Streetwise Professor

Oil rallied this week (but still finished well below $50/bbl) primarily on reports that Russia would cooperate on output cuts with OPEC.   Dmitri Medvedev has hinted that Russia might actually join the organization.

There are several reasons for skepticism.   First, Russia has dramatically reduced its oil export duty, and is contemplating a further cut:

Russia cut oil export duties to $287 per tonne from November 1, from $372.2 in October, in response to calls by producers who feared making losses on overseas shipments. Russia’s senior energy official, Deputy Prime Minister Igor Sechin, had lobbied for an even lower November tariff of $195.20.

. . . .

RIA Novosti reported that Russia could reduce oil export duty to USD 117 per tonne to USD 119 per tonne from the current USD 192.1.

Mr Alexander Sakovich deputy head of the customs payments department at the ministry said the average price for Urals crude on world markets in the monitoring period from November 15 to December 9 inclusive was USD 44.5 per barrel. He said the price could continue to change until December 15 given high volatility on the market.

Mr Sakovich said duty on light petroleum products could be cut to $91-$93 per ton against the current USD 141.8 and on heavy petroleum products to USD 49 per tonne to USD 50 per tonne from the current USD 76.4.

The Russian government decided to set export duties on oil and oil products on a monthly basis from December 1st and abandon the previously accepted bimonthly practice.

The most effective way for Russia to curtail oil exports (which is the only way it would have an impact on world prices) is to keep its export tax relatively high.   Lowering the export tax encourages exports, and is contrary to statements that it will cut output.   Sechin’s support for lower duties is especially important in this regard.

It is possible to both cut export duties and cut exports, but this would require the imposition of export quotas.   Just keeping the taxes higher would be a more sensible and straightforward approach.   Although higher export taxes would hurt Russian oil exporting companies–most importantly, Sechin’s Rosneft–this effect could be mitigated by some sort of compensation to these firms.   (To work, though, this would require that the compensation not be linked to current exports or output in any way, as that would just offset the effect of the tax.)

The fundamental inconsistency between promising to cut output/exports in collaboration with OPEC on the one hand, and cutting oil export duties on the other makes me question the credibility of Russia’s statements.     Moreover, formal monitoring and enforcement of members’ adherence to quotas within OPEC are doubtful enough, and informal promises from Moscow with no prospect of enforcement seem a very weak reed to lean on.   Indeed, if I were OPEC I would be very leery of Russia’s representations.   Russia has every incentive to encourage an OPEC output cut–and then to produce as much as possible to exploit the higher prices.   If Medvedev and Putin think that attending the OPEC meeting and promising cooperation make it more likely that OPEC will indeed cut, they’ll do those things.   The intent to adhere to those promises is highly doubtful, however.

Liam Denning expresses different reasons for skepticism in the WSJ:

Look at an atlas, and you will see that all of the members of OPEC sit within or very close to the Tropics.

That Siberia lies far to the north is one reason why Russian President Dmitry Medvedev’s hints about joining the oil group amount to mere posturing. The Organization of Petroleum Exporting Countries’ primary lever for influencing oil prices is raising or lowering members’ output — sometimes several times a year.

Try doing that when the Siberian winter freezes dormant wells closed, meaning they have to be drilled again. Meanwhile, summer thaws churn up the ground, bogging down maintenance equipment. In Russia, once you drill a well, it pays to keep it pumping.

In theory, the Kremlin could stockpile reserves to adjust export volumes. But this would take time and incur big costs in an economic crisis.

It also isn’t clear why Saudi Arabia, OPEC’s de facto leader, would want Russia to join the quota system. In 2007, the Saudis exported 7.9 million barrels a day, according to the U.S. Energy Information Administration. Russia exported seven million barrels. Saudi Arabia would risk seriously diluting its influence in an already fractious group. And for what? Does anyone think Moscow would abide by OPEC policies if it didn’t suit it?

In reality, Mr. Medvedev is dressing up Russia’s inevitable output decline — largely resulting from the state’s tightened grip on the energy sector — as a planned move co-ordinated with OPEC. Second, with the economy still a leveraged play on energy prices, and a possibly destabilizing ruble devaluation on the horizon, he is trying to talk up the oil market.

Far from hinting at increased Russian influence, the president’s words carry more than a hint of desperation.

Denning’s point about the inherently less flexible nature of Russian oil production is of great interest.   It means that actual Russian cuts in the short run are more credible in the longer run than cuts in, say, Kuwait. Kuwait can cut today, and increase output relatively easily in the near future.   If Russia cuts today, it is effectively committing itself to cut for a considerably longer period.   Knowing this, it is less likely that Russia will choose to cut.   It would be in a real jam if it cut in conjunction with OPEC, only to have the latter’s members (predictably) renege on their commitments weeks later.   In that case, Russia would have the worst of all worlds–lower output and low prices.

So, I concur with Denning’s basic argument that Medvedev is just talking his book (as traders say), and that he is trying to get some price action in exchange for cheap talk.

Rather than listening to Medvedev, or Putin for that matter, I would pay attention to the export duty.   That is the primary lever that Russia can pull to affect exports and hence world prices.   If Russia raises the duty, it means it is serious about cutting output.   If it keeps the tax low, or cuts it further as the Novosti article suggests, all the talk about cutting output in conjunction with OPEC is just that–talk.

There are two competing models in CDS clearing.   The CME model is to clear these products through its existing clearing structure, effectively “co-mingling” futures risks and CDS risks.   The alternative model, embraced by ICE and Eurex, will clear CDS and futures products seperately.

As I’ve mentioned on a few occasions, there is considerable tension among CME clearing members over the co-mingling idea.   This article from DJ News Wires details the competing claims and complaints over the various models:

CME argues that “co-mingling” futures and CDS contracts in its clearinghouse will avoid an additional capital call on banks and dealers.

The strategy has generated warnings from some of CME’s largest partners in the futures industry, who are concerned they will be exposed to CDS risk.

Patrice Blanc, chief executive of Paris-based Newedge, said co-mingling futures and CDS clearing is “dangerous,” and that it could “create huge systemic risk” for market participants.

Clearing CDS contracts is “a much more complex issue than it’s been made out to be,” Blanc said in a recent interview with Dow Jones Newswires.

Thomas Peterffy, CEO of electronic brokerage firm and CME clearing member Interactive Brokers, has also come out against mixing futures and CDS risk on CME’s platform.

Co-mingling of futures and CDS risk could threaten the integrity of a clearinghouse, says Roger Liddell, CEO of London-based clearinghouse LCH.Clearnet.

He also cautioned that clearing CDS trades may be more complicated than many believe.

“There is a risk in assuming that everyone can clear everything,” Liddell said at the Futures Industry Association’s 2008 Expo in Chicago last week.

I concur with the various cautions voiced by Liddell, Blanc, and Peterffy.   They are, in effect, in agreement with my assessment that CDS clearing presents acute balance sheet and product risks that are inherently more costly to share through a clearinghouse, due to asymmetric information problems.

Now, “co-mingling” is synonym for “diversification.”   In a world of complete information, the CME’s Kim Taylor would be exactly right:

Kim Taylor, president of the CME clearinghouse, has acknowledged the concerns. She argues that combining the risk of futures and CDS contracts in one clearinghouse provides diversification, lower overall risk and cutting trading costs.

Taylor, speaking on a panel at the FIA event, noted that risk management for the clearinghouse as a whole has become more efficient when CME has brought new product lines into its clearinghouse, notably the energy and metals contracts from the New York Mercantile Exchange.

In a world of complete information, with no information asymmetry, there are economies of scope in clearing.   Through the diversification effect, the riskiness of a combined CDS and futures portfolio would be lower than the sum of the risk of the stand alone CDS portfolio and the risk of the stand alone futures portfolio.   Moreover, clearing across products economizes on margins.   Again, due to the diversification effect, with a combined portfolio one can achieve the same default loss profile for a smaller margin than one can with seperate portfolios.

So, co-mingling sounds like a no brainer.   So why aren’t savvy market participants buying this?   I think the answer is pretty clear.   They understand that this is not a situation of complete information.   Due to information problems, moral hazard and adverse selection problems make it costly to clear CDS trades.   CME clearing members are quite right to be very leery of importing the product and balance sheet risks associated with credit default swaps into a futures clearing system that has worked very well.

Much news on the Russian economic front.

One of my favorite Russian commentors, Vladimir Milov, said this on Ekho Moskvy:

According to Kiselev’s next guest, Vladimir Milov, president of the Energy Policy Institute, compared with his previous annual question and answer sessions with the nation, this year “the president did not look confident”. Milov continued: “I would put it this way: there was less of the aplomb which we could observe in the previous years and more apologies and attempts to explain the situation.” “It was as if he (Putin) was apologizing for what is happening and, in my view, he was not very successful in this,” he said.

According to Milov, Putin is not suitable for the role of a crisis manager: “Putin is so used to the idea that everything is growing, that mentally it is very difficult for him to adjust.   One can see that he has a very inertial mentality and hence it is very difficult for him, in the conditions of the crisis, to respond to the current major and sweeping changes. He is definitely not suitable for the role of a crisis manager.”

Asked whether he approved of the government’s current strategy of “ensuring economic growth and GDP growth at any cost”, Milov replied: “To be honest with you, I can’t see the government acting in a coordinated manner, not to mention having a clear strategy or aim.” “It is evident that they (the government) have got into a muddle and are not ready to get together as a single team and draw up a coordinated anticrisis plan,” Milov said.

He went back to elaborate on the idea of the “inertia” prevailing in Putin’s and other leaders’ approach: “They are used to the situation of the past few years when everything was improving all the time owing to various external factors which they had nothing to do with, and they are simply not ready, they simply do not know and do not understand what to do in a situation when the economy is functioning in entirely different mode and when very difficult problems have emerged and the essence of which they do not understand either.”

“It is a question of fundamental incompetence and inability to assess the scale of the problems that have appeared very suddenly and are of rather an unexpected nature,” he added.

Asked how he would have dealt with the current crisis, Milov replied: “There are ways, but first of all we still need a competent leadership that would indeed understand the essence of the economic problems we are facing. Judging by what Putin said yesterday (4 December), he is a long way from having even a basic understanding of the nature of these crisis phenomena. He was still blaming America for everything. But soon, incidentally, most people will realize that America is America but jobs are being cut here, in Russia.”

Asked about the possible political consequences of the current economic crisis, Milov said: “It is a very difficult question because there are two opposite theories. According to one, the growing economic difficulties will undoubtedly start affecting a wider circle of people and very quickly push these people towards a realization that something needs to change in the political system and they (these people) will demand this.”

“But there is another theory”, Milov continued, “which says society can be rather adaptable –
people will be getting used to having slightly worse living standards and will start saying, as Putin did yesterday, that in its one-thousand-year history Russia has been through much worse times. At present it is very difficult to say what will happen in society and how this will affect the political system.”

And, in conclusion, he added: “Even if they want to, these authorities, which have only the most primitive tools at their disposal, will not be able to respond because they can’t provide any serious crisis management. Hence, if there is a significant public protest, I think they will simply have to go. There are no other options here.”

It’s easy to look like a genius when the prices of your main products go through the roof.   When oil was $140/bbl, Putin strutted about like the cock who thought his crowing made the sun rise.   Too often, people confuse luck for skill.   Happens with traders all the time.   Now, things are a little bit more difficult, and Vlad is not looking quite so good. Maybe Time should reconsider that Man of the Year thing.

The main issue is the ruble.   Due to concerns about the ruble, S&P has downgraded Russia’s sovereign debt rating, with a negative outlook (meaning that further downgrades are likely.)     Another first! (Russia is the first emerging market to have its rating cut by S&P.) S&P emphasized both macroeconomic and political risks in making its judgment. The political risks are especially important in my view.

In one rather (black) humorous moment, A S&P analyst opined:

“On the other hand, passage of measures to improve the legal and institutional framework for foreign direct investment and enhance competitiveness of the broader economy, as well as implementation of monetary policies to preserve the government’s still substantial liquid assets, could lay the foundations for greater resistance of the balance of payments to external shocks, and lead to a stabilization of the sovereign rating,” S&P’s Frank Gill was quoted as saying.

Good luck with the “passage of measures to improve the legal and institutional framework,” Frank.   That’s a very weak reed upon which to lean. In fact, if that’s the key to creating a firm foundation for future investment and growth–and I believe it is–then going short the ruble is a very good trade.

The increasing consensus is that (a) Russia is making a serious mistake by delaying the adjustment of the ruble to reflect the new bearish fundamentals (most notably the oil price), and (b) political considerations are driving this policy error.   Nouriel Roubini has an excellent analysis:

Given this sudden change in the Russian fortunes there are several key policy issues that the policy authorities need to deal with: of course given the external shocks (terms of trade worsening and sudden stop of capital and credit) it was important to use the buffer of foreign reserves to avoid a bank run by providing liquidity and capital to banks and by providing a fiscal stimulus to a country that is sharply slowing down. But the key unresolved policy issue is what to do with the exchange rate. Until recently Russia was on an effective basket peg (with 55% for the dollar and 45% weight for the euro). But with oil prices now down over 60% from the peak of the summer and with incipient current account deficits and fiscal deficits and a likely recession in 2009 the currency is obviously overvalued. A reasonable estimate of the needed exchange rate depreciation – with oil at about $50 a barrel in 2009 – is 25%. But until recently the authorities resisted the needed depreciation through aggressive forex intervention.

The reasons for resisting such necessary depreciation were varied: the banks and the corporate sector had massive foreign currency liabilities and a sharp movement of the currency would have led to nasty balance sheet effects and severe financial distress; the incipient bank run of retail depositors could accelerate if the currency were to fall sharply (Russian depositors were wiped out already twice in the transition period in the early 1990s and again in 1998 and they tend to be trigger happy); Putin staked part of his reputation and his view of a strong Russia on maintaining a strong rouble.

But the forex intervention that financed the capital flight out of Russia (a flight initially triggered by the increase in political risk given the Georgia conflict and then exacerbated by the global sudden stop of capital given the US financial turmoil in October-November) exacerbated the flight. Indeed, a good part of the forex intervention was sterilized thus preventing a significant stabilizing increase in domestic interest rates that an unsterilized intervention would have triggered. But, as a perfect case study of Triffin’s “inconsistent trinity”, a country cannot maintain a peg, have no capital controls and, at the same time, maintain monetary independence and avoid an increase in domestic interest rates that an expected depreciation triggers. The sterilized intervention thus led to a persistent bleeding of forex reserves that could continue unless such intervention is allowed to be unsterilized and thus force a rise in interest rates that would however be seriously costly in growth terms.

For a while the Russian authorities tried to skirt this inconsistent trinity inconsistency by introducing capital controls on capital outflows (taking the form of reading the riot act to local and foreign banks and financial institutions and telling them not to speculate against the trouble). But even such controls are leaky as many banks – faced with retail depositors converting roubles into dollars – needed to hedge such currency risk to avoid exacerbating their open currency positions mismatch. So the authorities cannot be too heavy handed against banks that are just hedging rather than speculating”. And unless capital controls are imposed in retail depositors their demand for currency hedging drives the financial institutions need to hedge in turn this currency exposure. So the conundrum of the inconsistent trinity still holds as there are limits to regaining monetary independence under fixed rates when such capital controls are effectively leaky and implemented partially.

The more appropriate way to regain a modicum of monetary independence and prevent a sharp increase in domestic interest rates that expectations of a rouble depreciation trigger is to let the currency peg go and flexibilize the exchange rate regime. Only after the currency has moved down enough expectations of further depreciation would quiet down. So, the right policy move would be one of a one-step large depreciation of the currency value that reduces significantly the amount of actual overvaluation of the currency. Instead, for the time being, the authorities have reacted by allowing only a gradual and modest depreciation, in a series of four 1% downward steps in the last month. But such small step depreciations exacerbate the capital flight incentives (and ensuing bleeding of reserves) as they lead to further expected depreciation expectations that triggers further flight. Only a relatively large unexpected step depreciation can stop such expectations and reduce the amount of the capital flight and forex reserve depletion.

But so far authorities had resisted such large step move for three reasons: losing face politically; worrying about a run on banks by depositors; and the large foreign currency exposure of financial institutions and corporate firms. These three reasons to resist a larger currency move are now becoming less important for several reasons. First, a continued bleeding of a large stock of reserves could cause a much bigger problem down the line – a real currency crash that would be politically even more damaging – if continued sterilized intervention leads to a sharp fall in reserves at the time when the current account and the fiscal account are likely to move into a deficit in 2009. Second, the risk of a bank run can be better managed via a controlled devaluation when reserves are still high rather than when reserves have been mostly depleted via a self-defeating defense of an indefensible peg.

Third, and most important, by now a significant part of the foreign currency exposure of the financial and corporate has been reduced by using the forex reserve intervention to effectively allow banks and corporate firms to reduce their exposure to foreign currency liabilities and thus avoid severe balance sheet effects when the currency moves by a larger amount. Effectively Russia has been doing what Brazil did in 1998-99 – i.e. bailing out ex-ante its banks and corporates by allowing them to cover their forex currency exposure via purchase of a large fraction of the reserves of the central bank.   This Brazilian “ex-ante bail-out” prevented the “ex-post bail-out” that would have been necessary if banks and corporates with a massive amount of foreign currency debt had experienced a large currency depreciation before they had the time to hedge such exposure. So now that the forex reserves of Russia have been run down enough to reduce the foreign currency exposure of the private sector the central bank can allow a faster rate of rouble depreciation without worrying about the banks and corporate going bust via the balance sheet effects of a large currency move on the value of their previous large foreign currency exposure.

All these factors suggests that the Russian authorities are now ready to let the currency fall at a faster rate than it the past. They have already moved in that direction by surprising markets with their weekly 1% moves. But since a much larger depreciation is needed and since further expected 1% moves will trigger even greater amounts of capital flight and reserve depletion a broader and large one-step move is now necessary and viable. The rouble may need to fall by about 25% before reaching a new equilibrium value. It is thus better to make a good chunk of that adjustment faster and in an unexpected way rather than keep on bleeding a large stock of forex reserves if small step movements trigger expectations of further depreciation. Now that banks and corporate firms are more hedged than before and the war chest of reserves has not yet fallen to alarming levels it is time to let the currency level take a larger burden of the necessary adjustment that the country needs to cope with lower oil prices, the sudden stop of capital, the increase in investors’ risk aversion and a global economic outlook that signals a sharp recession in advanced economies and a very likely recession in Russia too.

Roubini does endorse one argument that DR has made–namely, that defending the ruble has effectively bailed out those banks and corporations who have borrowed in foreign currencies. But Roubini argues that the time for that is over. The other deleterious effects of maintaining the peg which I have focused on are becoming too big to ignore. But Russia seems to be ignoring them, and primarily for political reasons, or, as Roubini puts it, “losing political face.” Putin’s ego is a very expensive proposition, indeed.

Roubini’s best point is that by burning through its reserves to prop up the ruble at levels completely inconsistent with the currently low price of oil, Russia is depriving itself of the means to manage the currency at a more realistic level when the real fiscal crunch begins to kick in sometime in 2009.

The incoherence of the Russian policy is becoming more widely acknowledged. One thing I had noted (in a reply to DR in the comments, I think) is that there was a certain dog-chasing-its-tail aspect to Russian policy, with the central bank printing rubles to try to provide liquidity to the domestic economy, and then sopping them up by buying them with dollars and euros. The ruble printing tends to drive the ruble down, so the bank has to sell more dollars to keep up the exchange rate. This can work, after a fashion, if, as Roubini notes, three are effective capital controls that effectively segment the domestic and FX markets, but these controls are not in place. As one Russian economist noted:

Yevgeny Gavrilenkov, economist at Troika Dialog, argues this has accelerated the exodus from the rouble.

“The expectation there will be a devaluation is present and . . delaying this is only making it worse,” he says. “The [central bank] is printing roubles to support liquidity and half of that . . is going to the dollar market. This is a bit absurd.”

Hence, Russia is blowing through its reserves in a thoughtless way that is impeding its adjustment to the new reality of a $40 oil price and depriving itself of the policy flexibility it will need down the road if world economic conditions–and hence the price of oil–continue to be weak well into next year.

All of which just goes to demonstrate the justice of Milov’s rather damning judgment on Russian economic policy and Putin’s crisis management acumen.

This is getting confusing.   First, there were reports that Russia would delay its implementation of electricity tariff reform (specifically, increasing rates to reflect economic realities).   This caused considerable anxiety among investors who had committed capital to build badly needed generation in anticipation of the tariff reform.   Second, a few days later, Putin and the government denied that the reform would be delayed.   Third, today’s Bloomberg reports that Putin’s assurances may no longer be operative:

OAO Gazprom, the world’s biggest natural-gas producer, declined the most in a week in London on concern that possible cutbacks in the Russia’s planned electricity price increases will be extended to gas prices.

Russia may scale back electricity price increases to 5 percent next year from an earlier proposed 19 percent increase, Interfax reported late yesterday.

Cuts in gas prices will probably follow so that thermal power generators, which rely on natural gas, won’t lose money in the first half of the year, according to Matvey Taits, utilities analyst at UralSib Financial Corp. in Moscow.

“If they review the tariffs for the generators, then I suppose they also have to revise them for Gazprom, because gas is the primary fuel for electricity generation in Russia,” Taits said by telephone. Concerns over gas prices are “one of the reasons” the shares are under pressure, he said.

Such policy uncertainty is hardly the way to create (I wouldn’t dare say “restore”) confidence among investors about the security of their investments.   It is particularly dangerous for Prime Ministers to weigh in on such issues, provide assurances, and then have these assurances given the lie within days.

I quote from the Book of Duh:

Top executives from four major financial exchanges told federal lawmakers Monday they believe the clearing of certain kinds of credit derivatives should be mandated by law.

. . . .”Clearing should be mandated for most [credit-default swap] instruments,” said Johnathan Short, vice president and general counsel for Atlanta-based ICE.

Terry Duffy of the CME chimed in (this is from Bloomberg–no link yet): “We do believe there should be a mandate for clearing of credit-default swaps.”

Eurex also joined the party, although they were a little more restrained in their remarks, with the exchange’s Thomas Book (whom I participated with in a panel at the SFOA in September) asking only for:

As a consequence, Congress should take into account whether the regulatory enhancements that it is considering will reinforce and be supportive of the migration of (credit-default swap) transactions from the current bilateral structure to regulated and transparent (central counterparties)

Well of course the exchanges want Congress to force clearing onto exchanges because, as Thomas so mellifluously put it:

It should be noted that although the benefits of clearing are significant for the integrity of financial markets, it cannot be assumed that centralized clearing will be automatically and broadly accepted by current (over-the- counter) market participants.

That is, the banks are unlikely to do it voluntarily, so it’s necessary to force them to clear. And if they’re forced to clear, guess who’s just licking their chops to do that business?: ICE, CME, Eurex.   Surely a coincidence.

Which begs the question, often asked here: If it such a great idea, why don’t the banks do it on their own initiative?

[Crickets chirping.]

I’ve beaten this horse so many times that I’m sure PETA is already filing a complaint with local law enforcement, so I’ll try to keep it brief and make my getaway.

One should pay considerable deference to the survivorship principle.   Although path dependence can complicate matters, the survival of a particular institutional arrangement in the face of viable alternatives suggests that it offers efficiency advantages over these alternatives. I have laid out a case as to the likely sources of such an efficiency advantage of bilateral arrangements over central clearing: lower costs associated with asymmetric information.

Only if one can identify some sort of market failure (e.g., a coordination problem) or externality is a mandated change in default risk sharing arrangements justified.   Although there has been a lot of serious talk about “systemic risk” and “financial stability,” there has been no real identification of a concrete externality, or a demonstration that mandated clearing would fix it.     Apropos yesterday’s analysis of the Allen-Gale book, the discussion of clearing has been carried out without reference to any credible theoretical or logical framework.

So, my challenge to the advocates of clearing: What externality that justifies the impostion of clearing?   If the individual firms who would belong to a clearinghouse don’t internalize the externality, why would a clearinghouse?   Why, despite the fact that the concept of clearing is very well known and tested, have wide swaths of the OTC market deliberately eschewed it?   What are the likely equilibrium responses to the imposition of clearing?   How exactly will clearing reduce systemic risk?

The political economy of this is very interesting.   The congressional committee (House Ag) with jurisdiction over the futures markets and the exchanges is pushing legislation to mandate clearing.   (Chairman Peterson has indicated that he hopes to have a bill in January.)   This suggests that this is being driven by politics and the concentrated economic interests of the exchanges, rather than a serious deliberation over the pros and cons.   (Well, “Duh” again.)

I will close with an entertaining quote from a Chicago trader and CME clearinghouse member who understands very well the risks (notably the balance sheet risks) that CDS clearing could pose:

Howard Simons, one of the Chicago traders who always loathed the New York CDS dealers, speaks for many of his comrades in rejecting the trading of CDS on the futures exchanges. “The clearing members of the CME [Chicago Mercantile Exchange] think trading this stuff is the stupidest idea in the world. I didn’t work my whole life so some investment bank can take all our capital. Do I look like Hank Paulson?”

One of the most succinct descriptions of balance sheet risk ever uttered.   Couldn’t have put it better myself.

No, not Old Soldiers, but those who soldier in the pits–the futures trading pits.   In a couple of weeks, the Minneapolis Grain Exchange will close its floor.

Less than 15 years ago, electronic trading had made its first inroads into the futures business, but the conventional wisdom was that floor trading was inherently more efficient and would dominate well into the future, with computers being a mere ancillary.   I know that argument well, because I heard it a lot–usually expressed in a very dismissive, go-back-to-academia-you-egghead sort of way.

I heard such derisive remarks because in 1994 I completed a study for the Deutsche Terminborse (now Eurex) that challenged this conventional wisdom.   I documented that electronic markets could be as liquid and deep, and perhaps more liquid and deep, than floor markets.   The responsein the industry, and especially in the US, where the floor trading community was deeply entrenched in the exchange hierarchy, was basically: “Data.   We don’ need no stinkin’ data–we KNOW the floor is more efficient and will live forever.”

Well, in one case, forever lasted about 4 years.   For the industry as a whole, it lasted about 10.

My study compared the electronic DTB and the floor-based LIFFE markets.   The DTB had commissioned the study, and had originally intended to keep it private, for use in their strategic planning.   The exchange was contemplating adding a class of members analogous to locals on floor exchanges in response to the constant refrain that locals were the main source of liquidity in the market.   The results of the study were surprising to the exchange (and admittedly, to me, given my previous exposure to the conventional wisdom), so they decided to release it.

The study received some play in the press, with articles appearing in Risk and the Financial Times.   The FT article quoted LIFFE head David Hodson snorting at my study, saying (in essence) that everybody knows the floor is best so one should just ignore Yank academic scribblings.

In 1998, less than 4 years later, DTB wrested the Bund futures contract from LIFFE, and the British exchange was teetering on the edge of oblivion.   (The DTB used my study as a part of the marketing blitz that resulted in its victory.)   David Hodson was ousted as LIFFE CEO.   (I resisted the temptation to send him a copy of the FT article. )

Soon, the move to electronic trading turned into a flood.   The CME, and especially the CBT, tried to resist, but eventually competitive pressures and customer demand compelled them to adopt computerized trading.   The CBT’s members’ attempts to resist, delay, stymie, and sabotage electronic trading, and their half-hearted moves to create electronic markets, undermined the exchange’s competitive position, and ultimately doomed the exchange to become the acquired, rather than the acquirer.

Why the intellectual resistance?   Well, part of it was self-serving: the floor crowd understood that their time and space advantage would disappear in an electronic environment.   But part of it was rooted in a genuine belief that floor trading WAS better.   This belief, in turn, reflected an all-too-human response to new technology.   The strengths of an incumbent technology are well known.   The existing technology has had time to develop and achieve its potential.   The new technology is often buggy and imperfectly realized; its failings and weaknesses are usually obvious.   Moreover, pragmatic, practically-minded people born and bred in the industry tend to view a new technology through the lens of their own experience.

Viewed through this lens, it was obvious that computerized markets didn’t have many of the valuable attributes of the floor.   They did have other attributes that the floor lacked, but these were all but invisible to most of those who had spent their lives in the business.   In the end, however, these invisible attributes of the new trumped the well-known virtues of the old.

When thinking about this history, it brings to mind parallels, like the dismissive reaction of cavalarymen to the introduction of the tank.   New ideas often appear ludicrous and doomed to failure when evaluated using the old paradigm–but often, they render the old paradigm completely obsolete.   In retrospect, it is easy to see when that has occurred.   The difficult thing is to identify prospectively which innovations will overturn the old ways altogether, rather than just facilitate their evolution–if they don’t flop altogether.   Many revolutions are trumpeted, few actually succeed.   Electronic trading has revolutionized the financial markets, and stories like the above from Minneapolis are reminders of how much things have changed.

Although I was an early advocate of electronic trading, I must confess to some nostalgic regret at the passing of the floor.   There is something romantic, something intensely human, about it.   The floor is fascinating historically, economically, sociologically, and even anthropologically.   But like many romantic, historical things (e.g., dashing cavaliers), it has become obsolete in the face of advancing technology, and will soon be of merely antiquarian interest.

Russia Weakens Ruble Defense After Record Drop in Crude to $39.

Dec. 5 (Bloomberg) — Russia weakened its defense of the ruble for a fourth time in a month, pushing the currency near a three-year low against the dollar, as the price of the nation’s crude oil fell by a record this week to less than $40 a barrel.

The currency slid as much as 1.2 percent to 28.1344 per dollar and dropped 1 percent to 31.5971 against the central bank’s target basket of euros and dollars. “The corridor has been widened,” a Bank Rossii official who declined to be identified said in a phone interview from Moscow today.

As for those of you (ahem) who took solace in the $5 billion rise in reserves last week, this was largely a technical seasonal development driven by tax payment considerations.   The article continues:

“Given oil is already below $40 a barrel we can’t rule out more depreciation,” said Evgeny Gavrilenkov, chief economist at Troika Dialog in Moscow, Russia’s oldest investment bank. “Any further devaluation depends on oil.”

Russia is facing its worst financial crisis since the government defaulted on $40 billion of debt a decade ago, prompting a 71 percent ruble devaluation against the dollar that eroded bank deposits.

Concern about the currency’s decline spurred Russians in October to withdraw 355 billion rubles ($13 billion) from their deposits, the most in two years, according to central bank data. Foreign-currency deposits rose 11 percent.

Putin’s Pledge

“The gradual approach feeds expectations of further devaluation and prompts the population and companies to convert all extra rubles into foreign exchange,” said Tatiana Orlova, an economist in Moscow for ING Groep NV. “This policy will likely lead to further depletion of foreign exchange and gold reserves.”

Those quoted in the article predict a ruble decline of between 15 and 30 percent.

The ruble has actually declined less against the dollar than other commodity currencies, even though Russia’s main export has declined in price more than, say, Brazilian soybeans.   This suggests that a big decline is coming.   And the consensus is increasingly that Russia is throwing good money after bad by attempting to slow this process:

Russia is wasting its cash reserves by propping up the ruble as lower oil prices drive away investors from commodity-led economies, according to Brown Brothers Harriman & Co.

“The pressure on the ruble will remain and Russia shouldn’t try to resist it by depleting its reserves,” said Win Thin, a currency strategist at Brown Brothers Harriman in New York. “Oil producers are really struggling in terms of trade shock.”

The CHART OF THE DAY shows that the 16 percent slide in the ruble is yet to match the decline in the currencies of commodity exporters including Australia and Mexico, which have fallen 33 percent and 24 percent versus the dollar since July.

Urals crude, Russia’s main export blend of oil, has slumped 68 percent since July to $43 a barrel, below the $70 average needed to balance the country’s budget next year. Russia has spent $148 billion or a quarter of its international reserves since August to defend the ruble.

Of the other “commodity currencies”, the Brazilian real slid 33 percent against the dollar, the New Zealand dollar dropped 30 percent, the Chilean peso 21 percent and the South African rand fell 23 percent.

Deferring the day of reckoning will only make the ultimate consequences all the worse.

A few posts ago I suggested that the Bruce Springsteen song “Glory Days” was quite apropos to Russia.   Today, another Springsteen song seems appropriate: “I’m Goin’ Down.”     What’s goin’ down, again, is the price of oil.

As I write, Brent on ICE is down $3.30–or 7.8 percent.   Cash settled WTI on ICE is down $3.33, or 7.6 percent.

A couple of weeks back, Michel asked when the price of Urals Med would fall below $40/bbl.   Since it was selling at $41.75 yesterday, I imagine that today is the day.

So . . . any guesses as to when we hit $30?

I have been adamant in my opinion that OPEC is a weak reed for non-OPEC producers like Russia to lean on, because cartel members face a prisoners’ dilemma that can make cheating a dominant strategy.   The market’s decidedly bearish reaction to various OPEC pronouncements suggests that most people who are putting their money where their mouths are share similar views.   Reuters reports that OPEC compliance–or lack thereof–has indeed been weighing on prices:

Members of the Organization of Petroleum Exporting Countries had pledged to lower output by 1.5 million barrels per day for November in order to prop up prices, but were only 66 percent compliant with the target last month, a Reuters survey showed on Tuesday.

OPEC’s decision to wait until later this month to take more supply off the market, combined with a steep sell-off in U.S. stocks, led to a drop of more than 9 percent in U.S. crude oil futures on Monday.

Benchmark U.S. stock indexes were up more than 3 percent on Tuesday as investors hunted for bargains amid optimism that the government will bail out the U.S. auto industry.

OPEC CUTS

OPEC members remained concerned about oversupply in the world oil market and may decide to cut output further at their next meeting in Algeria on December 17.

“We are concerned about the glut … I think there is an indication that we will have another cut,” Qatar Oil Minister Abdullah al-Attiya said.

Top oil exporter Saudi Arabia has highlighted $75 a barrel as a “fair price” for oil.

Meanwhile, sources said two OPEC members, the United Arab Emirates and Kuwait, will increase oil sales to many major Asian customers, sending mixed signals about OPEC output cuts.

This is especially ominous for oil sellers because (a) compliance usually is at its peak immediately following new agreements, and (b) even in a competitive market, some producers would cut output anyways in the face of sharply lower prices, so the two-thirds compliance overstates the extent to which anybody is taking one for the team.

There were recently reports that Russia would cooperate with OPEC in an attempt to stabilize prices, although Medvedev’s comments on the subject during his love-in with that looker Hugo Chavez were decidedly mealy-mouthed:

Major price swings aren’t in the interest of either oil- producing or consuming countries, Medvedev said yesterday in a Caracas ceremony where he and Venezuela President Hugo Chavez signed energy accords. He said Russia would “coordinate fundamentally with Venezuela” and other OPEC nations, without specifying how.

“We will be coordinating, but it doesn’t mean that we’ll be colluding.”

And just what does that mean, exactly?

Ironically, through its tax policy, Russia has already effectively cut world supplies:

November oil exports fell to their lowest level since 2004 as firms cut supplies because of high export duties while output headed for its first decline in a decade.

Falling shipments have become a major concern for the government since the budget depends heavily on oil-export revenues.

Energy Ministry data showed Tuesday that Russian oil exports via pipeline monopoly Transneft stood at 3.70 million barrels per day in November, down by 12 percent from 4.21 million bpd in October. Oil companies had threatened to cut November deliveries by as much as a quarter because they said exports were loss-making with an export duty at $287 per ton ($39 per barrel). The average price for Urals blend crude was about $55 per barrel.

The decrease in exports made the government change the scheme of calculating the oil export duty, which, starting from December, will be set monthly instead of once every two months.

The December oil-export duty calculated under the new scheme was set at $192.1 per ton, almost a $100-per-ton decrease from the November level, but oil firms have said it was still too high to make exports attractive.

Viktor Vekselberg, one of the major shareholders at BP’s Russian venture, TNK-BP, said last week that the new export duty would help oil firms survive but was not enough to encourage investment.

The Energy Ministry data also showed that Russia’s oil production fell by 0.4 percent to 9.82 million bpd in November from 9.86 million bpd in the previous month.

Oil output fell throughout the first half of the year, and analysts had expected that it would recover in the second half after a number of oil companies started new fields.

That cut of 500m bbl/day is about one-third of the promised OPEC cut, and (per the Reuters numbers) about one-half of the actual cut.   So, if unwittingly, Russia has done proportionally much more than OPEC to support prices.   (OPEC output is about 34 mm bbl/day, Russian output is about 10mm bbl/day, so the Russian reduction is about 5 percent, OPEC’s 3 percent.)

But–and here’s where the irony gets even thicker–due to the shrieks of the domestic oil producers, Russia is considering a cut   in export duties, which would result in higher exports, lower world prices, higher domestic (after-duty) prices, and likely lower government revenues.   Thus, Medvedev, Putin, and others are talking out of both sides of their mouths, simultaneously promising Chavez, OPEC, that they will “coordinate” to keep world prices high, and telling domestic producers that they will ease export duties.

Ummm, sorry to break it to you guys, but it’s one or the other–either keep the export duty high to reduce exports and help prop up the world price while screwing domestic producers, or cut it to help domestic producers and undercut fast friends like Chavez and Ahmadinejad (who are the most hawkish OPEC members) while putting further downward pressure on world prices.   “Both” is not an option.

Ain’t choices grand?   Let us know when you make up your minds.

Like a spoiled child who has lost a game at his birthday party, Vladimir Putin cries: “It’s NOT FAIR!“:

Prime Minister Vladimir Putin described the effect foreign markets have on domestic share prices as “unfair” during a government meeting Monday, saying the values of the securities do not accurately reflect those of the companies themselves.

Putin also spoke out against insider trading and again blamed the West for the country’s economic difficulties, adding that those trading on domestic exchanges would be compensated for financial losses, Interfax reported.

“Decisions concerning which securities to buy or sell on Russian markets are, for the most part, made abroad,” Putin said, the news agency reported. “Moreover, the criteria by which these decisions are made have very little connection to the actual state of our economy or Russian companies.”

At the same time, he was careful to point out that the country did not want to exclude foreign investors.

“No one is preparing to limit the activities of foreign capital in the Russian stock market — we welcome foreign investors,” Putin said. “But at the same time, the task lies in properly building a large class of domestic investors as a powerful and capable financial institution of its own.”

While the lack of domestic investors is clearly a problem and shares in Russian companies trade at levels below what might be expected given their fundamentals, said James Beadle, director of Pilgrim Asset Management, the blame for their performance should be shared around.

“On the face of it, Putin is completely correct — I think a lot of the market’s reaction has had nothing to do with the Russian economy,” Beadle said. “But Russia’s situation has been, as we know, worse than most emerging markets. I put that down to the weak economic environment, the political risk and a lack of domestic investors.”

While lashing out at the West, Putin said the government remained committed to turning Moscow into an international financial center.

“In the very near future, the government will examine a comprehensive plan regarding the financial center’s creation,” he said, adding that the financial crisis would perhaps change the global economic pecking order, affording Russia greater opportunity to achieve its goal.

Vladimir Milovidov, head of the Federal Financial Markets Service, followed Putin’s comments at the meeting by elaborating on the state’s plans for compensating investors for market losses, Interfax reported.

Milovidov explained that this would be achieved through a mechanism based on the Deposit Insurance Agency, which is designed to insure individual bank deposits.

“I don’t see any clear obstacles to the creation of such a system of compensation based on the idea of the Deposit Insurance Agency,” Milovidov said, although he added that the question would require further consultation with various ministries and departments.

There was skepticism over whether such a plan could work.

“It seems a little unrealistic to me,” said Tom Mundy, an analyst at Renaissance Capital. “Maybe it would be better to think about how Russia can restructure its financial institutions.”

While saying there was some truth to the charges Putin made, Mundy also said not all of the blame for weak domestic markets should be placed elsewhere.

“Russia’s financial institution did break down. The banks didn’t lend,” he said. “[The crisis] is an inherited problem, and I can understand why the market is frustrated. But it does not mean that Russia is completely blameless.

“There is a little bit of blame to be passed overseas, and there is some internal blame as well with these oligarchs who had [overleveraged their companies],” said Ronald Smith, chief strategist at Alfa Bank. “There’s blame all the way around.”

In line with Putin’s comments, the Presidium approved a strategic development project for Russia’s financial markets through 2020, Milovidov reported. He added that the Presidium also approved a draft law designed to combat insider trading.

Mundy said the Kremlin’s focus on a global financial center pointed to a healthy desire for economic integration and that, in the end, the crisis might actually help push along Russia’s economic development.

“‘The next stage in Russia’s development is probably creating more transparency,” he said.

I especially like the part about insider trading.   I’m sure no silovik ever does that.

The prattle about Russia as a financial center is simply delusional.   No secure property rights, no credible policy commitments, no rule of law, corporate raiding, expropriation of foreign investors–yeah, that’s the foundation for a world financial center.   You betcha!

And what’s the deal about compensating those trading on domestic exchanges for their losses?   That’s the ticket, give investors a put paid for with government money.   No better way to encourage wild risk taking–private gains, socialized losses.   The proposal also smacks of a scheme to tunnel state assets and direct them to the pockets of political favorites.   We are repeatedly told that individual investors don’t play the Russian stock market–that it is the playground of a limited set of connected players, the oligarchs prominent among them.   So this seems like just another bailout.

Tom Mundy gets a nomination for the Understatement of the Year Award:

“It seems a little unrealistic to me,” said Tom Mundy, an analyst at Renaissance Capital. “Maybe it would be better to think about how Russia can restructure its financial institutions.”

Ya think?