Streetwise Professor

The Treasury Department has released its draft OTC derivatives regulation bill, “The Improvements to Regulation of Over-the-Counter Derivatives Act.”  The actual language of the 115 page proposal follows quite closely what Geithner has been floating for several months–a clearing mandate for standardized derivatives, attempts to force OTC derivatives trading onto execution facilities, differential margin and capital requirements for cleared and non-cleared products.

My initial reactions:

First, there’s a whole lot of delegatin’ goin’ on.  A good part of the bill sets out the haziest general objectives, and then directs the CFTC, SEC, and “the Prudential Regulator” (either the Fed, the Office of the Comptroller of the Currency, or the FDIC, depending on a bank’s charter status) to come up with specific rules on what constitutes a standardized derivative, capital and margin requirements, position limits and so on.  There is an aggressive timeline for most of these rules–180 days.  Given the depth and breadth of the issues, and their contentious nature, and the needs to coordinate among disparate agencies, this will be very difficult to do at all, and extremely difficult to do well.

Second, the Treasury has finessed the jurisdictional issues by giving multiple regulators authority over OTC derivatives markets, with the injunction that everybody share and play well together.  Many of the provisions require that the CFTC and SEC issue rules jointly, with the proviso that if they cannot, the Treasury will prescribe them.

Given the delegation-heavy aspect of the proposal, there are few specifics to analyze.  But there are some aspects of the proposed bill that are spelled out with sufficient detail that deserve comment.

I’ve beaten the clearing mandate horse repeatedly before, so I won’t do more than repeat my previous conclusion that the mandate approach is wrongheaded, and ignores crucial economic issues.  The proposal does not require clearing when “one of the counterparties to the swap— (i) is not a swap dealer or major swap participant; and  (ii) does not meet the eligibility requirements of any derivatives  clearing organization that clears the swap.”  This would seem to permit an end user (e.g., a gas producer) to enter into a swap with a dealer without triggering the clearing mandate.

This is a desirable feature, and would permit end-users to enter into swaps without having to clear them; this could be especially important for end users concerned about the cash flow and liquidity risks associated with daily mark-to-market.  However, there are some peculiarities as to what constitutes a swap dealer or major swap participant that confuse me, and create ambiguity in the application of this exemption from the clearing requirement.  For instance:

The term ‘swap dealer’ means any person engaged in  the business of buying and selling swaps for such person’s own account, through a  broker or otherwise.

“(B) EXCEPTION.—The term ‘swap dealer’ does not include a person that  buys or sells swaps for such person’s own account, either individually or in a  fiduciary capacity, but not as a part of a regular business.”

“As part of a regular business”?  As opposed to what?  An irregular business?  A hobby?  I think most involved in this industry have a pretty good idea of what a swap dealer is, but would have a hard time recognizing one from the language just quoted.  A dealer is a firm that stands willing to quote prices at which it is willing to buy and sell products–a market maker.   The dealers/market makers usually enter into large numbers of off-setting positions.  Those features are totally absent from the bill’s definition of dealer.

Here’s the definition of a “major swap participant”:

The term ‘major swap participant’ means any  person who is not a swap dealer and who maintains a substantial net position in  outstanding swaps, other than to create and maintain an effective hedge under generally  accepted accounting principles, as the Commission and the Securities and Exchange  Commission may further jointly define by rule or regulation.

It seems the key phrases here are “substantial net position” for a purpose “other than to create and maintain an effective hedge.”  So, they’re not hedgers, and they have a substantial net position.  The addition of the “net position” language would seem to mean that swap dealers often don’t have net positions, which is true.

So, it would seem that what Treasury is trying to say is that a major swap participant is not a dealer and not a hedger, so that would suggest speculator.  But what about a hedge fund that is basis trading, or spreading between some cash instrument or commodity and a derivative?  A lot of speculators do just that.  Are they hedgers?  You could argue that the derivative is hedging the cash position, and under that interpretation any deal involving a hedge fund engaging in this strategy would be exempt from the clearing mandate.  I doubt that’s what Treasury means, but their drafting leaves a lot to be desired.  This imprecision will become a litigation magnet if it makes its way into law.

This is true not just because the clearing mandate turns on the classification of the counterparties, but because the execution facility mandate does so as well:

Except as provided in paragraph (8), a swap that is  standardized shall be traded on a board of trade designated as a contract market under  section 5 or on an alternative swap execution facility registered under section 5h.

“(8) EXCEPTIONS.—The requirements of subsection (j)(1) and (7) do not apply to  a swap if—  “(A) no derivatives clearing organization registered under this Act will  accept the swap for clearing; or

“(B) one of the counterparties to the swap—

“(i) is not a swap dealer or major swap participant; and

“(ii) does not meet the eligibility requirements of any derivatives  clearing organization that clears the swap.”.

So, if our hypothetical hedge fund doing a basis trade is deemed a hedger, any trade it does needn’t be executed on an alternative swap execution system (e.g., an electronic trading platform) that is subject to various requirements and obligations similar to those imposed on exchanges.

This whole regulatory schema is based on creating distinct classes of market participants, with different rights and obligations.  Given that the mandates in the proposal turn on the classifications of both parties to a trade, and that there is notable ambiguity in the definitions of the classifications, this will likely lead to some legal disputes.

The proposal also addresses the “standardization” issue, but again in an unsatisfactory way.  This is also crucial because the clearing and trading mandates also turn on standardization.  Most of the specifics are punted to CFTC and SEC, but the proposal does set out some criteria that the agencies should take into consideration when determining whether something is standardized.  These criteria include whether trade terms (including prices) are distributed, or relied on in determining the prices of other deals, and the volume of trade.  Unfortunately, however, most of the other criteria refer to the “terms” of the swap as the criteria by which CFTC and SEC assess standardization.  Are the terms of swap A like those of swap B that is cleared?  Are the differences in terms economically significant?

But it’s not just the terms that matter in determining suitability for clearing.  The risk characteristics of the instrument, and the availability of pricing information are also relevant.  Two deals with very similar terms may differ along these economic dimensions in ways that make one efficient to clear, and the other not.  (The volume of trading requirement is a crude way of assessing the price information availability issue.)  Moreover, these economically relevant factors may vary over time.  Is a CFTC/SEC determination permanent?  This would be problematic.  It should also be noted that due to economic differences, and variations of these economic conditions over time, that clearinghouses may not price risks appropriately, and that as a result the mandate could discourage mutually beneficial trades that parties would be willing to enter bilaterally because it is cheaper to do that than to clear.

The proposal also sets out rules for capital requirements and margins on non-cleared deals, but these aren’t that helpful:

BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—In setting  capital requirements under this subsection, the Prudential Regulators shall  impose:

“(i) a capital requirement that is greater than zero for swaps that  are cleared by a derivatives clearing organization; and

“(ii) to offset the greater risk to the swap dealer or major swap  participant and to the financial system arising from the use of swaps that  are not centrally cleared, higher capital requirements for swaps that are not  cleared by a registered derivatives clearing organization than for swaps  that are centrally cleared.

“(B) NON–BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—Capital  requirements set by the Commission and the Securities and Exchange  Commission under this subsection shall be as strict as or stricter than the capital  requirements set by the Prudential Regulators under this subsection.

So, capital requirements on cleared deals are positive, and requirements on cleared deals are higher than that.  That’s a huge help, guys.  This will touch off huge efforts to influence the determination of these requirements, and regulators will quite honestly not have the knowledge or information to set them efficiently.  I foresee reliance on crude proxies for risk, such as . . . wait for it . . . credit ratings.  Heaven help us.

Margin requirements are similarly fuzzy:

Prudential Regulators shall impose both initial and variation margin requirements  under this subsection on all swaps that are not cleared by a registered derivatives  clearing organization, except that the Prudential Regulators may, but are not  required to, impose margin requirements with respect to swaps in which one of  the counterparties is—

“(i) neither a swap dealer, major swap participant, security-based  swap dealer nor a major security-based swap participant;

“(ii) using the swap as part of an effective hedge under generally  accepted accounting principles; and

“(iii) predominantly engaged in activities that are not financial in  nature, as defined in section 4(k) of the Bank Holding Company Act of  1956 (12 U.S.C. 1843(k)).

“(B) NON–BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—Margin  requirements for swaps set by the Commission and the Securities and Exchange  Commission under this subsection shall be as strict as or stricter than margin  requirements for swaps set by the Prudential Regulators.

So, again: virtually no guidance on the principles regulators shall use to set margins, the counterparty classification issue, and the need to get numerous regulators to play nicely.

The proposal also opens the way for the vast expansion of position limits.  Swap execution facilities are required to set accountability or position limits, which means that the reach of these limits is extended to the swap market.  Moreover, Section 723 states:

The Commission may, by rule or regulation,  establish limits (including related hedge exemption provisions) on the aggregate number  or amount of positions in contracts based upon the same underlying commodity (as  defined by the Commission) that may be held by any person, including any group or class  of traders, for each month across—

“(A) contracts listed by designated contract markets;

“(B) contracts traded on a foreign board of trade that provides members or  other participants located in the United States with direct access to its electronic  trading and order matching system; and

“(C) swap contracts that perform or affect a significant price discovery  function with respect to regulated markets.

The definition of “significant price discovery function” is very broad:

SIGNIFICANT PRICE DISCOVERY FUNCTION.—In making a determination  whether a swap performs or affects a significant price discovery function with respect to  regulated markets, the Commission shall consider, as appropriate:

“(A) PRICE LINKAGE.—The extent to which the swap uses or otherwise  relies on a daily or final settlement price, or other major price parameter, of  another contract traded on a regulated market based upon the same underlying  commodity, to value a position, transfer or convert a position, financially settle a  position, or close out a position;

“(B) ARBITRAGE.—The extent to which the price for the swap is  sufficiently related to the price of another contract traded on a regulated market  based upon the same underlying commodity so as to permit market participants to  effectively arbitrage between the markets by simultaneously maintaining positions  or executing trades in the swaps on a frequent and recurring basis;

“(C) MATERIAL PRICE REFERENCE.—The extent to which, on a frequent  and recurring basis, bids, offers, or transactions in a contract traded on a regulated  market are directly based on, or are determined by referencing, the price  generated by the swap;

“(D) MATERIAL LIQUIDITY.—The extent to which the volume of swaps  being traded in the commodity is sufficient to have a material effect on another  contract traded on a regulated market;

These criteria would apply to most important, heavily traded OTC products.  Thus, the bill would give the CFTC tremendous power to impose position limits on combined OTC and exchange-traded positions.  Given the contentiousness of the position limit issue in energy alone, one can only imagine the difficulties that await when the CFTC’s powers to set limits extend to everything.

Overall, I think that it is a travesty to call this the “Improvements to regulation” act.  All of the substantive elements–the clearing mandate, the trading mandate, the setting of capital and margin requirements by relatively uninformed regulators subject to influence and pressure, the position limits–have no solid economic justification.  Indeed, the stronger justifications cut the other way in virtually every case.  Moreover, the ambiguities in the definition of key terms that determine the reach of the mandates are a recipe for trouble later on.  The delegation of virtually all implementation details to regulators, the rapid time frame for the formulation of specific rules, the need for coordination across regulators, and the lack of anything more than the haziest guidance will create immense implementation problems and lead to enormous influence activities.

All in all, therefore, this would be better titled “The (further) Bollixing of the Regulation of Over-the-Counter Derivatives Act.”

The Federal Trade Commission issued its final rule on market manipulation, as authorized by Congress under the Energy Independence and Security Act of 2007:

The  final Rule prohibits any person, directly or indirectly, in connection with the purchase or sale of crude oil, gasoline, or petroleum distillates at wholesale, from (a) knowingly engaging in any act, practice, or course of business – including the making of any untrue statement of material fact – that operates or would operate as a fraud or deceit upon any person, or (b) intentionally failing to state a material fact that under the circumstances renders a statement made by such person misleading, provided that such omission distorts or is likely to distort market conditions for any such product.

The rule, and the enabling legislation, are patterned on the anti-manipulation provisions of the securities laws, rather than the commodity laws.  And therein lies a problem, and renders the rule another monument to Congressional cluelessness on commodity market manipulation.

The emphasis on “fraud and deceit” makes some sense in securities markets.  Securities values are information-driven, and hence manipulative schemes in such markets frequently rely on fraud and deceit to distort investors’ information sets, and thereby distort securities values.

Things are quite different in commodity markets.  Although some manipulative schemes do rely on making untrue statements (e.g., false price reporting), by far the most important type of manipulation in commodity markets–including oil markets–involves the exercise of market power.  It is nigh on to impossible to wrench the concept of “fraud and deceit” to cover genuinely manipulative exercises of market power in the oil markets.  So, one of two things will happen.  Either the rule will prove completely useless, because it does not touch the most troublesome form of conduct in commodity markets; or the FTC will play legal Twister to try to interpret a rule written to attack information-based manipulations in order to take action against market power manipulations.

I would bet that the latter alternative is the more likely outcome, for a several reasons.  First, it is in the nature of regulator agencies to extend their power as far as possible, and stretch the rules to the breaking point to do that.  Second, the FTC will be under pressure from Congress to act in the event somebody does try to execute a market power manipulation.

I spoke with a group of FTC staffers while the rule was being drafted.  It was discouraging in the extreme to hear, that when I told them that the rule did not touch the most important form of manipulative conduct in commodity markets, that they were completely unaware that there was such a thing as market power manipulation.  I participated in a workshop on the rule that the Commission held in November, and hammered home the issues of market power manipulation.  But to no avail.  As stated in the final rule:

Some commenters argued that the final Rule should extend to conduct such as speculative activity or the unilateral exercise of market power, because in their view such conduct is inherently manipulative.   See, e.g., CFA at 8 (arguing that the Commission “could have considered the exercise of market power and excessive speculation as manipulation” because they “have no economic justification”); Greenberger at 1 (opining that the proposed Rule could offer a tough enforcement mechanism against speculative activity); Senator Cantwell at 2-3 (asserting that Congress intended for the FTC’s rule to reach a broad range of conduct, including the withholding of supply); Pirrong, NPRM, at 2 (arguing that the proposed Rule should not focus on fraud or deceit, but rather on the exercise of market power).   However, the rulemaking record does not support extending the final Rule to cover such conduct, except to the extent that the practices used are part of a course of conduct that otherwise violates the final Rule.

Whatever that means.  Translation: we had already released a Notice of Proposed Rulemaking that was totally silent on the issue of market power manipulation, so the train had already left the station and we weren’t about to look like fools and start over.

Actually, the FTC doesn’t bear the primary culpability.  Congress is the one that put the train on the wrong track.  It wrote the “fraud and deceit language” in the statute.  It was the one that had no clue about what manipulation in a commodity market really involves.

Sadly, it’s not the first time that Congress made the same mistake.  The law giving FERC anti-manipulation powers does as well, and as a result, FERC’s rule is also fundamentally flawed.

The Congressional cluelessness on all things derivative does not stop with manipulation.  It is pervasive.  It is on display daily in the myriad efforts to completely reshape derivatives regulation.  The ACES (Waxman-Markey) climate change bill contains several sections that would take derivatives regulation back to the days of rumble seats and the Charleston.  Other regulatory proposals bouncing around Capitol Hill would do the same.

What’s their motto?  “Today we screw up the energy markets! Tomorrow, the world!”?  It would fit.

I was interviewed by Kim Parlee on Canada’s Business News Network. I talked about commodity prices and China. I had written a post on the subject last week; Kim/BNN picked up on it and thought it worth discussing on air.  Commodities are a big deal in Canada, of course, and the commodity rally has translated into a pretty big currency and stock market rally in Canada.

Thanks to Kim and BNN.  I enjoyed it.

The SEC letter granting ICE Trust the exemptions necessary to clear CDS transactions provides a perfect illustration of the extraordinary shallowness that characterizes policy analysis of the subject of clearing:

The Commission believes that using well-regulated CCPs to clear transactions in CDS would help promote efficiency and reduce risk in the CDS market and among its participants. These benefits could be particularly significant in times of market stress, as CCPs would mitigate the potential for a market participant’s failure to destabilize other market participants, and reduce the effects of misinformation and rumors. CCP-maintained records of CDS transactions would also aid the Commission’s efforts to prevent and detect fraud and other abusive market practices.

A well-regulated CCP also would address concerns about counterparty risk by substituting the creditworthiness and liquidity of the CCP for the creditworthiness and liquidity of the counterparties to a CDS. In the absence of a CCP, participants in the OTC CDS market must carefully manage their counterparty risks because the default by a counterparty can render worthless, and payment delay can reduce the usefulness of, the credit protection that has been bought by a CDS purchaser. CDS participants currently attempt to manage counterparty risk by carefully selecting and monitoring their counterparties, entering into legal agreements that permit them to net gains and losses across contracts with a defaulting counterparty, and often requiring counterparty exposures to be collateralized.11 A CCP could allow participants to avoid these risks specific to individual counterparties because a CCP “novates” bilateral trades by entering into separate contractual arrangements with both counterparties – becoming buyer to one and seller to the other.12 Through novation, it is the CCP that assumes counterparty risks. For this reason, a CCP for CDS would contribute generally to the goal of market stability.

As part of its risk management, a CCP may subject novated contracts to initial and variation margin requirements and establish a clearing fund. The CCP also may implement a loss-sharing arrangement among its participants to respond to a participant insolvency or default.

Stop right there.   So, in a bilateral market firms

“carefully manage their counterparty risks because the default by a counterparty can render worthless, and payment delay can reduce the usefulness of, the credit protection that has been bought by a CDS purchaser. CDS participants currently attempt to manage counterparty risk by carefully selecting and monitoring their counterparties, entering into legal agreements that permit them to net gains and losses across contracts with a defaulting counterparty, and often requiring counterparty exposures to be collateralized”

but once things are cleared, it’s apparently: “No worries!   The CCP takes care of everything!”   These sentences represent one of the greatest logical leaps–that is to say, non sequiturs–that I have read in a long time: “Through novation, it is the CCP that assumes counterparty risks. For this reason, a CCP for CDS would contribute generally to the goal of market stability.”

Uhm, yes, the CCP assumes counterparty risks.   But they don’t disappear.   Given the size of trading positions, the total losses resulting from a particular default result in the same size of loss in bilateral or cleared markets; clearing just changes the allocation.   Indeed, it can make this allocation worse, not better.   Moreover, a CCP concentrates counterparty exposure, meaning that there is a concentrated point of potential failure.   That hardly contributes to market stability.

Note too that the SEC completely ignores any incentive issues.   It recognizes that bilateral counterparties spend considerable resources to manage counterparty risk because they bear the loss in the event of a default.   The letter is completely silent on the incentive of the CCP (compared to bilateral counterparties) to manage this risk.   It is also completely silent on the information available to the CCP as compared to bilateral traders to evaluate, manage, and price counterparty risk. The letter is also silent on the potential moral hazard problem that mutualization of performance risk through a clearinghouse creates.

Thus, in expressing a preference for one way to manage performance risk over another, the SEC makes not the slightest effort to analyze the incentives or abilities of agents to perform this task under alternative arrangements.   It just makes conclusory statements with no logical, factual, or analytical basis.

To put it bluntly, the mere fact that a CCP “assumes” counterparty risk in no way implies that it improves market stability.   The chasm between one the conclusion (clearing improves market stability) and the alleged basis for that conclusion (the mere fact that a CCP assumes performance risk) is wider than the Grand Canyon.   Assumption of risk is not the same as making that risk disappear.   Given the incentive and information issues, it is quite possible that it makes the risk worse.

The SEC then falls back on the other main justification for clearing:

A CCP would also reduce CDS risks through multilateral netting of trades.13 Trades cleared through a CCP would permit market participants to accept the best bid or offer from a dealer in the OTC market with very brief exposure to the creditworthiness of the dealer. In addition, by allowing netting of positions in similar instruments, and netting of gains and losses across different instruments, a CCP would reduce redundant notional exposures and promote the more efficient use of resources for monitoring and managing CDS positions. Through uniform margining and other risk controls, including controls on market-wide concentrations that cannot be implemented effectively when counterparty risk management is decentralized, a CCP can help prevent a single market participant’s failure from destabilizing other market participants and, ultimately, the broader financial system.

Most of the benefits of netting mentioned are private benefits.   If they are so large, market participants would have been incentivized to capture them long ago.   Instead, they are only forming CCPs under the threat of even more draconian government intervention.

Sadly, this letter is representative of virtually every regulator’s and legislator’s advocacy of clearing.   That includes the US Treasury, CFTC, various legislators (e.g., Barney Frank and Colin Peterson), and the EC.   Based on such shallow justification, said powers are about to re-engineer the largest and most sophisticated financial markets in the world.

For those who, like me, are skeptical of the solidity of China’s economic growth and the basis for the commodity rally, this article is for you:

Copper’s 76 percent rally this year may soon end on signs that China has stockpiled more than it can use in new homes, cars and appliances.

Inventories monitored by the London Metal Exchange posted their first back-to-back  weekly gains since February, increasing 8.3 percent from an eight-month low.  Sumitomo Metal Mining Co., Japan’s second-largest smelter, said Chinese imports are slowing after record purchases boosted domestic supplies, and U.S.  copper-scrap exporters report shipments to Asia are dropping.

. . . .

Refined copper imports by the Chinese more than doubled to 1.78 million metric tons in the first half and reached a monthly record of 378,943 tons in June, customs data show.

“China’s copper imports are likely to fall in the second half of this year because it bought so much in the first half, the government has stopped buying and demand from end-users may not be as big as people anticipated,” said  Zhao Mingwang, manager of futures trading at Zhuji, China-based Zhejiang Honglei Copper Co., which produces about 100,000 tons of wire and rods a year. “The imports were so large it’s hard to fathom where it all went.”

Most of the gains in LME-monitored inventories during the past month reflect the eightfold jump in the volume of material in warehouses in Singapore and South Korea, the closest to China.

. . . .

Inventories monitored by the Shanghai Futures Exchange more than doubled this year, sparking concern the pace of consumption in China hasn’t kept up with imports.

. . . .

Imports may have exceeded manufacturing demand by as much as 1.3 million tons in the first half, Kaku said on July 24. “I don’t think copper prices climbed because of a dramatic improvement in supply-demand conditions,” he said. “I’m skeptical about a strong recovery in the market.”

. . . .

Chinese lenders responded to the economic slowdown by tripling loans in the first half of 2009 from a year earlier to 7.37 trillion yuan, according to the nation’s central bank.

The increased lending spurred demand for properties, helping home prices in 70 major Chinese cities rise for the first time in seven months in June. Passenger-vehicle sales climbed 26 percent to 4.53 million in the first half, while commercial-vehicle sales fell 0.5 percent to 1.57 million, the China Association of Automobile manufacturers said July 9.

Dollar Slide

Investment in fixed assets, including water and road projects, jumped 34 percent to 9.13 trillion yuan, the National Bureau of Statistics said. Spending on capital projects accounted for 87 percent of China’s economic growth in the period, according to Morgan Stanley Asia Ltd. Chairman  Stephen Roach, who is based in Hong Kong.

This all suggests that the 8 percent (annualized) Chinese growth in the second quarter is far less than meets the eye.  It is the result of unleashing a flood of credit to finance “capital projects,” the quality of which is highly dubious; tripling the quantity of loans, to an amount representing 40 percent of the loans already on bank balance sheets, inevitably means that a large fraction of these loans are financing uneconomic projects.

Think about it.  Chinese banks are lending three times as much during the most severe world economic downturn since the depression as they did when the Chinese economy was booming last year.  A tripling of lending would inevitably lead to the financing of numerous negative net present value projects even in normal times.  In current circumstances, the waste of resources must be astounding.

As I’ve written before, massive government stimulus like that being undertaken in China and being funneled through the banks can lead to increases in measured output.  But the return on the projects funded is usually negative, and substantially so.  In other words, you pay people to dig holes, and buy cement to fill them in, the expenditure counts as economic “output,” but all you’ve got in the end is cement filled holes that will not do what capital is supposed to do: provide a stream of benefits into the future.

What’s more, when a large fraction of these projects come a cropper, this dramatic expansion of credit will leave the lending banks with a slug of bad debt, forcing the government to: (a) bail them out, or (b) watch them fail or turn into zombies, thereby constraining their ability to finance viable projects in the future.

In other words, the Chinese have responded to a financial crisis caused in large part by an excessive creation of credit in the US and Europe by engaging in their own excessive creation of credit.  The great exporting nation has thus imported the Hair of the Dog theory of economic policy:  Respond to one massive distortion by creating one’s own.

I don’t see how this can end well.  I understand the tremendous social pressures that make the Chinese leadership feel compelled to engage in this policy, but they are, in my view, just deferring the day of reckoning–and arguably making it far worse.

And since the commodity rally is based in large part on Chinese purchases, this also means that the rally is considerably overdone.  Indeed, another Bloomberg article suggests that the copper market (and arguably, other commodity markets as well) is the economic equivalent of a crack addict, dependent on a continuing supply of Chinese government largesse:

Copper climbed in Shanghai, after falling the most in two and a half months yesterday, as China’s central bank damped speculation it would curb lending, boosting the demand outlook for raw materials.

Futures tumbled yesterday as speculation the Chinese government would limit bank loans sent the country’s stock market plunging by the most in eight months, dragging base metals lower. Equities rallied today after the central bank said it will maintain a “moderately loose monetary policy,” aiming to consolidate the nation’s economic recovery.

“The tightening of bank lending has been the major fear in the minds of copper importers and dealers,” Lin Xu, analyst at China International Futures Co. in Shenzhen, said by phone today. “So the reiteration of a loose monetary policy from the central bank helped sentiment.”

Just further illustration that the Chinese are riding the tiger.  It’s damn hard to get off.  The problem is, you can’t ride it forever.

The statistics in the first article regarding the immense quantity of copper imports are truly staggering; perhaps the ChiComs have a special affinity for the Red Metal;-)  Note that China’s imports during a worldwide recession are double what they were when the Chinese economy was booming in 2008.  Stocks in LME warehouses are also beginning to increase even as prices are increasing.  (The same is true for other metals.) Oil inventories are also increasing.  And for the most part, these measured inventory increases do not include Chinese stocks.  Thus, commodity prices have been supported by massive Chinese stocking.  Chinese consumption, such as it is, and as indicated by the inventory build it is far less than their purchases, is driven by a massive stimulus that is not sustainable for an extended period.  The signs of recovery in the US, Europe, and Japan are faint, at best.   And even a recovery in manufacturing in the OECD, or an increase in OECD consumer demand that would give a jolt to Chinese output for export, would have to work through massive stocks in order before any price-supporting fundamental tightness occurs.  Other measures of demand, such as ocean freight rates, have been flat.

Commodity prices and inventories can move together if there is a spike in economic uncertainty that leads people to increase their demand for precautionary inventories: the only way to accommodate the increased demand for inventories is to raise prices to discourage consumption and encourage production.  But if anything, the main metrics of economic uncertainty–such as the VIX volatility index–have been declining while commodity prices have been increasing.  Price volatility for oil and other commodities was at historic levels in December of last year.  (Oil price volatility was higher during December than during the 1990-1991 Gulf War.)  So, increases in uncertainty/risk cannot explain the co-movement of prices and inventories.

All of this suggests that there is considerable downside risk in commodities.  The markets are supported by a Chinese stimulus program that even many Chinese officials recognize is not sustainable, and which is leading to sectoral distortions.  The stimulus has encouraged a buildup of inventories that will weigh on the market for a long time.  The signs of recovery in the US and elsewhere in the OECD are very fragile.  Even the slower than expected decline in US GDP in the second quarter is somewhat misleading as it conceals weaker than expected consumption.  Fundamentals remain very weak, and the market is dependent on extreme Chinese fiscal and monetary policy.  That translates into serious risk of a big selloff in commodities.

Following the CFTC hearings on position limits in energy reminds me of Through the Looking Glass:

‘Let the jury consider their verdict,’ the King said, for about the twentieth time that day.

‘No, no!’ said the Queen. ‘Sentence first – verdict afterwards.’

‘Stuff and nonsense!’ said Alice loudly. ‘The idea of having the sentence first!’

‘Hold your tongue!’ said the Queen, turning purple.

‘I won’t!’ said Alice.

‘Off with her head!’ the Queen shouted at the top of her voice. Nobody moved.

Chairman Gensler is an odd casting choice for the Red Queen, but he clearly has his heart in the part, given his opening remarks at the hearing:

But Gensler, the former Goldman Sachs’ executive who almost didn’t get the chairman’s nomination this year because of his past role in shielding over-the-counter derivatives from regulation, adopted a tough tone throughout the hearing.

“No longer must we debate the issue of whether or not to set position limits,” he said.

Then what are the hearings about?

And there’s this:  “There seemed, at least, that the commission is hearing support. I think it’s more a question of how, than whether.”

And his understudy, Bart Chilton, is clearly ready for the part:  “Whatever manner the agency proceeds, ‘going slow’ is not an option.”

Given that position limits are a mantra of the Senators to whom Gensler genuflected to get the job, it’s not really a surprise that they are now deemed inevitable.

Position limits in general are dubious at best.  There is little in the way of viable theories, and even less in the way of persuasive empirical evidence, that speculators distort prices in general, or cause prices to be excessively volatile.  There is no plausible theory or evidence that speculators caused energy prices to be artificially high in 2008.  As a consequence, position limits will almost certainly not reduce volatility for energy products, or reduce the frequency of price spikes.

After all, we’ve had considerable experience with position limits in agricultural commodities.  Note that the CFTC is essentially proposing to extend to energy and other commodities “in finite supply” (again, and examples of other types of commodities are . . . ) the same type of regime that has been in place for ags for years.  Yet, despite these limits, there has been substantial volatility in ag prices–including last year.  Moreover, there have been large spikes and crashes in ag prices despite the existence of a position limit regime there.  This should not be a surprise, as the theory of storable commodity pricing predicts that such price behavior is characteristic of efficiently functioning, competitive markets undistorted by speculation.

This perhaps explains the monomaniacal focus on index investors.  Via hedging exemptions, these types of firms have been able to amass positions in individual commodities (as parts of larger portfolios) in excess of the position limits.  Since position limits are in place in ag commodities, the fanatical opponents of speculation (fanatical in the Churchillian sense of “can’t change their minds and won’t change the subject”) need to focus on participants not subject to the limits.  Never mind that extant empirical evidence provides no support for the hypothesis that index investors are moving prices.  Or that the “theory” that these funds contribute to “demand” are completely bogus.  (It would be interesting for someone to see whether price correlations across components of major commodity indices have increased in recent years; if index investors are the dog and prices are the tail, since index investors act in a mechanical fashion across markets, they should induce very similar price movements across markets.)

Position limits have been around since the Grain Futures Act was supplanted by the Commodity Exchange Act in 1936.  I’m sure you’ve noticed what a dramatic effect they had on volatility–even before the rise of index investors.

So, we’re about to go for yet another run on the hamster wheel.

It is interesting to me to note that something that is almost impossible to be distorted by speculation–shipping rates–experienced almost the same spike and plunge as energy over the 2007-2009 period.  Shipping rates aren’t assets; they are the rental rate on assets.  Even if you have a speculative bubble in the prices of ships (i.e., a lot of ships are built on spec in anticipation of higher rates in the future), this should result in a fall in shipping rates; the entry of large numbers of ships should depress charter rates.  You can’t store the ability of a ship to make a voyage today for use in the future; you either use the space today, or you don’t.  You can’t buy up today’s space in anticipation of a higher rate in the future.  So, when you have price spikes in a non-storable like shipping space, you can’t attribute that to a speculative asset bubble, cuz it ain’t an asset.

What’s more, shipping rates are driven by global industrial activity.  The eerie similarity of the trajectory of oil prices and shipping rates (as measured by the Baltic Freight Index, for instance) therefore strongly suggests that underlying fundamentals, namely strong world industrial demand, drove both oil prices and shipping prices over the period of the energy price spike.  Indeed, I have some preliminary econometric evidence (more to come later) that shows that the Baltic Freight Index is strongly correlated with, and in fact leads, the price of oil.  (Lutz Killian has similar evidence, up through 2007: mine goes through April, 2009).

And then there’s  the issue of the details of implementation.  Given the complexity of the markets, the greater variety of products and instruments, and the greater variety of market users and strategies, designing a coherent position limit regime will be nigh on to impossible.

One disturbing matter relates to the aboveforementioned index investors, and financial market participants in commodities more generally.  Gensler stated:  “While I believe that we should maintain exemptions for bona fide hedgers, I am concerned that granting exemptions for financial risk management can defeat the effectiveness of position limits.”

So, “financial risk management”–by which I presume Gensler means investors that use commodity derivatives to improve the risk-return performance of their portfolios–are not bona fide hedgers apparently.

This reflects a widespread mindset, redolent of what Thomas Sowell calls the “physical fallacy” that physical commodity derivatives are properly for physical market players, and that others should not participate.  That is, commodity markets and financial markets should be separate.  To put it more pungently, those holding this mindset endeavor to make the commodity derivatives markets a kind of ghetto, limited to a certain group of players.

This makes no sense from the perspective of financial theory.  Integration of disparate markets with disparate risks improves the sharing of those risks, leading to a more efficient allocation and pricing of those risks.  Segregated markets–ghettoized markets–don’t permit the full scope of risk sharing, and lead people to bear more risks than is necessary.

In earlier posts I have explained why some commodity market participants may prefer that these markets be ghettoes, rather than having them integrated in the broader financial markets.  This can explain the support for position limits from some quarters of the commodity community.  No doubt these are some of the sources of support Gensler has been hearing from.

Thus, the whole position limit hysteria–which is a particular symptom of the broader underlying disturbance of speculator hysteria–is, as Alice said, stuff and nonsense.*

And for saying that, I may anticipate the sentence: “Off with his head!”

*”Stuff ‘n’ Nonsense” is also the title of an excellent Supersuckers rocker.

Konstantin Sonin is an excellent economist at the New Economics School in Moscow.  (Obama spoke there during his visit to Moscow.  My friend Sergei Guriev is Rector of the school.)  Konstantin and Sergei wrote an excellent paper using media freedom as a measure of property rights.

Unfortunately, Konstantin’s article in today’s Moscow Times lays a couple of eggs.  First, he argues that (a) production sharing agreements (“PSAs”) in energy markets are a means of protecting investors against political/expropriation, and (b) Russia has no need for PSAs because it presents no such risks:

An economist would normally criticize Deputy Prime Minister Igor Sechin. He rarely says anything meaningful in terms of economics. But twice in the past two weeks, it was necessary to come to Sechin’s defense. First, he was right in saying that Russia does not need a production sharing agreement, or PSA. Second, claims that Russia’s agreement to provide China with oil is unprofitable for Russia might really turn out to be groundless. But the lack of understanding on the subject and the controversy surrounding it attests to the lack of transparency in the agreement. This is an unacceptable situation, particularly when it involves such an important strategic interest.

Russia currently has three PSAs that are intended to protect foreign investors from political risks. Such agreements were specially created to allow major international corporations to sign long-term contracts with unpredictable, authoritarian regimes. In many countries, these PSAs have proven at least partially successful at protecting foreign investors from changes in leadership. But there is a certain stigma attached to them since they are only needed in unstable countries. In stable states with a safe investment climate, foreign investors do not require special protection because all investors are protected equally.

Although Russia does not need insure foreigners against risks connected with its own behavior, it might need to insure itself against the risks involved in deals with other countries.

First, PSAs are not in the first, second, third . . . instance a means of protecting investors against political risk.  Instead, they are a mechanism for sharing development cost risks.  Or, better put, they essentially put the development cost risk on the resource owner: the resource owner gets paid after the E&P company recoups its costs.  Second, even if they were intended to protect investors against political risk, how can Konstantin state seriously, in the aftermath of all that’s transpired in Russia (and the oil sector in particular) in recent years, that Russia poses no political or expropriation risks?  The risks there are huge.  Indeed, they are so large that I look in amazement when companies like Shell act like victims of the battered spouse syndrome and return to their abuser.  Third, if PSAs are intended to protect investors against expropriation and political risk, they do a lousy job of it.  Just ask Shell: it had a PSA for the Sakhalin II project, and a fat lot of good that did.  Indeed, PSAs have been used by the Russians to justify expropriation.

Konstantin’s second error in his defense of Sechin relates to the murky China-Russia oil deal consummated earlier in the year.  He argues that the deal was good for Russia, even though it was at below market prices, because it locked in prices, and therefore provided insurance (a hedge) against price fluctuations:

Although Russia does not need insure foreigners against risks connected with its own behavior, it might need to insure itself against the risks involved in deals with other countries.

Thus, there might be good reason to consider Russia’s agreement to sell oil to China at $55 to $60 per barrel as some form of insurance, considering that the deal only becomes profitable at a price of $80 per barrel. The idea of any insurance policy is that it chews up a certain percent of the profit when everything is going well but saves the insured party from major losses if things go badly.

Now here, Konstantin is somewhat unclear on what he intends by the word “insurance” and the phrase “things go badly.”  If by “insurance” he means price insurance, and “things go[ing] badly” he means a price collapse, the deal still is priced extremely unfavorably for Russia.  The price involved was well below the forward curve for oil for the foreseeable future, and the forward curve gives the price a seller can lock in.

As I noted in earlier posts on the subject, the seemingly unfavorable pricing makes sense, because it reflects a big credit spread.  That is, at the time the deal was done, Russia’s credit was in the dumper, and since the stated interest rate on the loan used to finance the pipeline was at a premium to LIBOR well under the premium on Russian debt prevailing in the market at the time, the Chinese were only willing to make the loan if there was an offsetting benefit–a below market price of oil.  That is, although Sechin touted the low interest rate in the deal, this was in effect a “teaser” rate–the oil price discount represented a hidden interest charge.

That is, the pricing of the deal doesn’t reflect insurance–it reflects Russia’s credit risk at the time the deal was done.

Russia’s credit has rebounded since the deal was inked.  Note Gazprom sold Eurobonds at a pretty good rate last week.  This raises a possibility that I raised in my original posts, and reiterated in a presentation on Russian energy strategy to a group of Foreign Service people (including some folks based in Moscow working on energy issues) today: namely, that Russia will try to find a way to back out of the deal, or force renegotiation, when the market turns.  Both the oil market and the credit market are much more favorable to Russia today than when the deal is done–which means the the deal done then is much LESS favorable to Russia today (and hence more favorable to China today) than when it was signed.  I see the potential for a dispute arising very soon.  That would be VERY interesting to watch.

Konstantin does make one very good point in his article:

Thus, criticism rained down on Sechin from all sides for having orchestrated an unprofitable agreement with China. But its profitability can only be gauged once all the terms of the agreement are finally made public.

That disclosure process should happen as soon as possible. The rules are very simple: If an economic agreement is signed in the best interests of the country, there is no reason to hide anything. If the agreement is sound, it will naturally withstand criticism from political opponents, analysts and the press. The fact that leaders are afraid to reveal the terms is probably a sign that the agreement has problems. If the agreement with China is flawless, why keep it secret?

Russia already has enough corruption without adding speculation about whether the agreement with China was on the up and up. If, however, anything underhanded is involved here and the agreement is not sound, Sechin’s contract with China might go down in history like the notorious privatization auctions of the early 1990s.

Hear, hear.  There is considerable room for skepticism about the benefits of the deal to Russia, because of the dishonest way that it was spun publicly; notably, Sechin’s crowing about the interest rate, and obfuscating about the oil price.  Both pieces of information are needed to determine the REAL interest rate in the loan, and therefore to determine whether it was on-market or not, and how far away it is from the current market (probably a lot, given the changes in the credit and oil markets).

Given that the deal’s economics probably look far worse for Russia today than they entered into the contract with China earlier this year, I wouldn’t hold my breath waiting for the Full Monty from Igor.  The most likely way that information will come out is that if the unfavorable economics are used to justify abrogating the transaction.  That is, the only way that the details of the transaction are likely to be made public is if Russia decides to claim that the Chinese screwed them as a justification for walking on the deal, or insisting on renegotiation.

Which just may happen.

I am a guest poster on today’s FTAlphaville.  The subject: clearing.  The post riffs off an article in the FT that notes the importance of price information for clearing to work efficiently.  The basic points are that price information is necessary but not sufficient for clearing to work; that clearinghouses are consumers of information, not just producers of it; and that the debate about standardization has focused on what is really a red herring–contractual standardization–and overlooked the difficulties of economic standardization.

Many thanks to Stacy-Marie Ishmael for providing this opportunity.

A reader sent me an email about my post ridiculing Timothy Geithner’s admission that restructuring the OTC derivative markets is really complicated, telling me that (a) I was very mean, and (b) I can be a real smart ass.  (That said, she also thought it was very funny.)  Both (a) and (b) are true–especially the latter, I guess.  My wife is always telling me that sarcasm is the lowest form of wit, but there are some things that are so outrageous that sarcastic ridicule is perfectly appropriate.

And I think that Geithner’s admission that a complete re-engineering of the financial system is extremely difficult is one of those things.  He is playing the Sorcerer’s Apprentice, unleashing forces that he doesn’t comprehend.  Somehow dry, play-it-straight analysis doesn’t seem to be an adequate response to such dangerous arrogance.

Indeed, one of the very pillars of his argument for the need for “reform”, the interconnectedness of the financial system, is precisely the reason why care is especially warranted in this instance.  Highly interconnected, dense networks like the financial markets are complex systems.  Small shocks to such complex systems can lead to discontinuous responses.  And such changes are almost always impossible to predict.

These markets are so complex that one should proceed with great caution before making wholesale changes.  This is especially true when these changes are predicated on a simplistic, not to say incorrect, diagnosis of the nature of the system.  Fools rush in where angels fear to tread.

It would be useful if Geithner–and Obama, for that matter–would read Hayek’s The Pretense of Knowledge or Sowell’s Knowledge and Decisions.  Perhaps such reading would at least temper the presumptuous arrogance that has characterized the administration’s financial regulation initiatives, and its other efforts to remake virtually every other part of the American economy from energy to healthcare.

But I doubt that it will.  And as a result, I would imagine that Mr. Geithner and his colleagues will provide numerous opportunities to exercise my talents in the lowest form of wit.

Tim Geithner has made a startling discovery: completely reorganizing one of the world’s largest financial markets–OTC derivatives–is an extremely difficult task, worthy of Hercules.  According to Forbes:

The Obama Administration has given itself two months to tell Congress what new legislation is needed to control over-the-counter derivatives, and testimony by Secretary of the Treasury Timothy Geithner late last week indicated how incredibly difficult the job of writing a law is going to be.

Scores of House members turned up to express their special concerns: Will grain elevator operators be required to register as users of derivatives? Can utilities continue to enter into the customized OTC contracts they regard as essential to their business? How, Secretary Geithner, are you going to prevent the derivatives business from migrating to Dubai?

Answering his critics, Geithner said repeatedly the government needed “to find the right balance” between conflicting arguments and conceded that regulation will be “an enormously complex process.” But failure is not an option, he said, because the economic crisis has demonstrated how destructive derivatives can be and how urgent the need is to subject them to new oversight.

Imagine that.  A root-and-branch shakeup of a market involving trillions of dollars of complex transactions, hundreds of firms, some of them quite complex and opaque, in just about every financial and commodity product, is going to be complicated.  Who knew?  

Boilerplate about “find[ing] the right balance” and “failure is not an option” (cliche alert!!!) is woefully inadequate.  There are myriad interconnected decisions that the “reformers” will have to make, each one of them bursting with unintended consequences, and potential for workaround and exploitation and regulatory arbitrage.  In going after the devils it thinks it knows (but really doesn’t), the administration will end up tangling with more heretofore unknown devils that it could possibly imagine.  

It would be comforting if the administration had a coherent diagnosis of just how OTC derivatives contributed to the financial crisis; a better understanding of how structural changes could mitigate these problems; and an appreciation of some of the likely adverse consequences of the proposed reforms.  Instead, we get reruns of the AIG melodrama and airy statements about how clearing and improved transparency will work wonders.  

Hence, failure is quite definitely an option.  Sadly, failure is most likely to result if Geither and the administration “succeed” at implementing their “reform” plan.  A plan that presumes one of the largest market failures in history, but which does not state coherently just what that market failure is and how it will be addressed, is a disaster waiting to happen. With no coherent overarching understanding of the source of market failure, there is no way to implement all necessary details of any plan intended to address it.  Moreover, lacking any such overarching understanding, it will be very difficult to distinguish the legitimate arguments of affected market participants from special interest self-pleading.  With so many decisions to be made, and so many affected interests, this will degenerate into a political bazaar like Waxman-Markey, and which health care “reform” promises to be.  And, just like Waxman-Markey, what is likely to emerge is a Frankenstein monster of regulation that is more likely to be the cause of the next crisis, than our deliverance from one.