Streetwise Professor

The Futures Industry Association, a trade group for futures commission merchants and exchanges, has come out strongly in opposition to the CFTC’s proposed energy position limits.  The most interesting thing to me about the FIA letter is the fact that one of the central pillars of its argument is similar to an objection I’ve been raising for some months: specifically, that the CFTC doesn’t have a legal leg to stand on because (a) Congress has authorized the CFTC to impose limits when “it is necessary to diminish, eliminate, or prevent” the “undue and unnecessary burden” of “excessive speculation” that causes “sudden or unreasonable fluctuations or unwarranted changes in the price” of any traded commodity, but (b) CFTC has made no finding that excessive speculation that causes unreasonable price fluctuations exists, or has existed, in energy products.  Indeed, it’s worse than that.  CFTC’s attitude has been “we don’t got to show you no steenking evidence.”  CFTC, and notably Chairman Gensler, have also invoked repeatedly the idea that concentration is a danger that should be controlled through position limits.  But the Commodity Exchange Act is silent on concentration in this context.

The FIA letter is quite blunt: “Substantively in the absence of the ‘necessary’ finding, the CFTC lacks the statutory authority to adopt position limits.”  FIA also states that “[t]he ‘excessive concentration’ and ‘uncontrolled speculation’ themes the CFTC cites are both factually unproven and legally irrelevant.”  The letter states further that the “‘excessive concentration’ focus is misguided.”  I agree with all this, and have said and written as much over the past year (or more).  I further agree with the FIA’s statement that “FIA is not aware of any convincing or even credible evidence that large traders with speculative positions in energy futures markets have trumped fundamentals as the determining factor in energy futures prices.”  (Emphasis in original.)  Again, agreed.

To summarize, like the FIA, I believe that the CFTC position limit proposal is unjustified and legally dubious.  It is unjustified because there is no credible evidence, or logical argument even, that speculation has distorted prices.  It would be nice to make policy on the basis of, you know, evidence, wouldn’t it?  (Isn’t this the administration that said it was going to base policy on science, not politics?)  It is legally dubious because the CFTC’s authority to impose limits is not absolute.  The CFTC can impose limits pursuant to a particular purpose laid out in statute, but the CFTC’s justification for its proposal (a) does not show that its limits are in fact necessary to achieve that purpose, and (b) includes considerations that are altogether absent from the statute.

This is regulatory overreach based on no evidence.  Other than that, it’s great!  Kudos to the FIA for joining me in pointing that out.

Gary “Jeremiah” Gensler continued his assault against CDS, this time from deep in enemy territory, at Markit’s Outlook for OTC Derivatives Markets Conference.  If it were up to Gensler, the OTC Outlook would be terminal.

In the speech, Gensler repeats several of his constant themes, and also adds some more, drafting off the cynical European outrage over sovereign CDS.  All of the tired standbys are here, including arguendo ad AIG (don’t leave home without it!)  but he also uses the shameless “derivatives used to mask Greece’s budget chicanery” argument.

I see.  We’re supposed to trust governments to regulate instruments that governments use to escape commitments they’ve undertaken.  What’s next?  Robert Downey Jr. for Drug Czar?

Gensler calls for regulation of derivatives dealers including capital and collateral requirements.  But siloed regulation of specific instruments makes little sense when these are just one element in the portfolios of complex financial institutions that engage in a wide range of risk taking activities.  A holistic approach by banking regulators is called for to ensure that risks are priced properly and consistently across all the instruments in bank portfolios.  But that wouldn’t give the CFTC a hand in the game, would it?

The CFTC chair also calls for transparency, arguing for something like the consolidated tape in equity markets.  I have no problems with that, having advocated a data hub for energy years ago, and suggesting it for OTC derivatives more broadly more recently.

But Gensler overstates the potential benefits.  He laments the fact that during the crisis there were “no reference prices for particular assets.”  Well, duh.  That’s because they didn’t trade.  And mandating that something trade on an exchange will not magically mean that it will trade at all.  Low volume instruments typically don’t trade on exchange because it’s not worth the cost of maintaining a market that is seldom used.  This isn’t Field of Dreams: just because you build a trading facility, doesn’t mean that people will come to trade everything on it.  Even with an exchange mandate and/or post-trade transparency, many instruments will still lack reference prices on a timely basis because there is no underlying demand to trade them with any frequency.

Which undermines Gensler’s next demand: that derivatives be cleared.  Sufficient trading activity is a necessary condition for clearing to be the best way of allocating default risk (though not a sufficient condition).  In addition, I note, wearily, that Gensler again invokes clearing as a deus ex machina that “guarantees obligations of both parties” and “takes trades off the books of financial institutions.”  Pray tell, where does the risk go?  Who provides the guarantee?  Is there a guarantee fairy?  Do leprechauns guarantee trades with a pot of gold at the end of a rainbow?  (Or is that needed for the Irish banks?)

In this speech, Gensler expands his criticism of CDS to take up the by now standard “no insurable interest argument” against holding “naked” CDS positions: who knew regulators were such prudes?  In a section titled “market manipulation” he regaled his audience with the story of how in the 18th century unscrupulous folk had taken out insurance on ships they didn’t own, which then seemed to have a bad habit of being lost.  This, and related schemes, led to the passage of statutes that required the purchaser of insurance to have an insurable interest.

There is an argument to be made for the efficiency of such rules in some contexts.  In particular, in the specific historical case Gensler discussed, the probability of detection was probably quite small, given the difficulty of proving that a particular vessel sank as a result of foul play (difficult if for no other reason that it was lying at the bottom of the ocean, perhaps with the bodies of its crew).  This meant that ex post deterrence of this conduct was likely very ineffective.  Moreover, there is no compelling benefit of A buying insurance on B’s property or life.

The question is whether this analogy is apt for CDS.  I think not.

First, there are potentially beneficial reasons for naked CDS.  Speculation of this sort can provide valuable information: markets that restrict short sales are typically less informationally efficient than those that don’t, and experimental evidence suggests that short sale restrictions encourage bubbles.  Moreover, market makers may sometimes take naked positions in CDS pursuant to their vital role of providing liquidity.  In addition, holding naked CDS against related positions (e.g., equity positions in the same firm, CDS positions in other firms in the same industry) can be sensible spread trading strategies that ensure that financial instruments are priced appropriately relative to one another.

Second, it is interesting that Gensler cannot point to any particular example in CDS analogous to what apparently happened to ships in the 18th century. He resorts to the “some say” dodge, stating that “some observers . . . contend” that CDS swap protection buyers “may have engaged in market activity to help undermine an underlying company’s prospects.”

Be a man Gary.  If you have evidence of this, let’s hear it.  If not, some say you should shut the hell up.  I would also note that Gensler’s argument can be applied to pretty much any financial instrument.  Owners of puts on a company have an incentive to do thing to undermine that company’s prospects.  What makes CDS special?

CFTC anti-manipulation standards require a finding that a manipulator had the ability to cause distorted prices, took actions that had the effect of causing such a distortion, and acted with the specific intent to do so.  Is Gensler arguing for a different standard for CDS?  Does he have any evidence that most CDS holders, naked or otherwise, have the ability to cause the distortions that Gensler conjectures?  Can he cite specific examples of where this ability to cause was actually exercised to cause the mayhem he describes?  Most importantly, does he seriously believe that such an action could be undertaken without being detected?   This seems an area in which ex post deterrence through enforcement action or private action is best suited, which is quite different from the shipping example that Gensler discusses.  Blanket bans against naked CDS don’t make sense in this context, as they preclude potentially valuable uses of this strategy, while (so far only hypothetically) misuses can be deterred efficiently ex post.

Gensler also trots out the empty creditor problem.  As I argued here and here, the conventional analysis of this issue (advanced most prominently by Henry Hu, and which Gensler essentially repeats) is seriously incomplete because it fails to address the latent Coase Question of what transactions costs preclude voluntary trades resulting in optimal allocation of rights.  Insofar as remedies are concerned, Gensler and I actually agree: he recommends position disclosure and voting in bankruptcy based on economic interest, just as I did last April in the first of the two posts linked above.

The CFTC chair also criticizes the Basel capital rules insofar as they apply to CDS.  I yield to no man in my disdain for these rules, and think that they were a major contributor to the financial crisis (to the extent that they incentivized banks to undertake the same trading strategy of holding large positions in AAA CDOs).  But I think that Gensler, in his Ahab-like obsession with CDS, focuses on a side issue.  Specifically, he criticizes the component of the rules that give capital relief to those who hold CDS as a hedge against other risk exposures.  He wants more restrictive capital treatment of CDS -hedged positions.  He pejoratively states that this treatment means that “a bank can essentially rent another institution’s credit rating to reduce its required capital.”

Well, yeah.  That’s what hedging is all about; an institution is laying off the risk to somebody who bears it at a lower cost. This can be done by selling the underlying instrument, or entering into a hedging transaction utilizing a related instrument.  Sometimes–a lot of the time–the latter is more efficient.   Economically, it makes perfect sense to require less capital against hedged positions.  It would be perverse indeed to do otherwise.

As to specific restrictions, Gensler suggests that “only CDS subject to collateral requirements could be allowed to provide capital relief.”  Perhaps he hasn’t read the most recent ISDA Collateral Market Review (released on March 1), which states that 97 percent of CDS positions are collateralized.

And by-the-way: AIG’s CDS contracts were subject to collateral agreements.

So, Gensler’s specific recommendations are red herrings, even in the context of arguendo ad AIG.

Would it that CDS and OTC derivatives were the only object of Gensler’s control fetish, and desire to swell the authority of the CFTC.  But no.  Not only are there position limits, but Gensler has also set his sights on the market for power firm transmission rights, setting off a turf war with FERC.

Gensler is attempting to put Rahm Emanuel’s “let no good crisis go to waste” dictum into action, exploiting the financial crisis–and importantly, more than twice told tales about the financial crisis–to advance a regulatory agenda that would concentrate tremendous power in his agency.  This agenda is built on fundamentally flawed analysis.  What’s more, the agency that he heads quite clearly has not demonstrated that it has the capability, resources, or expertise to exercise those powers effectively and judiciously.  And I am being very charitable in saying that.  (If you have any doubts, take some time and look through the reports the GAO has written about the CFTC over the years.  It does not make for happy reading.)

I have some novel suggestions, Chairman Gensler.  First, do no harm.  Second, be circumspect about anyone’s abilities–including yours–to micromanage huge, complex markets.

I knew that the Commodity Futures Modernization Act (CFMA) was a powerful piece of legislation, but I was unaware just how powerful.  It apparently has the ability to alter the space-time continuum, and affect events even prior to its passage.  How did I learn this?  From a letter signed by senators Feinstein, Cantwell, Snowe and Dorgan to Chris Dodd.  (I haven’t been able to find a copy online.)  The senators state:

As you know, in 2000 Congress made the mistake of exempting energy from commodities regulation in the Commodity Futures Modernization Act.  This exemption, known as the “Enron loophole” led directly to the Western Energy Crisis.

Uhm, compromise language that was ultimately incorporated into CFMA passed the House on 14 December, 2000, and was introduced into the Senate on 15 December.  A conference committee hashed out differences, and the bill was ultimately signed into law (by Bill Clinton) on 21 December, 2000.

Meanwhile, the California/Western energy crisis had been building throughout 2000.  Power prices first spiked in May, 2000.  The first blackouts were in June, 2000.  San Diego Gas & Electric made allegations of market manipulation in August, 2000.  FERC rejected California’s request for a price cap on–wait for it–15 December, 2000.  The peak prices observed during the entire crisis occurred in December, 2000.

In other words, the energy crisis was well underway long before the passage of the CFMA, and reached its crescendo at the very time that the bill was being passed, and well before it could have, let alone did, affect one transaction in energy or anything else.  Since cause must precede effect, for these senators to say, in the very opening paragraph of their letter, that the Act “led directly” to the crisis is complete and utter bilge.

What’s more the underlying causes of the crisis are well known, and had nothing to do with the matters addressed in the CFMA, and everything to do with the wretched market design put in place by the California legislature.  Indeed, to the extent that derivatives were involved at all, it was the legislature’s ban on the ability of CA utilities to enter into long term purchase deals or hedging contracts that exacerbated the crisis.

Insofar as Enron is concerned, its actions (e.g., Death Star, Fat Boy, Ricochet) were designed to exploit flaws in the market design (particularly the design of the Power Exchange–PX–and differing price caps across markets).  They had nothing to do with the kinds of things addressed in the CFMA.

(I would also add that the exemptions in the CFMA were not quite so broad as the senators suggest in their letter.)

So, the senators got off to a very bad start.  What about other matters raised in the letter?  Well, better, but not much.

The basic thrust of the letter is to argue against providing end user exemptions from clearing requirements, or treating end users more liberally generally.  The essence of their argument is that systemic risk is unpriced, and that clearing internalizes this externality.

This represents just another example of clearing as deus ex machina that magically addresses systemic risk concerns.  The authors of the letter, like many others who have discussed the subject, assume that (a) counterparty risks are not priced properly in OTC markets, and (b) central counterparties will do a better job at pricing counterparty risks.  As I’ve written extensively, neither claim is necessarily true, nor even plausible.

The letter commits another factual gaffe when it claims that there was a “systemic failure caused by the Enron bankruptcy.”  Certainly counterparties lost money as a result of the Enron bankruptcy, but there was no systemic failure, particularly if one defines “systemic failure” to mean a contagion effect.

The Enron failure did not cause a major upset in the energy markets.  The implosion of the merchant energy sector occurred some months later.  The key event was the SEC’s announcement that it was investigating Dynegy’s accounting on 25 April, 2002.  Subsequent to that time, merchant energy stocks declined by about 90 percent in value, and other companies went bankrupt (e.g., Mirant).

But this wasn’t a systemic contagion event.  Instead, it was the result of a widespread recognition that the energy trading boom was overdone, that profitability estimates were probably inflated, and profit projections would not be realized due to overbuilding of capacity and other reasons.  That is, every firm in the sector was overvalued, and when the market reached that conclusion, they all fell  in value.  There was a common shock, and the affected firms fell in common.  That implosion would have occurred, clearing or no.

This point about confusing contagion effects (in which the demise of one big firm induces financial distress in otherwise healthy firms to which it is connected) and simultaneous collapses of multiple firms caused by a common shock is quite important, and gets too little attention.  The common shock in the recent financial crisis was real estate price declines, communicated to large financial institutions through their holding highly correlated positions in real estate price sensitive investments.  That’s different than a contagion resulting from the bad decisions or bad luck of one firm bringing down others just through contractual connections.

We can barely expect such more discriminating analysis, alas, from senators who are either completely ignorant of the legislation that they write about, or who don’t understand the basic fact that cause must proceed effect.

Update (3/1/10): SWP daughter #1 wonders if a silver DeLorean and a wild haired professor were seen in the vicinity of either Congress or California when the CFMA passed.

Matt Leising and Shannon Harrington have been on a roll lately.  Today, they report that big buy side firms are resisting Fed calls to clear a targeted percentage of their deals:

The biggest credit-default swaps investors oppose targets for clearing trades as regulators attempt to curb risk in the $25 trillion market.

Pacific Investment Management Co., BlueMountain Capital Management LLC and AllianceBernstein LP are among asset managers and hedge funds that won’t agree to specific goals before the Federal Reserve Bank of New York’s March 1 deadline requiring them to outline the industry’s next steps to move swaps through clearinghouses, according to people familiar with the matter who declined to be identified because the talks are private.

. . . .

The asset managers, while backing efforts to broaden the use of clearinghouses, want assurances that cleared trades would be protected under bankruptcy laws, the people said. They’re also concerned they may be saddled with collateral costs that are double or triple what they’re paying now because they could lose benefits now granted by prime brokers that give credit for offsetting trades, the people said.

For example, hedge funds and other asset managers often will perform trades that seek to profit from price dislocations between index contracts and swaps on companies included in the index. Prime brokers typically will demand collateral on the net amount at risk from offsetting trades.

Tying Up Cash

If one leg of the trade were required to be cleared, while the other contracts aren’t eligible, fund managers may be forced to increase the amount they have to post, tying up cash, the people said.

This is ironic because the best economic case for clearing is that reduces counterparty risk for end-users.  For instance, the classical futures clearinghouse reduces customer default losses (but doesn’t necessarily eliminate them) that could result from the failure of a brokerage firm by shifting the liability to the clearinghouse, and thus, to the other brokerage firms that are members of the clearinghouse.  Note that the Chicago Board of Trade has always argued that no CUSTOMER has lost money as the result of a default; the CME now makes a similar claim.  Thus, if anybody should be clamoring for clearing, it is customers.

But, as the article notes, this doesn’t come for free.  In particular, the article notes that clearing, especially through single-instrument clearinghouses, can eliminate scope economies (achieved, for instance, through netting and cross margining), thereby inflating costs.

So it can be reasonable for customer firms to resist clearing even though if it benefits anybody, it is most likely to benefit them.

Dealer firms have agreed to clear a large fraction of some inter-dealer trades (e.g., CDS trades).  In other markets (e.g., interest rate swaps) banks have elected to clear a decent proportion (around 50 percent) of inter-dealer trades.  But in many respects, inter-dealer clearing offers fewer potential risk sharing advantages than customer clearing (that shifts risks from customers to the dealer-members collectively).

In bilateral markets, there is extensive inter-dealer trading; this creates performance risk between dealers.  Clearing basically does the same thing.  It can reduce some exposure, through multi-lateral netting, but as Duffie and Zhao have shown, and as I have shown, this gain is reduced, and at times non-existent, because clearing can reduce bilateral netting opportunities across a portfolio of instruments.  Thus, the exposure reductions may be limited, especially if the clearinghouse handles only a narrow range of the instruments that dealers trade.  But even if there is some exposure reduction, a lot of what inter-dealer clearing does is to share the same risk among the same players.

The way this risk is allocated can differ somewhat; in particular, it is possible that risk exposures through clearing are less concentrated than the bilateral inter-dealer exposures in non-cleared markets.  But dealers have incentives to limit concentration on their own, and do so through exposure limits and credit limits with each counterparty.  Moreover, dealers have the ability to use their own information to choose these limits in bilateral dealings, whereas the clearinghouse cannot rely on this information.  Thus, clearinghouse members may have exposures that are less concentrated than their bilateral exposures, but they still may be worse off because they take more exposure with some counterparties via the clearinghouse than they would voluntarily take in a bilateral market.  That is, concentrations in bilateral markets are endogenous, and high concentrations can be sensible, based on counterparty risk evaluations.

The resistance of some sophisticated buy side firms to clearing should be another hint to regulators and legislators that mandated clearing is not necessarily a good thing.  If those who, if anyone, would be the biggest beneficiaries of clearing, decide it’s not worth the candle, that strongly suggests that the total benefits are illusory.

Yesterday I was exchanging emails with a couple of folks about CFTC Chair Gary Gensler’s increasingly apocalyptic jeremiads against OTC derivatives.  (Indeed, I think I’ll start referring to him as “Jeremiah.”)  I offhandedly wrote “Pretty soon he’ll be saying that OTC derivatives cause cancer.”  Lo and behold, what do I read in today’s FT:

US taxpayers bailed out AIG with $180bn when that company’s ineffectively regulated $2,000bn derivatives portfolio, managed from London and cancerously interconnected to other financial institutions, nearly brought down the financial system.

I personally find it very disturbing that I can channel Gensler’s thinking.

The substance of the oped is more Gensler same-old, same-old.  Clearing is again the deus ex machina of his sermon:

Clearing houses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Transactions are moved off the books of derivatives dealers, which are part of financial institutions that may be both “too big to fail” and “too interconnected to fail”, and on to those of well-regulated central counter-parties. Centralised clearing has helped to lower risk in futures markets for more than a century.

Uhm, just who backs that guarantee, Jeremiah?  Could it be the very same derivatives dealers?  Meaning that the risk really isn’t moved off their books, and that they’re still interconnected?

Arguendo ad AIG makes its stock appearance (see the first quotation).  George Stigler once wrote that data is not the plural of anecdote.  What’s unbelievable is that Gensler (and Geithner and others) can’t even find multiple anecdotes, let alone anything rising close to the level of data.  What’s even more unbelievable is that his use of the AIG anecdote is deeply misleading–so deeply, that Gensler is either very dishonest or very badly informed.  First, although OTC derivatives deals were one source of AIG’s loss, they were not responsible for anything near the entire $180 billion bailout, but Gensler insinuates that they were.  Second, since it is unlikely that the AIG deals were clearable then, or would be today, it is misleading to use them to advocate clearing.  Third, Gensler doesn’t address the counterfactual question of what would have happened if AIG hadn’t written protection on mortgage CDOs; arguably, the crisis would have been worse.

Gensler also asserts that OTC derivatives were the underlying cause of the financial crisis.  He provides no evidence whatsoever–other than the tired AIG trope.  This is a complete misreading of the history of the crisis.  If you don’t believe me, I suggest you read Rene Stulz’s piece on derivatives and the crisis in the most recent issue of the Journal of Economic Perspectives.

Gensler also makes some assertions that are categorically incorrect.  For instance, he says: “The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk.”  It is, in fact, well known that excessive transparency can reduce liquidity.  There is NOT a monotonic relation between transparency and liquidity, as Gensler asserts.

More generally, on the transparency and exchange trading arguments, Gensler implies that market participants that willingly choose to trade on OTC markets instead of readily-available exchange alternatives don’t know their business.

I could go on and on, but I’ll let it rest here for now.

If the substance is tiresomely familiar, Gensler’s rhetoric reaches new heights.  He pegs the metaphor meter with his lurid comparison of the role of OTC derivatives in the financial crisis to the Chicago Fire, and the banks to the cow in Mrs. O’Leary’s barn that kicked over the lantern that ignited the fire.  (At least he spares us the apple story.)  (The reference to Mrs. O’Leary’s cow is actually quite fitting here, as that poor creature is almost certainly the least plausible cause of the Chicago fire; the editor of the Chicago Republican admitted he made up the story for its entertainment value.  He’d be more accurate talking about meteorites or Pegleg Sullivan–he should check out the Alkaline Trio song about old Pegleg.  But accuracy is merely an obstacle, it appears, in Gensler’s shrill attacks.)

(And another parenthetical about the metaphor overload: is cancer “interconnected”?  Usually cancer is used as a symbol of something maliciously that spreads, which is somewhat different from interconnection.)

Perhaps this remarkable performance is actually good news.  Gensler apparently believes that he has to ramp up the rhetoric in order to achieve his (defective) policy goals; that’s usually a sign of desperation, and a lack of success in previous efforts to persuade.

And that lack of success is not surprising.  Yes, it might have something to do with the fact that incumbents don’t want major changes in the ways they do business.  But it’s also due to the fact that faulty analysis unsupported by reliable facts or data is usually unpersuasive.

But perhaps there’s an upside; we have a new entry in the Bulwer-Lytton fiction contest: it qualifies both because it is fiction, and because of its overwrought writing.

In a matter of personal interest:

The U.S. Supreme Court rejected an appeal by Pacific Investment Management Co., clearing the way for a lawsuit seeking more than $600 million for the company’s alleged manipulation of the price of Treasury futures contracts on the Chicago Board of Trade.

The justices today let stand a federal appeals court ruling that said traders could press their suit against the company as a class action. Pimco, manager of the world’s largest bond fund, argued unsuccessfully that many of the investors in the class actually would have made money had the market manipulation taken place as alleged.

The lawsuit, filed in 2005, accuses Pimco of cornering the market for contracts on 10-year Treasury notes during May and June 2005. Pimco allegedly used its holdings to drive up the price for traders who had sold short — that is, contracted to sell notes on a specified later date — and needed to cover their positions.

And that’s all I have to say about that.  Here, anyways.

My original take on the CFTC energy futures position limits was that they were sufficiently generous so as to not represent much of a constraint on most market participants.  Upon further thought, I concluded that the “crowding out” provisions that would (a) limit swap dealers to double the spec limit, and (b) preclude those benefitting from the hedge exemption from speculating, or acting as swap dealers are landmines that could inefficiently constrain the operations of the futures markets as risk shifting and price discovery tools.

Christopher Doering of Reuters picked up on this phrase, and found others concerned about the same issue.  In effect, the rule will segment the market, creating ghettoes for hedgers, swap dealers, and speculators.

There are good economic reasons to believe that some hedgers might be able to compete effectively as swap dealers, or can speculate in addition to hedging.  (Indeed, as Working pointed out eons ago, hedging is really just speculating on price relationships.)  Moreover, some swap dealers might have hedging needs, or can efficiently supply speculative capital to the market.  The 2x limit on swap dealers is also problematic.  Why 2x?  Why not 3.14159x?  This limitation could constrain the ability of some swap dealers to achieve efficient scale, and may indeed have the perverse effect of shifting business to less well capitalized market participants.

What is truly scary is the “rationale” for this limit offered by that noted industrial organization economist, and expert on scope economies, CFTC commissioner Bart Chilton:

CFTC Commissioner Bart Chilton, a strong proponent of position limits, was unapologetic, arguing exemptions have given too much flexibility to players without stakes in the physical commodity.

“There should be zero patience for trading on your own book, if you have an exemption,” Chilton told Reuters, defending the new proposal as a safeguard against the impact of large traders roiling markets by making risky bets for their own accounts.

“Perhaps, if our proposal goes into effect, some will have to choose a business model,” he said. “Are they a speculator, a swaps dealer or a hedger? Part of the problem we have had over the years is that some wanted to be everything to everybody.”

Loaded with deep economic insights, that.  “There should be zero patience for trading on your own book, if you have an exemption”: a purely conclusory, unsupported, assertion.  Hedgers with substantial physical market information are often the most profitable speculators.

“Part of the problem we have had over the years is that some wanted to be everything to everybody.”  What does that mean, even?  Given the nature of information and information flows, it is quite understandable that there are complementarities between speculative, physical, and customer-facing (e.g., swap dealing) trading functions.  This is a highly competitive market, and one would expect that if there are complementarities that reduce costs, one would observe–as we do–some firms exploiting them.

Siloing physical market, speculative, and customer-facing activities precludes market participants from exploiting any complementarities.  If the complementarities didn’t exist, specialized firms would dominate in practice.  The success of multi-function firms in a competitive environment suggests that these combinations offer efficiencies.  There are no obvious regulatory constraints (e.g., price controls, rate of return regulations) that are (inefficiently) encouraging the evolution of integrated, multi-function firms.

Regulators throughout the government–in the US, but elsewhere too–are repeatedly substituting their judgments regarding efficient market structure for those of the participants in highly competitive markets.  Moreover, like Commissioner Chilton, their rationales for their judgments are often shockingly superficial, not to say ignorant, and fail to engage let alone answer fundamental economic questions.  It would be nice, if at least sometimes, regulators flogging particular proposals to change market structures could provide a coherent critique of why incumbent market structures are inefficient, and how the proposed regulation would remedy these inefficiencies–without introducing even worse ones.

First Eni, and now German giant E.ON have negotiated contracts with Gazprom that weaken, though do not break the oil price-contractual gas price link.  E.On has entered into a contract which ties the price for a fraction of its purchases to spot gas prices:

E.ON’s gas unit has agreed with Gazprom on taking a “low double-digit” percentage of its supply at tariffs linked to spot market prices, Handelsblatt said yesterday, citing E.ON Ruhrgas AG chief Bernhard Reutersberg. The outcome of discussions with Gazprom may have been “more favorable than expected for E.ON,” Oppenheim Research GmbH analysts said in a note yesterday.

Gazprom is at pains to point out that its fundamental contracting practices remain unchanged:

Germany’s E.ON Ruhrgas (EONGn.DE) said on Friday it had completed talks on more flexible gas purchasing contracts with Gazprom, allowing one of Europe’s biggest Russian gas buyers to get a chunk of its contracted supplies at spot prices. [ID:nLDE61I149]

The shares of Gazprom traded 1.1 percent up at 1512 GMT, in line with the broader oil and gas index .MCXOG of Russia’s top bourse MICEX .

“The agreements reached do not put into question the fundamental principles — the system of long-term contracts, the “take-or-pay” principle and the pricing system based on a peg to a basket of oil products,” the Gazprom source added.

That’s all well and good, for now, but if there remains a large disconnect between oil prices and spot gas values, the “fundamental principles” are maladapted to current market conditions, and Gazprom will be under substantial pressure to compromise on these principles.

The European gas market remains fragmented, and the spot market is still early in its evolutionary process; national boundaries still matter, slowing the development of a robust market like that in the US.  (Thanks to Michelle Hallack for a very informative update on European gas market developments.)  Nonetheless, spot market liquidity is improving, and the development of LNG and the lack of need for LNG in the US (freeing up cargoes for the European market) will speed that development.  Moreover, successful shale plays in Europe would also facilitate development of a broader gas market.  All of these developments will undermine the need for long term take-or-pay contracts linked to oil.  The E.ON and Eni deals therefore likely represent just the beginning of a revolution in gas contracting in Europe, a development that will not redound to the benefit of Gazprom.

The last couple of days I’ve felt that when I wrote “Teleconnections” I was like that guy in the TV show “Early Edition” who got the paper (the Chicago Sun Times) delivered to him before it was published.  Yesterday Bloomberg had an article about a shale gas bonanza in Europe; today’s WSJ has an article describing how Italian energy firm Eni has renegotiated its contracts with Gazprom, as I suggested would happen in the post, because (a) oil prices and gas prices have delinked, due in large part to increased non-traditional supplies, and (b) the development of LNG has helped spur development of a spot market for gas:

In an interview, Eni Chief Executive Paolo Scaroni said the renegotiated long-term contracts will allow the company to counter deep changes in the economics of Europe’s natural gas market, which has weakened of late.

. . . .

For decades, steady gas prices allowed Eni and other distributors to purchase natural gas supplies from fields in Russia and Norway using contracts linked to the price of oil. Over the past year, however, oil prices have recovered from the financial crisis while demand for natural gas has not. That left European gas companies on the hook to purchase gas supplies at higher rates than their spot market prices.

Natural gas prices have also been hurt by the emergence of new supplies, including shale gas fields in North America and an abundance of liquefied natural gas projects, Mr. Scaroni said. “Around this, the drop in demand and the growth of liquefied gas, we renegotiated some characteristics of our long-term contract,” Mr. Scaroni said, declining to elaborate on the terms of the new agreement.

Gazprom head Alexei Medvedev was rather vague about the changes too:

Gazprom Deputy Chairman Alexander Medvedev told a press conference earlier this week that Gazprom had renegotiated the contracts with European companies taking “into account the trends in the European market and the crisis.” However, the “base principles” of the long-term contracts remained unchanged, Mr. Medvedev said without elaborating. Gazprom declined to comment on the matter.

I wonder just what “base principles” and “characteristics” mean. Reading between the lines, I would wager that it means that the pricing mechanism has been shifted (as conjectured in “Telecommunications”) from oil prices to spot gas prices.  It is also possible that the take-or-pay provisions have been altered, as a shift to a more accurate pricing mechanism would reduce the scope for opportunism that TOP clauses are designed to combat.

It is very interesting that even Eni is renegotiating.  The Italians have been particularly slavish in their dealings with Gazprom and Russia.  When Gazprom would say “jump”, Eni would ask “how high, boss?”  The fact that this company has succeeded in wresting contract changes from Gazprom is a very clear indication of how the bargaining power, and the perception of bargaining power, have changed.  And, methinks, the process has only begun.

As I noted in the original post, these changes will have geopolitical effects, not merely economic ones.  One interesting thing to consider is how it will affect Ukraine.  The eastern Europeans and FSU countries generally, and the Ukrainians specifically, will receive less direct benefit from LNG and other new sources of gas.  Moreover, to the extent that western Europe is less dependent on Russian gas–or, put economically, its demand for Russian gas is more elastic due to the availability of alternative supplies–Ukraine is less important to it.  This doesn’t seem to bode well for Ukraine’s ability to fend off Russian pressure.

Developments here in Texas are having consequences around the world, in places that couldn’t be more different–like Russia.  Specifically, Gazprom has announced that the massive Shtokman gas project in Russia’s frozen north has been postponed.  It may not be unpostponed any time soon.  Part of the reason for postponement is the lingering effect of the financial crisis on the demand for gas in Europe.  But another big part of the reason is that the economics of the project were predicated on exporting liquified natural gas (LNG) to the US.  With the massive production of shale gas in Texas, Louisiana, and Arkansas, the US will not be needing LNG imports any time soon; as a result, the US has supplanted Russia as the world’s largest gas producer.  Indeed, the US may become an LNG exporter.  The technology for accessing shale gas may also open up previously unreachable supplies outside the United States, some of which should be able to reach consumption markets by pipelines, and some in the form of LNG.

Given the centrality of gas to Putin’s (“Gasputin’s”) geopolitical schemes, these developments are to be welcomed.  They should be welcomed by Russians too (though not those feeding at the rent trough); anything that undermines the rents that support the natural state is a boon for those who suffer from its stultifying effects.  These developments may save the Europeans from themselves and their inability to devise a coherent, unified strategy to combat the gas weapon, and reduce the intensity of the Great Game in the Caspian region and Central Asia.   The development of new unconventional gas supplies should also but a serious crimp in any plans for a gas OPEC.  All good.

In other words, drill horizontally baby, drill horizontally.

The development of a more active spot market for gas in Europe, driven by LNG, should also permit a change in contracting for Russian pipeline gas.  Currently, contract prices for Russian gas are tied to oil prices.  Although oil and gas are substitutes, and exhibit some correlation in values, the connection is quite loose.  The development of a spot gas market would permit indexing contract prices for pipeline gas delivered to Europe to European spot prices.  This would reduce, and arguably eliminate, the divergences between gas values and contract prices that create incentives for opportunistic behavior that necessitate rigid contractual terms such as take or pay provisions that are currently the source of friction between Gazprom and European consumers.

The huge ramifications of the technology of drilling for natural gas bring to mind the 1970s James Burke show “Connections.”  What happens in the hot, humid Piney Woods country can shape destinies on the dusty plains of Central Asia or the frozen wastes of Russia.  Truly amazing.