Streetwise Professor

The FT has an interesting article about the difficulties and uncertainties facing cap & trade schemes, even in Europe where they’ve been implemented.  A good part of the article focuses on the loss of intellectual coherence in climate policy in Europe, as regulations and taxes are being mooted to reduce CO2 emissions.  Such command and control bolt-ons are inconsistent with the basic concept of cap & trade, which is that by determining a price of carbon the market will induce efficient responses to reduce emissions on all relevant dimensions:

And the more the carbon market shrinks in its ambitions, the more it faces a broader threat: that of losing touch with its original objective. Credits could continue being traded in the old way. But if the main thrust of carbon reduction is tackled by other means, the market could face questions about its social utility.

But to me, the most interesting part of the article relates to the arcane area of offsets:

Nibble, nibble. Then we come to the aforesaid vexed question of offsets.

That is the system whereby EU companies build projects in developing countries – which are not subject to carbon caps – and thereby earn the right to emit more back home. The premise is that each project emits less than the existing version – or less than some notional alternative, which is not the same thing.

There is scope for abuse here. And, some claim, there is growing protest among locals who might not be too keen on a pulp mill or dam at all, let alone one built with foreign capital. Hence the curious sight reported by one environmentalist of thousands of Thais last year waving placards reading “Stop selling carbon credits”.

Since offset-based credits account for only a fifth of the total, the simplest solution might be to abandon offsets altogether. But that would be resisted by EU industry, since the whole job of meeting carbon targets would thereby fall on EU plants. It would also be a further reduction in the scope of the scheme.

For those not familiar with offsets, these are basically projects that absorb greenhouse gases or lead to reduced production of said gases by substituting low emissions technologies for high emissions ones.  Planting a forest that absorbs CO2 is an example of an offset.  The party planting the forest would receive CO2 credits based on the amount of carbon absorbed by the forest which could be sold.  The income from the sale of the permits can be used to recoup the costs of creating the offset, and earning a return on the capital committed.

As the article notes, Europe relies on offsets for about 20 percent of its CO2 reductions; the US ACES bill passed by the house depends even more heavily on offsets.

I teach (along with colleagues Victor Flatt and Praveen Kumar) what is likely the first university course in carbon trading offered in the US (and perhaps globally).  While teaching the course, prepping for it, and listening to my colleagues and student preparations, I have become convinced that although there is a strong conceptual case to be made for offsets (if it is cheaper to capture carbon somehow rather than reduce carbon output on other margins), the practical difficulties make it highly problematic to rely heavily on them.

The practical objection relates to transactions costs, notably what is sometimes called the measurement branch of transactions cost economics.

Every transaction involves some measurement.  Measurement is costly, and like all costs, it is desirable to economize on these expenses.  Measurement costs can be so large as to make some transactions prohibitively expensive.  Economizing on measurement costs can also affect the nature of transactions.  (As a prosaic example, to prevent excessive, wasteful measurement, it may be economical to package several pieces of fruit in sealed packages, rather than allowing consumers to pick over individual pieces.)

In my lectures in the carbon trading class, I discuss how commodity measurement issues have posed challenges in commodity markets, and how market participants have developed mechanisms to address these challenges.  Based on this history, and and an understanding of the unique issues associated with carbon and especially carbon offsets, I conclude that measurement problems are likely to be extremely knotty in this context.

The root problem is that incentives to monitor quality differ between transactions for “bads” like carbon, and transactions for goods, like wheat or oil. In transactions for private goods, the buyer has an incentive to monitor the quality of the good provided by the seller.  Moreover, the parties to the transaction have an incentive to develop ways to balance the costs and benefits of improved measurement.

In contrast, in a market for pollution, almost by definition the “consumer” in the transaction has no incentive to monitor.  Since the effects of the bad are extremely diffuse, the willingness and ability of those “consuming” it to monitor it are minimal.  Indeed, this is  one of the sources of transaction cost that must be invoked to justify the public regulation of CO2 emissions in the first place (in lieu of private Coasean bargaining, or reliance on torts).

So third parties must do the monitoring.  But this is likely to be very burdensome, for a variety of reasons.  At any point in time, it is a non-trivial problem to monitor the amount of carbon absorbed by any offset project.  Think of the challenges of measuring the amount of carbon absorbed by a forestation offset project.

Moreover, offset projects are supposed to be permanent.  Think of the forest example again.  If the forest burns down, the carbon captured–which has resulted in the distribution of valuable CO2 permits to the developer–is released.  Conceptually, you could provide the appropriate incentives by requiring the developer to acquire and retire an amount of carbon emission permits equal to the amount of CO2 released by the fire.  But here we face a stock-flow problem: the developer may be on the hook for say, 50 years worth of permits.  The developer has every incentive to retain very little capital, and just declare bankruptcy in the event.  So, to give the appropriate incentives to trade-off the benefits and costs of risk of loss of permanence, it may be necessary to require the purchase of insurance; or bonding requirements; or capital requirements.  But how do you price the insurance?  How do you determine the bond or capital that gives the right incentive?  Offset projects differ in permanence loss risks; who measures that risk (which will vary by project and by the efforts of the operator of the offset to control the risk of release) and prices it so that developers have the incentive to create the right mix of offsets?

Presumably we will see the creation of offset rating agencies to address some of these issues.  In light of the financial crisis, enough said?

And here’s another thought apropos the financial crisis.  I predict that if offset projects are created, financial instruments will be created to distribute (“slice and dice”) the risks of loss of permanence, and the risks of underperformance.  Specifically, I predict the creation of CDOs–carbon derivative obligations–that will create offset tranches from portfolios of offset projects.  The lower rated tranches will bear the first risk of loss of performance, the mezzanine tranches the second risk of loss, and the AAA pieces will only fail to pay out completely if the offset portfolio’s performance is so poor that the less senior tranches are wiped out.

After all, failure to produce the anticipated/promised amount of carbon offset is almost exactly analogous to a default, which is just the failure to produce a promised cash flow.  It is therefore to be expected that the risks will be managed, sliced, and diced in very similar ways.

But permanence isn’t the only issue.  Offsets are also supposed to be “additional,” meaning that a particular offset project wouldn’t have been created even without the prospect of receiving valuable carbon credits.  For instance, if the ability to sell natural gas or power makes a project to capture methane viable even absent the inducement of carbon credits, providing such credits provides an excessive incentive to create such projects.

And just how does one measure additionality, exactly?  It requires a detailed understanding of the economics of a particular project.  (The issues here are very complex.  Think of a wind power project.  Wind power is erratic, and typically requires backup from fossil fuel units to maintain reliability.  It’s not trivial to model what the actual amount of fossil fuel consumption that is eliminated by a wind project.)   Moreover, and even more problematically, since these projects are durable, it requires an understanding of the but for equilibrium; what does the equilibrium long term supply curve for these projects look like in the absence of a subsidy (via the provision of credits)?; what alternative technologies are being displaced?  Any measurement of these quantities is highly, highly subjective, and built on layer after layer of assumptions.

These problems would be pretty daunting even if enforcers/measurers had good incentives, and were not subject to influence.  But how does one incentivize those making the evaluations?  How does one economize on influence costs, which are likely to be quite substantial?  Again, all of the problems with rating agencies that culminated during the financial crisis occur in spades here.  And when one considers that offsets are to be created internationally, corruption and enforcement problems may be particularly acute in some jurisdictions.

In other words, offsets sound great in theory, but are likely to be extremely expensive in reality, especially if they are introduced on large scale.  These expenses need to be taken into consideration when evaluating the costs and benefits of cap & trade generally, or of specific cap & trade plans.  Moreover, these costs may prove so prohibitive that it would be better to eschew offsets altogether, or sharply circumscribe their use.  But this will mean that the cost of carbon will be that much higher as the burden of adjustment to caps will be forced onto other margins subject to diminishing returns.

From my perusal of various sources, it doesn’t seem that the measurement issue has been adequately analyzed, or measurement costs adequately quantified.  As a result, it is likely that the costs of a cap & trade system will be far greater than have been estimated.  That is a sobering thought.

In a burning ring of fire?  One can hope.  I refer to the price of Rusal stock, which has tanked even further since its inauspicious reverse pop immediately after the IPO:

United Co. Rusal Ltd., the world’s largest aluminum producer, fell for a third day in Hong Kong trading, extending its drop since last month’s initial public offering to 20 percent.

The shares slumped 4.5 percent to close at HK$8.66 ($1.11) on the Hong Kong Stock Exchange. They cost HK$10.80 each in the IPO. Today marked the eighth slide in nine sessions for Rusal, controlled by billionaire Oleg Deripaska, since trading began.

“Hedge funds that participated have been disappointed with the dynamics of the IPO and are closing the trade and taking the loss,” said Joseph Dayan, head of international sales and trading at Otkritie Securities Ltd. in London. “The fact that liquidity is drying up is another negative.”

Now, part of this decline can be laid to the decline in world markets and the related news regarding the increasingly bleak prospects for the world economy in the past couple of weeks.  But it also arguably reflects that the Rusal IPO had more than a little pump and dump aspect to it.

Speaking of Rusal, Oleg Kozlovsky and I discussed Deripaska during our conversation.  Oleg said that it was widely perceived that Deripaska is willing to abase himself any way Putin desires in order to maintain his position, and that most of the public interactions between the two (e.g., Pikalyovo) are only so much theater.

No, not me–although I am sure that a few of you would disagree.  No, I refer to Senator Maria Cantwell (D-WA) and her confreres, who clearly have some deep seated neuroses and phobias when it comes to anything involving derivatives and speculation.

Cantwell actually earns a twofer today.

First, she is the co-sponsor of a new cap & trade bill.  Although cap & trade isn’t dead, it is coughing up blood; even Obama has recognized that it has no chance of passing soon.  Along with Senator Collins (R, sorta-ME), Cantwell has introduced a bill that would institute a cap & trade regime.  It is, blessedly, much simpler than the grotesquely bloated, complicated, and convoluted ACES bill that passed the House in 2009; apparently Cantwell and Collins believe that ACES is doomed, and that a simpler bill may be the only hope.  Conservation of paper is, alas, its main redeeming feature.

It isn’t really a cap & trade bill.  It’s better described as cap, definitely, trade, not so much.  And the latter feature is what lays bare Cantwell’s phobias.  To read what she and Collins have proposed is to enter bizarro world.  They impose onerous restrictions on the trade of emissions rights and derivatives on them, apparently out of a belief that (a) speculation is evil, and (b) derivatives can only be used for speculation.

There are two completely non-sensical provisions in the bill that relate to trading emissions rights, and derivatives on them.

First, the bill permits only emitters to own certificates, and to purchase them at (an annual) auction.  This means, specifically, that financial institutions cannot buy or trade certificates.  Presumably, this is intended to bar the market to those malign speculators.  But its actual effects will be to make the market extremely illiquid, and to make it unnecessarily costly for those who have more permits than they need to trade them with people who have fewer than they need; financial institutions would be the natural market makers and liquidity suppliers, and baring their participation would starve the market of liquidity.  This will hamper the efficiency of the market, and make it costlier to achieve the emissions reductions imposed by the cap feature of the bill.  Moreover, it is likely that absent such a restriction, certificates could be used as collateral and facilitate end user financing, an alternative that would be precluded under the bill, making it more costly for emitters to finance their purchases of certificates.

Second, and even more bizarrely, the bill prohibits those very end users from trading any derivative contract on emissions.

Let me repeat: the bill prohibits those very end users from trading any derivative contract on emissions.

Huh?

Under a cap and trade scheme (and I mean scheme), end users are exposed to carbon price risk, and over very long time horizons.  They are natural hedgers who need derivatives to manage that risk exposure, but the Cantwell-Collins bill would preclude them from doing that.  The bill creates risk by pricing carbon, but at the same time denies those affected by this risk the ability to manage it.  That borders on cruel and unusual, and just makes it unnecessarily costly to achieve carbon reductions.  Pain with no gain.

But note the bill doesn’t ban derivatives outright, so Cantwell and Collins are apparently perfectly willing to contemplate a carbon casino where only speculators can play (though not in the certificates themselves).  But the speculators will not be allowed to provide valuable risk bearing services to hedgers.  No, it doesn’t make sense to me either.

Seldom have I seen anything so inane coming out of Congress, and that is saying something.

Separately, Cantwell came out with a call for increased regulation of commodity derivatives generally:

The US commodities market should be freed from “reckless speculation” and abusive trading practices, a leading US senator has urged, as she attempts to stop the price of everyday items like petrol and food from being impacted by financial traders.

Senator Maria Cantwell, who is separately trying to revive the Glass-Steagall reforms of the 1930s which would prevent retail and investment banks from operating under the same roof, yesterday called for increased regulation of the commodities and derivatives market.

The Democrat politician is attempting to push regulation of the commodities markets – a hot topic in the summer of 2008 when oil prices topped $140 a barrel – back to the top of the political agenda.

She is calling for stronger powers for the Commodities Futures Trading Commission (CFTC), including the potential to police the unregulated over-the-counter derivatives market, which has worth $25 trillion at the end of June 2009.

And how, pray tell, does the Senator support her case?  By calling on the vaunted expertise of megatool Michael Masters:

Backed by hedge fund manager Michael Masters, of Masters Capital Management, she called for the proposed reforms to take their place alongside wider financial regulatory reforms currently being discussed by the US Congress.

Mr Masters believes that there is a strong correlation between the credit crisis and volatile commodity costs, which have seen a rise not only in oil prices but in basic food staples in recent years.

Correlation, causation.  Whatever.

Masters and I participated in a workshop on oil markets sponsored by the Energy Information Agency back in November.   I can state categorically that he doesn’t understand the economic function of derivative markets, or of the functions that financial intermediaries play in these markets.  He says things like (I quote from memory, but this is almost verbatim) “financial markets are for allocating resources over time, but commodity markets are to get goods from producers to consumers.”  Well, yeah, but commodity markets are also crucially about allocating resources over time, because the time patterns of consumption and production don’t necessary always match exactly.  In fact, they almost never do.  (Think about a seasonal commodity, like corn or natural gas.)

So even beyond risk shifting, you need futures and forward markets to encourage the efficient allocation of commodities over time; getting stuff from producers to consumers inevitably involves intertemporal trade.  What’s more, financial intermediaries are frequently the best able to perform the function of storing and financing commodities.  After all, what they do is facilitate intertemporal resource allocation, and commodity storage and financing is just a specific example of that.  But not in Mastersworld, evidently.

Talk about the blind leading the blind–or is it the phobic leading the phobic?  Maybe group therapy is available at a discount.

After Masters made this statement at the EIA workshop, I replied along the above lines.  Only less politely.  I started by saying something like: “I can’t believe you said that.  It’s one of the dumbest things I’ve ever heard.  Commodity markets are all about allocating resources over time.”  Always trying to win friends and influence people.

I doubt either of these measures is going anywhere.  Fortunately.  But they reveal a disturbing mindset that is all too common on Capitol Hill, and among the pilot fish that swim symbiotically with the senatorial sharks.

Most IPOs “pop” on their first day of trading.  Their prices typically rise, and often by a lot, above the offering price.  The pops tend to be bigger on less developed markets.

Daring to be different, Oleg Deripaska’s Rusal had a negative pop.  Indeed, it was down 10.6 percent below the offering price.  Now, some of this can be attributed to the fact that the Chinese market has been trending down, and went down between the pricing date and the first trading date.  The Chinese aluminum firm Chalco went down 9.7 percent between the day that the Rusal issue was priced, and the first trading day.

But however you measure it, Rusal was a big underperformer, relative to typical IPOs.

In some sense this isn’t a surprise.  UralSib’s Chris Weafer suggested the issue was as much as 50 percent overpriced.

So why did the issue sell out when it was arguably overpriced?  Well, one possibility is that this was a combination of a state bailout of Deripaska/Rusal, and a debt restructuring.  Russian state owned bank VEB took about a third of the issue, and Sberbank and VTB, also Russian state banks took down pieces as well (though I haven’t been able to find out how much).  Moreover, participation was limited by the HKSE to big institutional investors, including many banks who had lent Rusal a large amount of money, some of which was to be repaid with IPO proceeds.  Overpaying by the state banks would effectively provide state support for Rusal.  Overpaying by those who had lent Rusal money, who were then paid for their debt using the IPO proceeds, would be a backdoor way of making the banks take a haircut on the debt.

Given that this whole IPO was pushed by the banks as a way of reducing their exposure to Rusal, overpaying 10 percent for the equity can reasonably be seen as a small price t0 pay to take a few pieces out of the Rusal albatross hanging around their necks.

This is a black eye for the Hong Kong Stock Exchange, though.  The negative pop is just the culmination of a very ugly, ugly process.  I don’t know if there’s soap strong enough to wash the Deripaska/Rusal stench from the HKSE.

Not that they weren’t warned, and not that they should have needed a warning to know.  Deripaska is P-O-I-S-O-N.

I was in NY today, giving a press conference at NYMEX about my WTI study.  After that, I went down to the floor for a (taped) interview about the study with CNBC.

Wow.  How the world has changed.  I haven’t been on an exchange floor in a while; increased security post-9/11 has made it much more difficult.  But I spent a good deal of time on the floors in Chicago in the 80s, and in the 90s.  I was at the CBT the day the new trading floor was opened for a dry run: I remember watching hundreds of traders lining up at the entrance, like marathoners before a race, then sprinting to stake out a place in the new bond and note pits.   There was an indescribable energy on the floor.  It escapes my powers of description, really.  It’s something you had to experience.

And the operative thing there is the tense of “to have.”  You HAD to experience it, because you really can’t experience it anymore.  And that’s what I experienced first hand at NYMEX today.  I was taping right next to the crude oil pit.  Back in the day, there is no way you could have stood there, and conducted an interview to be played on TV: the noise would have made it impossible.  No problem today.  The few handfuls of traders in the pit were all reading newspapers.  I was there probably 15-20 minutes, and didn’t see one trade.  Not one.

Yeah, there was some action in the options pit, but the futures pits were essentially D-E-A-D dead.

Above the pits were many Trading Technology* screens, which were reporting the action from the electronic trading.  That’s where all the action was.  If there was a visual symbol of the dominance of electronic trading, that would be it.  The blinking blue and red screens, lording over the pit, almost mocking it with their continuous movement symbolizing a live, moving (but disembodied) market while the pit itself was almost funereally still.

I have mixed emotions about this.  In the early-to-mid-90s I was pretty outspoken in my opinions that electronic trading would make the floor obsolete.  I was ridiculed, publicly and in print, by the CEO of LIFFE, for my research showing that the electronic DTB Bund futures market was as liquid as the LIFFE’s floor market; he was not alone in his views.  I resisted the temptation to return the ridicule 4 years later when EUREX (the successor to DTB) wrested the Bund business from LIFFE.  So, in some respect, the eerie silence on the NYMEX floor is a professional vindication.

But still.  There is something–was something–truly special about the floors.  They were fascinating economic and social systems–true ecosystems.  The informal norms of floor trading–the institutions–were amazingly complex.  And highly, highly entertaining.  Moreover, the floors were a connection to history; trading on the CBT in 1995 wasn’t that much different from in 1895–at least at the pointy end, where trades were actually done.  A bunch of guys (yes, almost all guys, even in 1995) yelling and gesturing at one another.  As a student of history, there is a sense of loss when such a tangible connection to the past fades away.

There’s a new movie, Floored, that depicts life on the floors in Chicago in their twilight.  I haven’t seen it, as it’s just playing at an art house in Chicago, but hope to do so if/when it comes out on DVD.  Some folks in Chicago are ticked off (no pun intended–and you know inside baseball if you even know that COULD be a pun:) that the film (if it’s at an art house, it must be a “film,” right?) focuses on the sex,drugs, greed, and rock & roll aspects of floor trading.  Yeah, it’s undeniable that that’s part of the culture, but it’s not the whole thing, or even a big part of it, so I can understand that those who love the markets would be dismayed by such a one-dimensional portrayal.  Perhaps I will be dismayed too when I watch it.  But sex sells, and there has to be a better way to understand some of the social complexity of the floor than watching Trading Places.   One would hope, however, that a serious filmmaker would team up with some serious social scientists and do a documentary that explores the anthropology/sociology/economics of the floors.  Or that the Smithsonian captures memories of traders, like it does of old blues players and such.  Before all the old traders just fade away.  Because it’s happening before our eyes.

* Full disclosure: TT is a consulting client.

I was talking to some folks at a research/policy institute at another university about regulation of carbon derivatives trading who are attempting to educate Congress (or, more precisely, Congressional staff) on the matter.  They told me that there was a widespread belief on Capitol Hill that customized, OTC derivatives offer little or no social benefit, and that as a result, their use should be highly restricted, if not eliminated altogether. The view is that these instruments create systemic risks, but confer no corresponding benefit that cannot be offered by exchange traded products.

I disagree, for reasons I set out in a Brookings paper released last fall.  But I don’t want to focus on the details of that argument here.  Instead, I just want to flash back to a historical example that demonstrates that limiting the contracting choices of commodity market participants can have extremely perverse effects, and can in fact create systemic risks.

The legislation that restructured the California electricity markets, AB1890, precluded the state’s major utilities from entering into long term contracts for power.  Instead, in order to ensure the “success” of the spot market for power, the utilities were required to buy electricity from generators through an exchange–the Power Exchange (“PX”).  The bill also capped the price that utilities could charge their customers for power.

This legislation created a huge short position for the utilities.  They were exposed to increases in prices on the PX, and could not pass on these costs to customers.  Most importantly, the bill prevented the utilities from managing their price risk by engaging in long term forward contracting.

We all know what happened.  Power prices spiked, and two utilities still subject to the constraints (SoCal Edison and PG&E) suffered huge losses.  PG&E went bankrupt.

The problem would likely have been less severe had the utilities been given the ability to hedge.  Indeed, the absence of forward contracts may have exacerbated the price spikes, because these contracts would have precommitted the generators to supply power, whereas they arguably had an incentive to restrict output on the PX when conditions became tight.

Moral of the story: limiting the ability of firms to manage risks can impose substantial dangers of financial distress on those companies.  Indeed, if they limitations are systemic (as they were in California), they create the risk of a systemic problem.

Now, the analogy should not be stretched too far.  In its infinite, tofu-fueled wisdom, California chose to favor one type of exchange trading (spot auctions on the PX) for different reasons than Congress in its infinite God-knows-what-fueled-wisdom is contemplating favoring exchange trading of carbon (and other) derivatives.  Moreover, the restrictions in California were particularly draconian, especially when combined with the retail price caps.

Nonetheless, the tale should be a cautionary one.  Firms use derivatives contracts to pass risks to others who bear them at a lower cost.  If you constrain their ability to do so, they will wear more risk than they would otherwise.  This raises the likelihood that they will suffer crippling financial losses.  The more draconian the restrictions, and the wider the scope of their application, the greater the likelihood, severity, and extent of these losses.

That is, by avoiding one risk, you create others.  Rational policy requires a prudent trade-off between these various risks.  But fixated as they are on the risk (largely chimerical, IMHO) of OTC markets, most policy makers in DC are blind to the risks they are effectively choosing.  Their ability to weigh these tradeoffs is, moreover, extremely limited due to a fundamental lack of information.  Carbon trading regulation in particular will have systemic effects: it will impact every producer and consumer of energy.  How could Congress possibly have the knowledge to evaluate the risks that they are forcing on such a vast and diverse group of companies when they restrict their ability to choose the instruments that they can use to manage that risk?  Short answer: they can’t.

I would hope that the California experience would at least make policy makers aware of the possibility that restrictions on the contracting choices available to market participants creates risks.  So far, however, the debate appears to have taken no recognition of this very real possibility.  Keeping their eyes fixed on the skies to reduce the risk of being hit by a falling object, they face the very real risk of stepping into an open manhole.

The CFTC floated its proposal to set energy futures & futures options position limits yesterday.  Here’s the NOPR, and here’s a cheat sheet and FAQ about the proposal.

The result is no surprise to me.  In the weeks leading up to the announcement, many reporters had called to ask for my take on the CFTC’s likely course of action.  I responded that the CFTC would do something, but that the limits it chose would be relatively generous.  The agency was between a rock and a hard place.  On the one hand, Congress clearly expected action; indeed, I strongly suspect that Gensler had to promise that he would act on energy position limits to get the job in the face of skepticism from Bernie Sanders and some others in the Senate.  On the other hand, it eventually dawned on the Commissioners that overly restrictive limits would just drive business to OTC, and perhaps overseas; given that Gensler in particular wants to rein in the OTC markets, this would be an extremely perverse outcome.  So, they did something, but not much.

Which isn’t the best alternative, but it’s not the worst either.  The best alternative would have been to take a principled stand like the FSA, which has remained skeptical on position limits because of the lack of any evidence that speculators distort prices.

Indeed, the entire justification for the CFTC action could be summarized as (with apologies to The Treasure of the Sierra Madre): “Evidence?  We ain’t got no evidence.  We don’t need no evidence.  We don’t have to show you any steenkin’ evidence!”

Don’t believe me?  Well, here’s what they say:

The Commodity Exchange Act directs the CFTC to act prospectively, as necessary, to curb or prevent excessive speculation . . . The CFTC’s notice of proposed rulemaking does not speak to whether there was excessive speculation in the regulated derivatives markets for energy commodities. [From the FAQ.]

The CFTC need not demonstrate that there has been excessive speculation in the regulated derivatives markets for the major energy commodities. [Emphasis added.]

I see.  There is no evidence that speculation has distorted prices in the past, but the Commission feels it is perfectly acceptable to act against the purely hypothetical possibility that it might in the future–even though the logical and empirical basis for the hypothetical is extremely dubious, at best.

A couple of other comments on the proposal.

First, it creates a tripartite classification of market users–bona fide hedgers that use futures to manage physical risks; swap dealers that use the contracts to manage financial risks, and speculators.  Swap dealers can hold positions equal to twice the limit to which speculators are held.  This seems like being a little bit pregnant.  The higher limit is an implicit admission that swap dealers do use these instruments to manage financial risks.  Indeed, many of these risks are transferred from the very same physical market players whom the proposed limits favor as bona fide hedgers.  (Swap dealers offer risk management solutions to physical players, and then lay off some of that risk through the futures markets.)  So then what’s the point on limiting the position swap dealers can hold to hedge their OTC books?  And why is “two” the magic number.

Perhaps this is best seen as a backdoor approach to push trading from the OTC market onto exchanges.  Not a good idea.

Second, some aspects of the proposal are intellectually incoherent.  For instance, (a) there are all month limits, and (b) the limit for cash-settled contracts is five times the limit on delivery-settled contracts for firms that hold only the former.

Now, if you believe that market power manipulation is the problem, and if you believe that delivery settled contracts are particularly susceptible to market power manipulation, then all month limits are unnecessary; a spot month limit would be sufficient to mitigate manipulation.  (It’s wrong, as I showed in a JOB paper some years back, to conclude that cash settled contracts are not susceptible to market power manipulation, but it is a widely held belief.)

So, by choosing all month limits, the CFTC must believe that market power manipulation alone is not the problem; speculation can distort prices in other ways.   But if you believe that (not that you should, but if you do), you should also believe that speculation in cash settled contracts could also distort prices.  (A lot of the hyperventilating about index funds, and OTC markets, is based on the view that people making bets affects the outcome of the race.)  But if you believe that, you wouldn’t privilege cash settled contracts through a much more generous position limit than for delivery settled ones.

Perhaps this incoherence shouldn’t be a surprise.  Given the complete absence of any credible theory or evidence as to how speculation distorts prices to guide policy making, silliness is inevitable.

How will this play out?   Apparently the Commission is quite divided.  Moreover, it has indicated that it will take its sweet time in evaluating comments on the proposal, and may revise it accordingly, stretching the implementation time line.

My guess is that this is a strategic decision.  The Commission at least recognizes that any coherent approach to limits (even if the coherence is based on flawed theories and evidence: I just mean intellectually consistent) must encompass both the OTC markets and the exchange traded markets.  If the Commission wants to, for reasons known only to its members, crack down on speculation generally, acting on the futures markets alone is doomed to failure.  But they are waiting on Congress for authority to act in the OTC market.  Slow walking the proposal gives Congress time to act, and may indeed goad it into action.

In brief: laws, sausages–and CFTC proposals.

Greg Meyer at the Financial Times wrote a piece covering a just-released study I did analyzing the performance of the CME-NYMEX WTI crude futures and ICE Brent crude futures during the financial crisis.

The full study is here: scroll down to the bottom for the PDF.

Cliff’s Note version: (a) the financial crisis was a period of unprecedented volatility in the oil markets, (b) the hedging performance of both pricing benchmarks declined during the crisis, (c) the crisis affected front month WTI more acutely than second month WTI or either front or second month Brent, (d) the performance of second month WTI was comparable to that of both Brent contracts, (e) the most likely cause of the observed price behavior was the major shock to demand, which resulted in a sharp increase in oil in store at Cushing, (f) spread behavior was not something peculiar to WTI, because the fundamental shock affected West Texas Sour crude (also tributary to Cushing) too, (g) oil stocks and WTI spreads continued to covary positively, as you’d expect, though the relationship was weaker during the period of the crisis, but (h) oil stocks and Brent spreads covaried negatively during the crisis.

Timmy! Geithner has been keeping a low profile lately–but maybe it’s just the anti-terror FUBAR that has drawn attention away from him.  But today he gets a banner headline on Bloomberg:

The Federal Reserve Bank of New York, then led by Timothy Geithner, told American International Group Inc. to withhold details from the public about the bailed-out insurer’s payments to banks during the depths of the financial crisis, e-mails between the company and its regulator show.

AIG said in a draft of a regulatory filing that the insurer paid banks, which included Goldman Sachs Group Inc. and Societe Generale SA, 100 cents on the dollar for credit-default swaps they bought from the firm. The New York Fed crossed out the reference, according to the e-mails, and AIG excluded the language when the filing was made public on Dec. 24, 2008. The e-mails were obtained by Representative Darrell Issa, ranking member of the House Oversight and Government Reform Committee.

R asks if this could be the last straw for Timmy!  You’d think, but if Janet Napolitano and John Brennan are still among the employed (I wouldn’t say “gainfully employed”), it’s pretty clear that you can get away with a lot these days.  A whole helluva lot, in fact.

The Bloomberg article is very short on reasons why the FRBNY was so adamant on keeping the details of the AIG deals quiet.  Any GueSses?

No doubt this was of a piece with the Paulson-Bernanke insistence that all big banks take TARP funds, in order to pool the true weaklings with those not in desperate shape, so as to stem potential runs on the weaker institutions.  No doubt revelation of the details would have raised questions as to why it was so, so important to pay off Goldman, DB, etc., and ASAP.

I would love to hear an explanation as to how this could possibly be consistent with Geithner’s insisting to the Special Inspector General that the financial condition of the AIG counterparties was (I quote from memory) “not a relevant consideration” in the government’s decision make said counterparties whole.

Again: he was either lying when he said that, or everything else he has said or done in regards to the AIG intervention is a lie.

This raises another issue.  Geithner, along with others in the administration (notably Gensler at CFTC) has been preaching The Gospel of Transparency when flacking for clearing and exchange trading mandates.  Sunshine and transparency have magical powers, they intone, that will protect us against systemic risk.  Those who oppose transparency are merely greedy special interests protecting their turf.

But the FRBNY’s actions with AIG, and Treasury and Fed actions more generally, make it clear that the powers that be clearly believe that transparency can be damaging under some circumstances.

I’m perfectly willing to stipulate that, and then debate what is the right amount of transparency, and more importantly, what is the appropriate process to determine the level of transparency in various settings.

What I can’t abide is highhanded lectures about the virtues of transparency and the need to force it on individuals and firms, delivered by the likes of Timmy! Geithner, who is more than willing to do big deals away from prying eyes when it suits him.

The UK’s Financial Services Authority (FSA) released a report on OTC derivatives market reforms in December.  In contrast to most government reports I’ve read on the subject, this one is thoughtful and arrives at pretty well reasoned judgments.  It recognizes the trade-offs involved.  It is a little too sanguine on the merits of clearing for my taste, but does not recommend mandates.  It recognizes the burdens of mandated clearing and the associated cash flow risks on end users.  It advocates an increased reliance on data repositories (something I advocated in late-2008 for OTC derivatives, and for energy years before that).  It identifies counterparty risk management as the key issue, and concludes that mandated exchange trading is unnecessary to address this issue, and an unwarranted attempt to impose market structures.

Its analysis of position limits is especially good. I liked this part:

The second limb of the Commission’s proposal is to give regulators the possibility of setting position limits to counter concentrations of speculative positions. Such an approach would go beyond the existing legislative remit in the UK and more importantly we have not seen evidence which supports such an approach. The UK regime applies its position management tools to all participants, without a specific emphasis on those that do not have a desire to hedge physical positions, or take physical delivery. We do  not consider activity by financial participants to be de facto manipulative. We do not therefore consider that there should necessarily be a distinction made between “large speculative” and “large   non-speculative” positions for the purposes of combating manipulation – the focus should be on combating “large positions that lead to manipulation” irrespective of whether they are held by financial participants or not.

And this:

9.20 Over the last two years, certain commentators and market observers have linked the growth in financial, or “speculative”, participation in commodity markets with recent significant price movements, particularly in oil.We recognise that this type of investor has impacted the nature of commodities markets as a whole, for example, as a result of different methods of trading and increased volumes.

9.21 However, the majority of academic studies and evidence do not support the proposition that prices have been systematically driven by this increased inflow of financial interest.  Indeed the majority of commentators have concluded that commodity price movements cannot be solely attributed to the  activities of any one class of investor and are principally attributable to market wide factors.We agree with these conclusions.

Proposals for combating price movements

9.22 The FSA’s regulatory aim (as defined by legislation) is on maintaining fair and orderly markets, not limiting price movements or volatility. In any event, we do not believe a case has been made which demonstrates that prices of commodities, or other financial derivatives, can be effectively controlled through the mandatory operation of regulatory tools such as position limits, whether on exchange or OTC. Analysis of market data where position limits are already in use suggests that this has not shown a reduction in volatility or absolute price movements compared to contracts where they are not.

9.23 We also consider that limiting financial participation more generally would hamper market efficiency. To use oil markets as an example, increased participation has brought significant benefits, such as greater depth and liquidity.

In contrast, on this side of the water, from the Chairman of the FSA’s US counterpart, the CFTC, we get drivel like this.  He’s said it all before.  Arguendo ad AIG.  Horror stories about interconnections.  Completely misleading conclusions based on outrageously inappropriate analogies between impossible to price toxic assets like MBS-based CDOs and vanilla swaps.  Assertions that end-users don’t know their own economic interests, and subject themselves to the predations of a “small group of derivative dealers.”  (His comparison between buying an apple and the OTC derivatives market is especially idiotic.)  Wildly misleading insinuations that clearing will reduce interconnections in the financial system.  Similarly wildly misleading insinuations that OTC trades are not collateralized.  (Before anybody says this about AIG again, read the AIG Special Inspector General’s report.  Please.)  Egregiously misleading insinuations that failure of a clearing member “does not harm its counterparties.”  (Then, pray tell, who eats the loss?  The derivatives fairy?)

Ugh.  What inanity awaits us when CFTC announces its position limit changes?

Overall, the Europeans are quite dismayed at the trajectory of regulatory and legislative initiatives here in the US.  This dismay is documented in a couple of articles by Jeremy Grant in the FT.  This quote is priceless:

Richard Raeburn, EACT chairman, said companies were looking for a “clear carve-out” from the clearing and exchange-trading requirements.

“My fear is that what happens in the US will pre-empt the ability to be sensible over here,” he told the Financial Times.

Yes, Mr. Raeburn, be afraid.  Be very afraid.