Streetwise Professor

Why is it that everything involving Russian business, and especially Oleg Deripaska, is murky beyond belief.  In a battle of leaks with Reuters, Bloomberg reports that the Hong Kong Stock Exchange has approved a $2 billion Rusal IPO.  Supposedly, however, the exchange imposed an unprecedented condition: that retail investors not be permitted to buy shares.  But the Hong Kong securities regulator says that such a constraint is not permissible under the law.  It also makes no sense.  Even if they can’t buy at the IPO, what’s to prevent them from buying in the secondary market.  Thus, the constraint would not protect retail investors.

John Helmer reports that there has been no formal announcement of the listing approval under the official protocols (i.e., a posting on the HKEx website).  Moreover, exchange officials have been dodging questions.  Thus, it is by no means clear that the IPO has truly been approved.

One can only imagine the pressure the exchange and the Hong Kong regulator is under.  And not from Russia only, but also from the big banks who are into Rusal for big money and desperate to get paid off from the proceeds of an IPO.

At the same time, the exchange and the regulator have to realize that Rusal, Deripaska, and Russia are poison, poison, poison.  You know that based on the merits–or more accurately, the demerits–of Rusal as a business and Deripaska as a businessman, there is no way an IPO should go forward.  This is especially true given the legal cloud Rusal and Deripaska are under in London, given a lawsuit filed by  Mikhail Chernoy that is bearing down relentlessly.

It will be very interesting indeed to see whether the exchange drinks the poison.  The most sensible explanation to what is going on is that Rusal leaked the story of the approval to put pressure on the exchange.  The exchange is also under pressure from the banks to go forward, and from the Russian government.  But the exchange really wants nothing to do with it.  Perhaps it is trying to stall, hoping that other developments, most notably the Chernoy suit, will make it necessary for Rusal to withdraw the application.  Good luck with that.

This is a very interesting case study in self-regulation (a subject I wrote a good deal about in the ’90s).   There are important members of the HKEx who have a vested interest in the IPO going forward.  There are others who would not benefit from this, but who would suffer from the inevitable damage to the exchange’s reputation.  It will be quite fascinating which faction will prevail.

Sorry about the lack of posts.  I’m in Rio de Janeiro for a conference jointly sponsored by Columbia Law School, a Brazilian think tank FGV, and the Brazilian securities regulator that ended yesterday. (I was going to say “blame it on Rio” but that would be lame:)  Good conference, though tiring as all the Brazilians gave their talks/comments/questions in Portuguese, with simultaneous translation, which takes concentration to follow–although I can only imagine how how it is to do.  (Interesting socio-political question as to why the conference was, unlike most, bilingual.)

Anyways, several things have caught my eye in my glances at the news.  The Russian items resonate with a theme often expressed/discussed on SWP–the repetitive, Sisyphus-like nature of Russian life.  Fighting the same battles, again and again.

1. Yegor Gaidar passed away.  The controversial architect of many of the Yeltsin reforms, he was ultimately disillusioned by Russia’s path under Putin.  I reviewed his book here.  Here’s the opening line of the review, which can serve as an epitaph:

Cassandra was the Trojan woman whom Apollo gave the gift of prophesy-and the curse of never being believed. Yegor Gaidar sees that Russia’s future depends crucially on coming to grips with its past, but present events make it clear that his prophesies, like Cassandra’s, fall on deaf ears.

In his new book,  Collapse of an Empire, Gaidar has a pressing purpose: to alert Russians-and the world-to the dangers denying the real reasons behind the collapse of the USSR. Gaidar has a strong historical sense (which is often absent among economists, alas), and from his understanding of history (most notably, of Weimar Germany and post-Hapsburg Austria-Hungary), he knows that imperial collapse can be disorienting and dispiriting to the empire’s subjects, even if the empire brutally repressed them. He also knows that demagogues and revanchists can exploit this disorientation and depression to achieve power. Those suffering from post-empire depression are very susceptible to demagogic myths that imperial glory was destroyed by “stabs in the back” from enemies foreign and domestic, and that restoration of this glory requires the people to unite behind an authoritarian leader who will ruthlessly pursue traitors at home and take revenge on foreign foes.

But he foresees that this is ultimately the road to disaster.

2. Medvedev is aiming to reduce Russia’s “colossal” drinking problem by cutting alcohol consumption by 72 percent.  All I can say is: Good. Luck. With. That.  Here are the grim statistics:

Medvedev in June told Health Minister  Tatyana Golikova that Russia’s alcohol consumption is “colossal” and asked the government by today to find ways to fight excessive drinking and bootlegged vodka production. Illegal spirits make up about half of total alcohol consumption in Russia, lawmaker  Viktor Zvagelskiy said yesterday in an interview in Moscow.

“More than 23,000 people are dying from random [actually sounds kind of systematic] alcohol poisoning currently in Russia,” the market regulation service said in the plan. “More than 75,000 people are dying from illnesses caused by excessive drinking.”

Gorbachev attempted an aggressive anti-liquor campaign that succeeded in reducing substantially alcohol related problems–but which also wreaked havoc on the Soviet budget, given the importance of alcohol taxes as a source of revenue.  (Thus, it is ironic that this news came out on the same day as that of Gaidar’s death, for he wrote about that episode in his book.)  Gorbachev’s campaign also spurred dramatically the production and consumption of illicit alcohol.  (I remember reading that it was common for Russian military pilots to claim that they were experiencing icing and had to de-ice even when this wasn’t true, so they could siphon off the de-icing fluid to drink.  I’m sure that did wonders for military preparedness.  No surprise, then, that Matthias Rust was able to fly a small plane unmolested to land in Red Square).

The Bloomberg article suggests that Medvedev/the government recognize this, and are going to try a simultaneous battle against licit and illicit alcohol by (a) enforcing minimum prices on vodka sales, (b) raising beer taxes, and (c) cracking down on moonshine.  This is very ambitious, and almost certainly doomed to failure.

This presents another wonderful corruption opportunity for those responsible for enforcing the new restrictions.  It is very difficult to see how any enforcement efforts can succeed in a country so riddled with corruption.  The cynic would say that the announcement of such efforts is just a way to increase the take of the “enforcement” bodies and their employees.

3. Apropos the recent “It Blew Up Real Good” post of last week, Russia has announced that it is delaying construction of the fourth Borei class SSBN.  Although the article suggests that this delay is connected with the problems with the Bulava missile, if true that would suggest that the Russian navy is very, very pessimistic on the missile’s prospects.  There are 2 Boreis under construction.  The fourth would not be ready for some years even if it were laid down immediately. If the navy thought that the Bulava problems are fixable, given the lead time on sub construction it would not make sense to delay due to the recent spate of test failures.  However, if the Bulava program is in serious jeopardy, it would make sense to delay construction, perhaps to re-design the Borei to carry a different missile.  Thus, if there is any connection between this announcement on the delay of the sub construction and the Bulava problems, the inference would be that the Bulava is unsalvageable.

The delay could just indicate budgetary issues, however, so one cannot be too sure about this inference.

4. One non-Russian item.  Mark Roe of Harvard Law School has written an interesting piece on the privileged status of derivatives under bankruptcy law.  (I was quoted on this subject in The Economist last month.)  Mark’s argument is a very interesting one: namely, this contributes to systemic risk by reducing derivatives traders’ monitoring of the creditworthiness of their counterparties.  He argues that since they don’t have to worry about fraudulent conveyance claims, derivatives traders can enter into deals in the confidence that they can get what failing counterparties owe them, and let the devil take the hindmost.  The fact that they are first in line reduces the incentive of derivatives counterparties to pay close attention to the financial condition of those they trade with.

This argument has some attractions, but I’m not sure I buy it completely; even if derivatives traders have lower incentive to monitor, other creditors’ incentives increase, so it’s uncertain whether the total amount of monitoring, or the pricing of credit risk at the margin, is affected by this particular choice of priority rules.

I’ll give it some thought.  On the beach 🙂  More later . . .  amanhã . . .    maybe.

FT Alphaville–an (excellent) Financial Times blog–graciously invited me to write a guest post on the financial “reform” legislation that is moving through the House of Representatives (and just passed yesterday).  (Thanks, Stacy-Marie.)  Here it is:

Guest post: Prof Craig Pirrong on moves to overhaul to the derivatives market

Posted by  Guest writer on Dec 11 13:38.

Lawmakers in DC are due to resume debate on major financial reform legislation currently working its way through the US House of Representatives. One closely-watched aspect of that debate is sweepingoverhaul of over-the-counter derivatives markets. Lawmakers are pushing to mandate that most derivatives be centrally cleared and traded either on exchanges or swap execution facilities. Professor Craig Pirrong of the University of Houston discusses some of the proposals.

In attempting to impose standardization on the ways that derivatives are traded, and derivatives counterparty risks are managed and shared, the legislation reflects a one-size-fits-all mentality (not to say fetish) that is sadly typical of most legislative attempts to construct markets.   These standardization directives fail to recognize that market participants are diverse, with diverse needs and preferences, and that as a consequence, it is desirable to have diverse trading mechanisms to accommodate them.

Standardized exchange products with central clearing are well-suited for some products and some users, but more customized arrangements (including customized, bilateral agreements relating to counterparty risk) are preferable for others.   And one should be extremely skeptical about claims that to enhance their profits, greedy bank-dealers force derivatives end users into trading on opaque, concentrated markets instead of transparent exchanges; end users have had the opportunity to choose, and exchanges have competed aggressively to try to attract them, but many end users nonetheless have decided to trade in markets that are allegedly stacked against them.   Is it really wise to predicate a radical restructuring of markets on the view that end users are suffering from the financial analog to battered spouse syndrome?

Ironically, one of the controversies that has come up in the debate over amendments to the proposed legislation involves supposed backsliding from the old time standardization religion.   An  amendment changes language defining “swaps execution facility” to allow trading of swaps through voice brokers to meet the bill’s requirement that swaps be traded on such a facility or an exchange.   Moreover, other language in the amendment allegedly allows banks to continue business as usual.   That is, whereas reform advocates envisioned that under the new law swaps would be traded almost exclusively on exchanges or transparent, exchange-like venues, they claim that the new language would perpetuate the existing ways of trading swaps in scary “dark” markets.

This is not a bad thing at all – contrary to what some have  argued.   A variety of execution mechanisms developed to satisfy the disparate needs of market users with respect to pre-trade and post-trade transparency, credit and collateral arrangements, and product design.   To the extent that the amendments recognize this reality, and give market participants some flexibility in selecting the mechanisms best for them, the authors are to be commended.   To the extent that the bill still imposes unnecessary mandates, they are to be criticized.

One final note: proposals to force derivatives trading onto exchanges have been tried before – back when grandma wore high button shoes.   As financial markets developed, these restrictions proved unworkable and unwise.   The advocates of one-size-fits-all reform would have us repeat the same errors.   Back to the future is not progress.

[The background here is that the first regulation of futures trading in the US, the Grain Futures Act passed in 1922 required all “contracts for future delivery” to be traded on “a designated contract market” (i.e., an exchange).   The Commodity Exchange Act (passed in 1936) extended this to non-agricultural commodities.   This created huge issues starting in the 1980s particularly when new products that had futures-like features started to be traded OTC, and banks starting offering products to retail customers that had interest rates tied to the S&P or gold.   The question became: what was a future?   One-size-fits-all became clearly unworkable.]

The French Vice Chairman of the UN’s Inter-governmental Panel on Climate Change (IPCC) has accused the FSB of causing Climategate by hacking into UEA CRU’s computers.  This presents ol’ SWP with something of a dilemma, with many of the targets of my ire–the French, the UN, the IPCC, and the FSB–arrayed against one another.  What a target rich environment.  On the one hand, I can’t miss.  On the other, it does make choice of target something of a challenge.  LOL.

And I’d be sitting down, ladies and gentlemen, because on this one I have to side with the FSB, at least on the basis of what we know so far.

Here’s what IPCC VC said:

“It’s very common for hackers in Russia to be paid for their services,” Professor Jean-Pascal van Ypersele, the vice chairman of the Inter-governmental Panel on Climate Change, said in Copenhagen at the weekend. “It’s a carefully made selection of emails and documents that’s not random. This is 13 years of data, and it’s not a job of amateurs.”

The leaked emails, Professor van Ypersele said, will fuel scepticism about climate change and may make agreement harder at Copenhagen. So the mutterings have prompted the question: why would Russia have an interest in scuppering the Copenhagen talks?

This time, if it was indeed the FSB behind the leak, it could be part of a ploy to delay negotiations or win further concessions for Moscow. Russia, along with the United States, was accused of delaying Kyoto, and the signals coming from Moscow recently have continued to dismay environmental activists.

When Ed Miliband, the Secreatary of State for Climate Change, visited Moscow this year, he had meetings with high-level Russian officials and pronounced them constructive. But others doubt that Russia has much desire to go green.

In brief, M. Van Ypersele rests his case on (a) opportunity, and (b) motive.  The notorious abilities of Russian hackers provided the opportunity.  This cannot be disputed.  The motive is much murkier, however, and very indirect.  First, Ypersele assumes that the motive of the leak was to derail Copenhagen.  Perhaps–or perhaps it could have been the result a fit of conscience by someone at CRU (or an affiliated institution) who was scandalized by the anti-scientific behavior of Jones et al.  That could explain the very specific documents targeted in the leak emphasized by Ypersele.

Second, Ypersele stretches to argue that Russia has an especially strong motive to derail the implementation of a global cap and trade system.  The reverse could be true, given that Russia owns the largest stock of Kyoto-created emissions credits: an aggressive climate change deal that required other nations to reduce sharply emissions would enhance the value of these credits.  Yes, Russia has other agendas, such as protecting inefficient polluting industries and encouraging demand for its energy.  Thus, it is hard to determine on net whether Russia’s interests lie with or against CO2 caps.  (And in saying “Russia” one always has to remember it is the Russian elite and power structures that matter.  The credits could create a very nice slush fund for these folks to skim.)

There are other interests–Saudi Arabia comes to mind–that does not have such conflicting interests.  And, as Ypersele notes, Russian hackers are paid for their services: I’m sure Saudi money spends just as well as Russian, and the Saudis are likely to have more at the moment.

So the motive angle is very weak, and does not put Russia at the top of the list of suspects.  (This is sounding like a game of Clue or something.)

Nor does the fact that the documents appeared on a server in Tomsk mean much of anything.  The hackers originally tried to put the stuff on the RealClimate website (and no, I won’t link to that) using a computer in Turkey.  Then, using a computer in Saudi Arabia, they put up a link to the Tomsk site.  Given the murky international connections in the hacker world, it’s impossible to make anything of this.  Moreover, these sorts of analyses inevitably get into the Holmes-and-Moriarty on the Train quagmire: the FSB wouldn’t have put the stuff on a Russian server because it would have drawn suspicion; because people would figure the FSB would never draw suspicion to itself by posting on a Russian server, they put it on a Russian server; because people would figure . . .

This isn’t like Georgia at the time of the invasion in 2008, or in Estonia on 2007.  In each of those cases the motive was clear, few others had the same ability or opportunity, and other circumstances made it clear that Russian interests, and likely the Russian state were involved.  Here, the circumstantial case that Ypersele advances is pathetically weak. Not to say that it’s impossible that the FSB was involved, just that it’s far from proven, or even the most likely scenario.

One final thing.  The NYT article linked above discussing Russia’s Kyoto credits has yet another example of the economic idiocy that characterizes its news pages:

That is because Russia, as a result of the collapse of much of its heavy industry in the 1990s, owns one of the largest stocks of credits to offset carbon emissions.

The unearned windfall, a legacy of the Kyoto agreement that tried to deal with the threat of  climate change, is worth several billion dollars. If abruptly sold abroad, those credits could send the price of carbon on the world’s fragile emissions markets plunging toward zero.

I see.  The credits are worth billions.  Unless they’re sold.  In which case they’re worthless.  Whatever.

This ranks with a story I read some time back in the NYT which expressed astonishment that the unemployment rate went up even though the rate of increase in layoffs had fallen.  First derivative.  Second derivative.  Again–whatever.

Anybody who gets economic analysis from the NYT is sadly misinformed, but probably considers him- or herself as one of America’s elite.  Which explains quite a lot of our current economic and political troubles.

Perhaps reporter James Kanter can hide behind the adverb “abruptly.”  But why would Russia dump them on the market if that would drive the price to zero?  And if the price doesn’t go to zero due to self-destructive behavior, the whole premise of the rest of Kanter’s article disappears.  Oy.

Update:  An interesting analysis by a systems administrator that casts serious doubt on the hacker story.  In brief: it is almost certain that all the documents had already been assembled, probably by a freedom of information act officer, in response to or anticipation of FOIA requests.  Now, it could have been the case that a hacker gained access to this and disseminated it, but since it was (per this analysis) assembled and ready to go out, it’s also quite possible that this was a leak.  And if it was already assembled for FOIA/FOI purposes, the reasonable inference is that it would have been released in time.  That said, the release weeks before Copenhagen–just enough time for the story to get traction, not enough time for it to die–is crucial.

I’ve had several calls from reporters asking my opinion on the Lynch Amendment to Barney Frank’s derivatives regulation bill.  For some reason, Forrest Gump pops into my head every time that question is asked.  You know, the part where he says “stupid is as stupid does.”

As I am sure you all know, the amendment introduced by New Jersey Massachusetts representative Stephen Lynch, imposes restrictions on the ownership and control of the clearinghouses that the Frank bill will require the vast bulk of derivatives to be traded through.  The amendment imposes similar restrictions on ownership of exchanges and swap execution facilities.

Specifically, the amendment defines a class of “restricted owners” that includes swap dealers and major swap participants, and limits the amount of a clearinghouse (or execution facility or exchange) that these restricted owners can own or control collectively to 20 percent.  The justification for this limitation is to reduce conflicts of interest, the specific nature of which are not identified.

This represents yet another example of Congressional micromanagement of the organization and governance of financial institutions.  In my view, it is incredibly wrong-headed.

Let’s focus on clearing organizations.  Remember what they do.  They are a mechanism for pricing (via collateral) and sharing counterparty risk.  Any financial institution that agrees to participate in the sharing arrangement will reasonably expect to have control rights in the organization that oversees this sharing mechanism.  No sane financial institution is going to agree to share in a large fraction of the risk borne by a clearinghouse if it is restricted to having a small share in control.

This means that restricting ownership and control rights will inevitably exert a decisive influence on the allocation of counterparty risk through a clearinghouse.  If the swap dealers and other major swap market participants are limited in the amount of control they can exercise, they will limit the amount of risk they are willing to bear.  So who will bear it?

The traditional clearing firm has been effectively a mutual/cooperative.  Several intermediaries agree to share and manage counterparty risk.  These intermediaries offer various trading services, including brokerage and market making.  Counterparty risk is created as a result of the deals that they intermediate, and they find it in their mutual interest to price and share this risk collectively.

This mutual model has survival value.  Even the exchange clearinghouses that Frank et al apparently consider the ideal to be imposed on everybody are effectively mutuals governed by the major intermediaries.  (Once upon a time, the Board of Trade Clearing Corporation permitted every CBOT member to become a member of the clearinghouse, and adopted a one-member, one-vote voting structure.  However, over time, the organization evolved and became dominated de facto and de jure by the largest futures commission merchants.)  Nor is this an anachronism reflecting merely path dependence and hysteresis.  Indeed, one of the largest clearinghouses, LCH.Clearnet, has recently become a more focused mutual-type organization with increased control by large financial intermediaries; in a major reorganization completed weeks ago, LCH fended off a take-over effort launched by major market users by buying out smaller members and giving the big intermediaries a bigger stake in the organization.

This makes sense if the large intermediaries are the efficient bearers of counterparty risk.  If they are the efficient bearers, they should bear it.  And if they bear it, they will certainly condition their willingness to do so on their ability to control the organization.

Moreover, major market users have another reason to want to control the clearinghouse.  “Trading services” is a bundle of a variety of different services, of which clearing is merely one.  These services are consumed in close to fixed proportions.  Moreover, there is likely to be market power in the provision of several of these services, and clearing in particular has natural monopoly characteristics.  An independent clearing organization could exploit its scale economies, and exercise market power and extract rents from major intermediaries that use its services.  Moreover, to the extent that there is market power in one or more parts of the trading services business, this could exacerbate double marginalization problems, leading to other pricing efficiencies.

User control of the clearing function can prevent such exercise of market power.  The mutual/cooperative form allows the major users to obtain clearing services at cost.  If the major users of clearinghouse services cannot control the clearinghouse, those who do control it have an incentive to extract rents from the major users by charging inefficiently high prices.

Thus, from risk bearing and pricing perspectives, user dominance of clearinghouses makes economic sense.  Maybe, just maybe, that’s why users have dominated clearinghouses nearly everywhere and at all times.  Could it be?  What do you think about that, Rep. Lynch?  Barney?  (Barney is a big backer of Lynch’s amendment.)  Or do you guys just know better?  (We are not worthy!)

To me, what Lynch views with suspicion as a conflict of interest is actually an alignment of interest.  It aligns the control rights with risk exposures.  It similarly aligns the interests of those pricing the service with those who consume it.

If implemented, the Lynch amendment would make the mutual model unworkable.  As a rough estimate, if big users are limited to a 20 percent stake, 80 percent of the risk would have to be borne by somebody else.  Which would be who, exactly?  Equity investors?  Why would they provide capital?  Presumably to get a return.  Which would likely require the clearinghouse to be established as a for profit venture.  A venture that would have an incentive to charge supercompetitive prices for its services to extract rents from big users.  And mightn’t such equity investors have an incentive to take risks, given the asymmetric nature of equity returns arising from limited liability?  Isn’t that directly contrary to the whole reason for mandating clearing in the first place?

Also, does it make sense to weaken the ability and incentive of those with specialized expertise in evaluating counterparty risk to monitor and control the specialized organization established to manage this risk?

This is all so perverse.  Why do Lynch and Frank want to impose a constraint that almost certainly will reduce the efficiency of the organization that they have seized on as the way to improve the operation of the derivatives markets?  Or is this just a backdoor way of throttling the derivatives markets increasing the costs of using them through idiotic restrictions on the way they are organized, owned, and governed?  (Make firms who trade derivatives clear them.  Make clearing more expensive by preventing the implementation of efficient ownership and control structures.  Voila!  Fewer derivatives trades!)

There is one potentially real inefficiency that can arise through user-dominated clearing organizations.  Due to the economies of scale in clearing, it is likely that only a single clearinghouse will survive in equilibrium.  As I’ve shown in my work on exchanges, a cooperative organization supplying a natural monopoly service can generate rents for its members by restricting membership.  It lets in just enough members so that no competing organization can survive, but due to the entry limitations reduces output and raises prices to the ultimate consumers of these services.  “Non-profit” exchanges did that for a long time.

Mandating that a clearing organization permit open access would eliminate this problem, but create another.  In particular, to maintain the financial stability of the clearing organization, it is likely desirable to prevent financially weak firms from joining.  The hard thing is to write rules that would be sufficiently discriminating to prevent the clearing organization from using financial requirements for membership as an excuse for excluding potential members in order to enhance market power rents.

That is a real concern, but the Lynch amendment is an incredibly crude way of dealing with it.  Drafts of the various derivatives regulation bills mandate that no clearing organization should implement anti-competitive policies. It would be better to leave it at that, and delegate enforcement of this provision to the anti-trust authorities than attempt to handle the entry barrier problem with restrictions on organization, ownership and governance that impede efficient risk bearing and monitoring, and encourage other ways of exercising market power.

So sayeth Michael Palin, in the priceless Monty Python Argument Clinic Sketch.  In his recent testimony before the Senate Ag Committee, CFTC Chairman Gary Gensler makes an unconnected series of assertions (many categorically untrue) intended to establish a proposition.  Here’s the SWP annotated version:

First, standard OTC transactions should be required to be cleared by robustly regulated  central counterparties. [That’s the proposition to be “proved.”] By guaranteeing the performance of contracts submitted for  clearing, the clearing process significantly reduces systemic risks.  [Unsupported assertion.  Also not necessarily true.]  Through the  discipline of a daily mark-to-market process, the settling of gains and losses and the  imposition of independently calculated margin requirements, regulated clearinghouses  ensure that the failure of one party to OTC derivatives contracts will not result in losses  to its counterparties.  [Categorically untrue for multiple reasons.  OTC derivatives typically marked-to-market; indeed, the AIG debacle that Chairman Gensler’s trots out repeatedly to scare people into supporting him came to a head due to mark-to-market.  Moreover, mark-to-market provides no guarantee that third parties, including clearing member customers and other members of the clearinghouse, will not incur losses.]  Right now, however, trades mostly remain on the books of large  complex financial institutions.   These institutions engage in many other businesses,  such as lending, underwriting, asset management, securities, proprietary trading and  deposit-taking.  [So?  What are the logical consequences of this?  Mightn’t there be economies of scope in these activities?  If there aren’t, why has the market evolved in this way?  Could it be the case that offering a broad array of financial services to its customers a financial institution generates information that lowers the costs of intermediation?]  Clearinghouses, on the other hand, are solely in the business of  clearing trades.  [So? again.  This is a completely, utterly unsupported assertion related to the economies of scope, or lack thereof, in financial intermediation.  Again begs the question of why, if this is the efficient arrangement, it didn’t prevail in the competition of the marketplace.] To reduce systemic risk, it is critical that we move trades off of the  books of large financial institutions and into well-regulated clearinghouses. [Conclusion completely unsupported by previous statements.]

I believe that all clearable transactions should be required to be brought to a  clearinghouse, regardless of what type of entity is on either side of the trade.   This  would remove the greatest amount of interconnectedness from the large financial  institutions. [Again, no support for this assertion.  Moreover, no explanation as to how a clearinghouse that by its very nature connects large financial intermediaries and their customers “remove[s] the greatest amount of interconnectedness”–WTF that means.]

In Energy MetroDesk John Sodergreen reports that a lobbyist says that Gensler is a rock star in Congress because “no member has a clue what they’re actually proposing in the financial reform area–and Gensler does.”

I judge the first part of this statement (e.g., no Congressional clue) to be true, with near metaphysical certainty.  As the foregoing deconstruction of Gensler’s testimony shows, the post-dash statement is not.  Indeed, how could people who don’t have a clue know whether what somebody is telling them is BS or not?  The endorsement of the self-admittedly ignorant (see my earlier post on the NPR guys who interviewed 13 House Financial Committee members) somehow proves Gensler’s wisdom?  Huh?

[I give John S. kudos.  He managed the very difficult task of saying nice things about me and Gensler in the same edition of the same publication. 🙂  I am billed as “one of the CFTC’s most ardent critics.”  One of?  I guess I have work to do.]

It is a sad day when the main question I have is whether the best metaphor for the current financial regulation reform is the aforementioned Argument Clinic Sketch, or the “Burn the Witch” scene from Holy Grail.  That’s a very hard call.

Yes, Russia can breathe easy.  Even when it comes to corruption, it’s not the worst!  Bad–tied for 146th out of 180, according to an average of surveys assembled by Transparency International–but not the worst.  Indeed, not even the worst in the FSU–several ‘Stans are all well below Russia.

And I am sure that the “whatabout Ukraine” crowd is asking, well, “whatabout Ukraine.”  Well, amusingly, it is tied for 146th place, although since ties (based on rounding to 1/10th of a point) are arranged alphabetically, and the lowest and highest scores for Ukraine are both higher than Russia’s, my guess is that without rounding Ukraine edged out its former Gulag cellmate.

Speaking of ties, Zimbabwe joined Russia and Ukraine in 146th place.  Now that’s something to be proud of.

It should also be noted that Russia isn’t even close to being the least corrupt in the FSU. Indeed, one ‘Stan–Kazakhstan–came it at 120, and even Azerbaijan beat Russia’s 2.2 score (out of 10!) by a tenth of a point. The Baltic states aren’t even in sight, with Estonia at 27 and Lithuania and Latvia at 52 and 56, respectively.

But, according to accounting firm PWC, Russia IS the worst, when it comes to, er, agency problems:

Russia is the worst country in the world for companies in terms of employee theft and extortion by officials, a PricewaterhouseCoopers LLP survey showed.

Seventy-one percent of domestic and foreign companies in Russia were victims of fraud in the past year, double the rate reported in fellow BRIC countries Brazil, India and China, PwC said in a report released today. That’s a “shocking” increase of 12 percentage points from 2007, when the last survey was conducted, PwC said. In Japan, the figure is 9.6 percent.

Theft and bribery hit Russia’s financial, energy and mining industries the hardest, according to the survey of 3,000 executives from 55 countries, including 86 Russians. “The nature of these industries means that they are particularly exposed to both asset misappropriation and corruption, the two most prevalent types of economic crime,” PwC said.

. . . .

PwC said the prevalence of government graft in Russia is twice the global average, with 48 percent of all companies surveyed reporting an instance of bribery or corruption in the last 12 months.

The problem has been exacerbated by the country’s record economic contraction, which has lowered the “morale” of employees and made “asset misappropriation” more tempting, PwC said. The economy shrank 10.9 percent in the second quarter, the most on record, and 8.9 percent last quarter.

More people are feeling “real pressure to ‘cross the line’ or to look the other way,” PwC said.

The line about the special vulnerability of energy and mining is of particular interest.

One other Russia bit caught my eye today.  Russia’s industrial output contracted in October:

Russia’s  industrial slump deepened in October as companies failed to build up inventories and credit remained tight even after eight central bank interest rate cuts since April.

Output fell 11.2 percent from a year earlier after the decline eased to 9.5 percent in September, the  Federal Statistics Service in Moscow said via e-mail today. Production rose a non-seasonally adjusted 0.8 percent on the month. The medianestimate in a Bloomberg survey of 10 economists was for an annual decline of 8.1 percent.

. . . .

Manufacturing in October plummeted an annual 17.5 percent, the most since May, and dropped 4.3 percent compared with the previous month in the first monthly decline since August.

Output and generation of electricity, heat and water dropped 6 percent last month compared to the same period in 2008, the smallest annual decline since April.

Passenger car production in October plunged an annual 58 percent, while output of trucks declined 54 percent compared to last year, the statistics service said.

Wage arrears increased in October by 6.4 percent, to 5.4 billion rubles ($188.4 million) after declining 8.6 percent in September, the statistics service said in the report today.

This may be the case of every silver lining having its cloud.  The strengthening of commodity prices (thanks, Ben! thanks, China!) has bolstered the ruble, which adds another blow to an already devastated manufacturing sector.

The corruption news–with the energy and mineral industries at its heart–and the Dutch Disease effect, both demonstrate just how hard it will be to transform Russia’s economy.  The powerful won’t want to stop the gravy train, and as long as it is going it will be very difficult for non-resource industries to take hold.

Like I say.  Purgatory.

CFTC Chairman Gary Genlser continues to make concentration and diversity his primary justifications for expanding position limits:

I believe we should consider setting position limits to guard against excessive concentration in the energy futures market,’ said Gensler at a luncheon held by the Natural Gas Roundtable, a nonprofit organization.

The CFTC is weighing whether to set position limits — a maximum market share — for oil and other energy products. The agency already sets limits on agricultural contracts.

‘When the CFTC set position limits for certain agricultural commodities, the agency sought to ensure that the markets were made up of a broad group of market participants with a diversity of views,’ said Gensler.

This raises several questions.

First, what is the statutory basis for position limits designed to reduce concentration and increase diversity? I see none whatsoever.

The relevant statute–available right there on the CFTC’s website–makes it clear that position limits are for the purpose of reducing “excessive speculation” that causes unwarranted price changes:

Excessive speculation in any commodity under contracts of sale of  such commodity for future delivery made on or subject to the rules of  contract markets or derivatives transaction execution facilities causing  sudden or unreasonable fluctuations or unwarranted changes in the price  of such commodity, is an undue and unnecessary burden on interstate  commerce in such commodity. For the purpose of diminishing, eliminating,  or preventing such burden, the Commission shall, from time to time,  after due notice and opportunity for hearing, by rule, regulation, or  order, proclaim and fix such limits on the amounts of trading which may
be done or positions which may be held by any person under contracts of  sale of such commodity for future delivery on or subject to the rules of  any contract market or derivatives transaction execution facility as the  Commission finds are necessary to diminish, eliminate, or prevent such  burden.

It couldn’t be much clearer.  Congress has authorized the CFTC to fix trading limits “for the purpose  of diminishing, eliminating,  or preventing such burden [of “sudden or unreasonable fluctuations or unwarranted changes in the price  of such commodity”].”  Period.  Full stop.  Not a word about “concentration” or “diversity.”  Like Bart Chilton’s musing about “unintentional manipulations,” Gensler’s advocacy of position limits based on these concepts is completely unmoored from the law.

That is, “excessive speculation” that distorts prices can provide a legal basis for position limits; Gensler’s “excessive speculation” (with no attempt to connect such concentration to price distortions) cannot.

Second, what is the evidence that variations in concentration across markets affect market quality?  I am not aware of any.  That is, what constitutes “excessive” concentration?: how would we know when this level is reached?

Third, what does Gensler believe causes variations in concentration across markets?  Could there be fundamental economic considerations that affect the level of concentration?  Could it be that trying to micromanage concentration through position limits would impose costs because these limits conflict with these fundamental economic considerations.

Fourth, more generally, what are the costs of position limits (e.g., in terms of constraining risk transfer)?  Has Gensler made any effort to weigh the costs against his estimates of the benefits?

Fifth, what levels of concentration are problematic?  Under what theory?  What is the evidence that supports this contention?

Sixth, are there any markets that have reached this level of concentration?

Seventh, is there any evidence that position limits materially impact concentration?

In terms of what concerns concentration poses, concentration levels (per CFTC data) are not large as compared to, for instance, industrial concentration in most markets.  In crude and nat gas, 4 firm concentration ratios range between 25 and 40 percent, while 8 firm ratios are in the 30-50 percent range.

I think that Gensler’s clear desire to shift the grounds of the debate from the (legally required) “excessive speculation” issue to something else (the legally meaningless idea of “excessive concentration”) reflects the fact that there is clear lack of both logic and evidence to support any claim that “excessive speculation” has, in fact, caused “unwarranted” price fluctuations.  Lacking such evidence, Gensler is attempting to hitch a ride on the financial crisis.  As the article quoted above says,  “Chairman Gary Gensler of the Commodity Futures Trading Commission said the financial crisis last fall showed the risk posed by ‘large concentrated actors on the financial stage’.”  He provides no evidence that this concentration caused problems in the futures market even during the height of the crisis (which would, interestingly, undercut his argument that clearing is a panacea to systemic risk).  And even if it did, it still provides no legal basis for position limits, which must as noted above, can be imposed only “for the purpose  of diminishing, eliminating,  or preventing” undue price fluctuations caused by excessive speculation.

By repeatedly invoking “concentration” and almost completely ignoring the sole legal basis for position limits, Gensler may actually call into question the legitimacy of any position limit regulation the Commission does pass.  If Gensler really believes that concentration is a problem, he should advocate amendment of the Commodity Exchange Act to make concentration a justification for imposing limits.  By straying from statutory authority in his advocacy for position limits, Gensler risks becoming another out of control regulator attempting to ensure that no good crisis goes to waste.  He has a lot of company in that, but that’s no excuse.

The amendment that would have limited dealer ownership of clearinghouses to 20 percent  has been stripped from Barney Frank’s OTC derivatives bill:

In a bill passed last week by the House of Representatives’ financial services committee to reform the  over-the-counter derivatives markets, an amendment was inserted at the last minute by Massachusetts congressman Stephen Lynch that appeared to limit the stake banks could collectively own in a clearing house to 20 per cent.

. . .

Susan Milligan, special counsel at the OCC, said it was “purely anti-competitive” and would have favoured for-profit clearers compared with quasi-utility clearers like the OCC.

Steve Adamske, spokesman for the financial services committee, said on Thursday the 20 per cent limit had intended to limit dealer control of clearing houses but legal experts had decided it was invalid as it conflicted with another amendment.

The bill would, however, limit to 20 per cent the voting rights of dealers for “designated contract markets, exchanges and alternative swap execution facilities” – and not for clearing houses.

Wonderful, isn’t it, to observe the careful deliberation with which our Solons weigh decisions that affect trillions of dollars of risk exposures?  Just throw a bit of offal into the grinder–who’ll notice?  And at whose behest was this inserted?

Legislators react with high dudgeon to bankers’ cavalier attitudes towards risk and limited accountability, but they run far greater risks with other people’s money with virtually no accountability every day.  They have no room to talk.  Whatsoever.

For months I have been extremely skeptical about the Chinese economy.  I am not alone.

In the aftermath of China’s release of its GDP numbers, indicating 3Q growth of 8.9 percent, many voices–including those from within China–are expressing doubts about the sustainability of the government’s frenzied stimulus policies. From the FT:

Most fiscal rescue packages stimulated consumption of tradable goods. China, however, has gone the other way. It has been frantically  building roads and power plants.

That approach was based on the assumption that a collapse in exports would be a blip – one that could be offset by state-sponsored splurges on fixed assets. Itsthird-quarter gross domestic product numbers showed that the strategy had been a success, on its own terms. Over the first nine months, the economy grew 7.7 per cent. Of that, investment accounted for 7.3 percentage points and consumption 4 percentage points. The decline in net exports lopped off 3.6 percentage points.

But what if that assumption was wrong? The decline in exports was slowing, yes, but shipments in September were still 15 per cent worse than they were in the month of Lehman’s demise – the 11th straight month of falls, and not much better than the 17 per cent fall in the darkest days of March. The longer they remain sluggish, the longer fixed-asset investment will have to compensate, raising the risk of growth being hit by an investment-led slump.

With unusual frankness, the statement from the National Bureau of Statistics noted that the export picture was “severe”. Otherwise, the gap between rhetoric and reality keeps widening. While regulators and sundry bank executives keep popping up to warn about the  risks piling up in financing new assets, for example, the banks keep lending. September’s total of Rmb517bn of new loans was a quarter bigger than August’s. M2, a measure of money supply, grew a record 29 per cent year-on-year. A gentle contraction from here, as policymakers seem to be indicating, would take years to bring M2 growth down to its long-run average.

A temporary fix is developing more than a whiff of permanence.

Qin Xiao, Chairman of the Chinese Merchant’s Group and the Asian Business Council is alarmed:

While consumer prices are mostly under control, asset price bubbles are growing rapidly because of huge liquidity injections by governments around the world. Globally, there does not seem to be an exit strategy in place to drain this liquidity from the system. Certainly, in China, stock and property bubbles are a concern.

While we have avoided the worst recession since the Great Depression, we are probably  heading for another asset bubble and more financial turbulence. What can we do? Compared with pouring money into the economy, draining money from the economy is a much tougher job for central banks. The dilemma is this: if we tighten monetary policy, there is a high possibility of a “second dip” next year; and if we continue the loose policy, another asset bubble might be not far away.

I do not believe a quick, steep bounce driven by fiscal fixed investment is a good thing for China. Nor is a moderate slowdown anything to be afraid of. Monetary policy must not neglect asset-price movements. Therefore, it is urgent that China shifts from a loose monetary policy stance to a neutral one.

I am also worried about the role of governments after the crisis. There are some who say that this is a crisis of the market economy. It is not; nor is it a time to turn our backs on markets. There have been failures of regulation and oversight, particularly in the west. In China we are still developing our regulatory system. It is a time to strengthen oversight, improve governance and push for freer and more efficient markets in China and abroad.

However, there is growing concern, especially in China, that the temporary stimulus programme might evolve into permanent government control of the economy. The Chinese government should continue to loosen its grip. Prices, especially of energy but including water and food, need to be freed further. The currency needs to be liberalised. Privatisation needs to move ahead. China needs freer markets, not more state control.

FTAlphaville provides some additional background:

And lo and behold — China’s third-quarter GDP  statistics have just been released, and they show an 8.9 per cent growth compared with the same period last year.

Make no mistake, however. This is a growth almost entirely driven by government policies and stimulus packages.

Fixed asset investment, China’s main measure of capital spending, jumped a massive (and probably still  questionable) 33 per cent. At the same time, however, exports are still contracting, falling 15.2 per cent in September, and 23.4 per cent in August. The trade surplus narrowed $45.5bn to $135.5bn.

China’s seems to be a Michael Jackson economy.  Its apparent vigor is the product of a regimen of drugs prescribed to mask organic weaknesses (in China’s case, a massive fiscal and monetary stimulus intended to offset the effect of a collapse in exports)–and to treat the side-effects of previous drug regimens. This putatively therapeutic approach can permit apparently normal function–and even result in seemingly superhuman performance–for some time, but the cumulative effects are ultimately destructive.  In many cases, the denouement is catastrophic–as with Michael Jackson.

China’s Enron-like GDP management seems to be attempting to buy domestic peace by engaging in vast infrastructure investments until such time as export demand picks up, thereby permitting a reversion to the previous model of export-driven growth.  Timing is everything here.  The deleterious effects of the drug regimen cumulate at an increasing rate.  Larger doses need be given in order to achieve the same effect.  The risk of a brutal popping of myriad asset price bubbles, with the consequent shock to the financial system and the real economy, grows with the duration of the fiscal and monetary imbalances.  Unless exports turn around rather quickly, the imbalances in the Chinese economy are highly likely to result in a huge bust.

To the extent that markets outside of China have been bouyed by the ripple effects of that country’s massive stimulus, such a bust would erode asset values and economic growth in said markets.  And nowhere would the effects be more pronounced than in the commodity markets–and commodity-intensive countries.  It is hard–nigh on to impossible, IMHO–to ascribe the robust performance in commodity prices (in the face of persistently high and sometimes ballooning stocks) to anything but the effects of China’s natural resource-intensive stimulus spending, commodity hoarding encouraged by cheap credit, and (arguably) Chinese government stockpiling.  A messy end to the Chinese stimulus would translate into an extremely bloody fallout in primary commodity producing nations.

And that means you, Russia.  In bailing out itself, China has almost certainly saved Russia from an absolute economic catastrophe.  Not that things are rosy in Russia, by any means, but the current situation would be immeasurably worse without China’s stimulus-fueled commodity binge supporting prices. (And it must be noted that Helicopter Ben has pitched in too. I wonder if Putin has sent him a thank you note?)

I am not predicting an inevitable collapse in China, followed by fallout elsewhere.  It is possible that the huge Chinese bet on exports recovering before the baleful effects of the stimulus regimen take hold may pay off.  But the nature of the stimulus does create a significant downside risk in the Chinese economy, and in the world economy, especially in primary resource producing nations.