into a corner.

But crucially, Putin also outlined a state-directed governance mechanism.  As described by John Helmer:

Putin’s fourth point in the pricing formula is a vague undertaking to a new form of state supervision of input costs and state planned price benchmarks, enabling the FAS and the Ministry of the Industry to deter or control sharp price deviations.  “The relevant federal agencies will be instructed, said Putin, “to calculate the economic benchmarks for metals prices and prices for other basic goods and services.”

In brief, Putin is advocating a system in which the state plays an important role in setting and administering prices, and governing contractual relationships between big firms.

This is part of the logic of the natural state.  Competition and conflict over rents is highly destabilizing to such a state.  The state has to limit access, dampen competition, and intervene in the interactions between nominally independent firms in order to maintain stability.

The fact that the most powerful man in the country is involved in these matters intimately, and on a daily basis, also reveals the fundamental political character of these ostensibly economic issues.  The most powerful politician must use his power primarily to maintain the delicate balance between vying factions identified first and foremost by their commercial interests.  Failure to do so–the deluge.

Calvin Coolidge once said “the business of America is business.”  Things are a bit different in Russia.  Of it, it can be said that the politics of Russia is business.

Russian central bank head Sergei Ignatiev claims that the European crisis poses no threat to Russia:

“I don’t think all these events will have a strongly negative effect on the Russian economy,” Ignatiev said at a conference in St. Petersburg today. “The Russian banking system is better prepared for external shocks than it was in 2008.”

The economy is protected by sufficient liquidity, a “much more flexible ruble,” and large international reserves, the world’s third biggest after China and Japan, according to Ignatiev. While the Russian currency reflects external volatility, it can better withstand external shocks than it did before the global financial crisis, he said.

Of course, that’s what Putin, Medvedev, and even my boy Kudrin said said in 2008, when the storm clouds were breaking in the United States and Europe.  And we know how that worked out: rather than being a safe harbor from the storms buffeting other economies, as Putin and Kudrin had claimed, Russia was hit harder than virtually any economy.  Indeed, only months after boasting about his country’s immunity from the world crisis, in a speech at Davos Putin raged at the West for creating a “perfect storm” that had swept over Russia.

Putin’s confidence in September was based on many of the same factors Ignatiev cites, notably its reserves.  But its reserves have been depleted, and its economy has not recovered from its battering in 2008-2009.  There is also considerable reason to doubt his happy talk about the banking system.

It’s interesting to compare what Ignatiev said to what Kudrin said in January, 2008, when the strains on the world financial system were becoming manifest:

Russian Minister for Finance, Aleksey Kudrin, released a sensational statement Wednesday. Speaking at the World Economic Forum in Davos, the Russian minister offered to mitigate the world credit crisis with the help of Russia’s reserves. Kudrin stated that Russia was an “island of stability in the sea of the world crisis.”

“Investors will continue to invest billions of dollars in the rising Russian economy. Stock market crises and their consequences will not be utterly negative for us,” Kudrin said. “Our country managed to achieve economic stability and to save considerable gold and currency reserves which play the role of an air bag for the national economy,” Kudrin said.

Mr. Ignatiev, it appears, has learned nothing, and forgotten nothing.  Russia’s reserves did not save it from the crisis, let alone the world.  Why would Ignatiev think things would be any different a second time around?  That would be a triumph of hope over bitter experience.

If Europe spins downwards, as is still possible, or if China runs into turbulence (trying to deflate asset bubbles, for instance), the same dynamic that ravaged Russia before will do it again.  A recurrence of the financial crisis, this time driven by a sovereign debt crisis instead of a real estate crisis, would again crater demand for Russian material exports, reducing national income sharply and putting added strain on government finances.  The “flexible currency” Ignatiev touts is unlikely to prove so, as the same terror at repeating the 1998 ruble collapse would induce Russia to spend its reserves to prop up the currency.

If you’ve been following the volatile markets lately, you’ll have noticed that oil prices have swooned as worries about the sovereign debt crisis have waxed, and have rallied as these worries have waned (like today).  You’ll have noticed too that the Russian equity market and the ruble have been riding the same roller coaster.

As I said often during the crisis, Russia is a high beta economy.  Due to its commodity price exposure, and the sensitivity of commodity prices to world economic conditions, Russia remains hostage to world economic conditions; when Europe and/or the US and/or China get the chills, Russia catches pneumonia.  The European debt crisis threatens those conditions, and Russia with it.

So Ignatiev is either a fool, or whistling past the graveyard when he responds with such insouciance to the European crisis.  If the European situation turns for the worse–as I think it is likely to do, today’s market euphoria notwithstanding–Russia will awake to the strains of “I’ve Got You Babe” and relive the terrors of 2008-2009.

Last week the Senate passed the financial “reform” legislation, which now goes to a conference committee that will produce a bill that combines the Senate bill with that passed by the House months ago.  (Ironically, the vote came when I was at a very nice conference on financial regulation hosted by Notre Dame.)

The Senate bill is best measured in pounds rather than pages.  (Pounds of what I’ll leave to your imagination.)  It is comprehensive, and from what I can tell, it is comprehensively wretched.  Stephen Bainbridge, whose opinion I respect a good deal, strenuously objects to the nationalization of corporate governance embedded in some of the bill’s language.  The infamous Lincoln swaps provision, which I’ve written about, is a horror.  It is some kind of sick joke to remake the entire derivatives market–and the banking sector–with a transparently populist ploy heaved up by a rather undistinguished senator (but I repeat myself) from Arkansas in a desperate attempt to stave off a primary challenge.  (Said ploy being incompletely successful, with Blanche Lincoln facing a runoff against her more lefty opponent.  Which probably gives the provision continued life when it should be put out of our misery with all dispatch.  The joke is even sicker when one considers that if current polls are at all accurate, Lincoln will be demolished in the general election.)  The clearing mandate is also a disaster in waiting.

Rather than deconstruct the whole abortion, I’ll focus on a couple of (relatively minor, in the scheme of things) features that illustrate its intellectual incoherence.

The first relates to market manipulation.  Here is a place where Congress could do some good by rewriting the existing law.  As I’ve written extensively over the past 15 plus years, US manipulation law could use a serious overhaul.  I’ve made concrete recommendations, including in a recent article in the Energy Law Journal.

But instead of doing something reasonable, the Senate passed an amendment proposed by the aptly named Senator Cantwell that does the exact opposite of what I recommend in the ELJ piece.  Specifically, apparently lacking the ability to form an original thought, Cantwell and the Senate fire up the copy machine and essentially Xerox the anti-manipulation language in the Securities and Exchange Act.  The amendment (S3348) outlaws “any manipulative device or contrivance.”

Boy, that’s such a big help.  Makes things crystal clear, no?

Look, a major problem with US commodity manipulation law is its complete failure to define what is  manipulative, and to provide courts and commissions with any guidance as to just what kinds of conduct are manipulative, and what tests should be applied to make that determination.  In its attempt to ensure that the law is sufficiently broad to catch everything that could be construed as manipulative, Congress has instead passed language that is so vague that the law can hardly catch anything.  The amendment’s language does nothing to correct that.

Moreover, Cantwell sings paeans to the securities law’s anti-manipulation provisions and precedents, and the effects of previous utilization of similar language in other commodity manipulation laws:

This language in this amendment is patterned after the law that the SEC uses to go after fraud and manipulation; that there can be no manipulative devices or contrivances.

It is a strong and clear [not!] legal standard that allows regulators to successfully go after reckless and manipulative behavior.

This legislation tracks the Securities Act in part because Federal case law is clear that when the Congress uses language identical to that used in another statute, Congress intended for the courts and the Commission to interpret the new authority in a similar manner, and Congress has made sure that its intention is clear.

In the 75 years since the enactment of the Securities and Exchange Act of 1934, a substantial body of case law has developed around the words “manipulative or deceptive devices or contrivances.”

The Supreme Court has compared this body of law to “a judicial oak which has grown from little more than a legislative acorn.” It is worth noting that the courts have held that the SEC’s manipulation authority is not intended to catch sellers who take advantage of the natural market forces of supply and demand, only those who attempt to affect the market or prices by artificial means unrelated to the natural forces of supply and demand.

Mr. President, Congress granted the same antimanipulation authority to the Federal Energy Regulatory Commission in 2005 in the Energy Policy Act. We did this as a result of the Enron market manipulation. I am very proud of this legislation and its ban on manipulation in electricity and natural gas markets. I say that because there was a similar issue of deregulation of energy markets that led to the Federal regulators not doing their job.

Since we have implemented this language in the electricity markets, the Federal Energy Regulatory Commission, since 2005, has used its authority to conduct 135 investigations. Of those 135 investigations, 41 have resulted in settlements involving civil penalties or other monetary remedies totaling over $49 million.

Two investigations brought about enforcement actions against manipulation, one against Amaranth for $291 million—-

The PRESIDING OFFICER (Mr. Udall of Colorado). The Senator has used 5 minutes.

Ms. CANTWELL. Mr. President, I ask unanimous consent for an additional 1 minute.

The PRESIDING OFFICER. Without objection, it is so ordered.

Ms. CANTWELL. The alleged market manipulation brought enforcement action against Amaranth for $291 million in civil penalties and Energy Trading Partners for $167 million in civil penalties. That is just an example of what a statute with teeth and a regulatory entity can do to actually stop manipulation when given that authority.

Sigh.  There are so many things completely wrong with this it isn’t even funny.  Most importantly, the relevance of SEC precedent to commodity market manipulation is a cross between (a) completely non-existent, and (b) actively counterproductive.  Most importantly, as I point out in the ELJ piece, whereas the most important kinds of commodity manipulations are market power manipulations (e.g., corners) most securities manipulations are information/fraud driven.  The canonical securities manipulation is the pump-and-dump, which has nothing whatsoever to do with market power manipulation that should be the first order target of any commodity anti-manipulation measure.  So, the vaunted SEC precedents are worth exactly bupkus.  No, that’s too generous.  They will be actually counterproductive as enforcement attorneys and judges try to pound a market power manipulation peg into a fraud hole.

The ETP case that Cantwell mentions is a perfect example of this.  I was an expert for ETP in this case, and know it intimately; as an aside, Cantwell is less than accurate in her characterization of the outcome of that case, because the government settled for a lot less ($5 million to the government, plus a set aside of $25 million to pay potential settlements in third party lawsuits) than the $167 million figure she cites, and that was a let’s-get-this-behind-us-gift to FERC, which brought the case.  Substantively, the FERC had to twist itself into knots to try to characterize the conduct it found offensive into the “deceptive device or contrivance” category.  FERC’s theories, uhm, evolved, to put it mildly; actually “devolved” would be a better characterization.  At every iteration, I was reminded of Maxwell Smart: “Would you believe?”  (No, actually.)  Rather than being the shining example that Cantwell paints it to be, the ETP case was a perfect example of the fundamental idiocy of trying to export securities law manipulation concepts and precedents to the commodity markets.

Instead of improving manipulation law, the Cantwell amendment will make it worse, as hard as that is to believe.  I don’t know if I’ve ever written a more depressing sentence.

Cantwell focuses on intent.  But that isn’t the only problem with existing commodity manipulation law.  Artificial price and causation have also posed problems too.  But all are eminently fixable through an application of solid economics, as I discuss in more detail in the ELJ piece, and which I demonstrated in my book on manipulation in the mid-90s and my piece on the Ferruzzi squeeze from 2004.

Another poster child for the intellectual bankruptcy of the Senate bill is its provision to empower the CFTC to extend position limits to OTC energy derivatives.  I have pieces forthcoming in Regulation and the Swiss Derivatives Review analyzing speculation and position limits in commodity markets.  The title of the Regulation piece suffices to convey the conclusions: “No Theory?  No Evidence?  No Problem!”  That is, the CFTC’s current proposal to impose position limits is not grounded in an understanding of the economics of commodity markets, and is completely unsupported by empirical evidence.  The same, obviously, is true of the provision in the just passed legislation.  But we’ll get limits nonetheless.

The Senate provision is particularly troubling because it will likely have effects on the Commission’s futures position limits as well as on OTC limits.  Fear of driving trading to the OTC markets restrained the Commission in its setting of the proposed limits, and led some Commissioners to express reservations about the entire effort.  With OTC position limit authority, those constraints and reservations evaporate.  Now the only competitive constraint on the CFTC is the threat of trading moving overseas.  But that threat is less severe than the competitive threat to the domestic OTC market, so it is quite possible that the Commission will impose more onerous restrictions on both exchange-traded and OTC-traded positions now that it has the OTC authority.

At the Notre Dame conference Chester Spatt warned of the unintended consequences of regulation.  Quite so.  And the Senate bill, and whatever comes out of conference, will spawn myriad unintended–but not unpredictable–consequences, most of them quite pernicious.  When the Insane Clown Posse (AKA the United States Congress) is done “reforming” our financial markets we’ll learn to our regret that however flawed our existing system is, it is a far, far better thing than the product of the constructivist irrationality of Dodd, Lincoln, Cantwell, and Frank et al.