Streetwise Professor

I was quoted on a Marketplace story on the energy market regulation changes I blogged about yesterday. Nice to get the last word.

Robert Amsterdam’s excellent blog was kind enough to post an interview with me on Russian food price controls. Here’s the interview. (Boy, do I need to get a new picture.)

The CFTC is supporting Congressional efforts led by Sen. Levin of MI to pass legislation that would allow it to impose position limits and obtain position information on energy derivatives traded on ICE (and presumably other electronic OTC trading platforms) in order to prevent energy price manipulation:

The CFTC is seeking mandatory daily reporting to the agency of large ICE trades, limits on the number of ICE energy contracts a single trader could control and exchange rules to force a trader to unwind large contract positions.

To recycle a line I’ve used before, they want to reduce manipulation in the worst way–and they’ve found it. Position limits and position reporting are inefficient ways to reduce the frequency of manipulation, as compared to readily available alternatives. There are so many defects in these remedies, it’s hard to know where to begin.

For one thing, position limits must be set based using very crude information about the market conditions that will prevail when the position limits are in effect. Sometimes the limits will be too large to constrain much manipulative behavior. Other times, the limits will be smaller than necessary to combat manipulation, and will be so small that they constrain the legitimate activities of market participants.

This last effect is very important. It is economically efficient for some traders to accumulate large speculative positions. These speculators absorb risk from hedgers. Position limits constrain speculators’ ability to take on risk, meaning that hedgers will find it costlier to transfer risk to speculators. They will hedge less as a result. That’s a real cost.

I have just completed a paper that shows that even if position limits constrain manipulation, they reduce overall welfare because of they interfere with the efficient allocation of risk. In essence, position limits throw out the baby with the bath. Sure, they constrain the rent seeking, manipulative activities of speculators, but they also constrain speculators’ efficiency enhancing risk bearing function too. In the standard mean-variance/Anderson-Danthine hedging/speculation equilibrium model of my paper, the latter effect outweighs the former, and position limits reduce welfare. Thus, even if they are successful in reducing manipulation, that doesn’t mean that they’re good public policy.

This possibility has been totally ignored in the debate, such as it is, over position limits in energy. This reflects a general ignorance of the socially beneficial effects of speculation, and indeed, the hostility to speculation that has dominated the Congressional and regulatory intellect for decades (stretching back into the 19th century.) Risk transfer is a primary function of derivatives markets, and position limits interfere with this primary function. This is a real cost, but one that is too often ignored.

Position reporting wins no prizes for efficiency either. Presumably the theory is that the ability to monitor positions gives regulators the ability to identify incipient manipulations, and intervene before things get out of hand. Now let’s deal with the reality.

The first reality is that how big is big–i.e., how big a position must be before it poses a manipulative threat–depends on variable market conditions, and how the trader acts. Just seeing that somebody holds a big position tells you absolutely bupkus. As a result, regulators will start to scrutinize big positions only when price distortions become manifest in the marketplace. Well, by the time this happens, a lot of the damage is already done. Maybe the regulators can keep things from getting worse, but the idea of preventing manipulation before it affects prices is a pipe dream. Even when armed with position information, regulators only become engaged when price distortions become apparent.

And even when they intervene, there is no guarantee that they will succeed. They can jawbone, but sometimes regulators can be fooled, persuaded–or intimidated–into inaction by manipulators. Think that doesn’t happen? Want to buy a bridge?

Regulators can also be wrong, and it is important to remember that when attempting to intervene during an alleged manipulation regulators necessarily have worse information than is available after things play out. The manipulative “end game” (as I call it in my ’93 JOB piece on manipulation) often provides the most powerful information on whether a manipulation in fact occurred. For one thing, the price movements post-manipulation–the “burying the corpse” effect–often provide the strongest evidence that prices were distorted. (After a corner ends, the manipulated price collapses relative to other prices as the excess deliveries are dumped on the market. These deliveries are the “corpse” of the corner, and disposing of them is referred to in the biz as “burying the corpse.”) (And to reiterate, Bill, I didn’t make up that phrase. P. D. Armour did. Sorry for the inside humor, folks, but I couldn’t resist–although I did restrain myself from making a really cutting remark.) Also, the alleged manipulator’s behavior–whether he takes deliveries at prices that appear uneconomic–provides the strongest evidence on his motives and intent.

Errors are important. Regulators can intervene and force liquidations of large positions when there is really no manipulation, or they can fail to intervene when a manipulation is actually in progress. Both kinds of errors are costly. Given the lack of crucial information before things play out, for a given probability of one type of error, the other type of error is higher when regulators try to intervene before the fact than afterwards. As I’ll discuss momentarily, civil (or even criminal) sanctions imposed after the fact can utilize better information, reduce the frequency of one or both kinds of error, and reduce the frequency and severity more efficiently than early intervention.

Reporting is wasteful for other reasons too. It is costly to collect this information, most of which will never be needed to detect or prevent a manipulation.

Moreover, traders can avoid position limits and reporting by moving their activities into the non-electronic OTC market, using voice brokers or just bilateral deals with other traders. To the extent that it is more efficient to execute transactions electronically on a platform like ICE, this displacement of trading activity is inefficient (though it is a boon to voice brokers.)

So what is better? Dropping the hammer on manipulators after the fact, that’s what. Law and Economics scholars (notably Steve Shavell) have identified conditions under which deterrence through the imposition of sanctions ex post is more efficient than ex ante prevention. Most importantly, deterrence is efficient (relative to prevention) when the offense is detected with high probability, and malfeasors are not judgment proof.

Both conditions characterize manipulation in derivatives markets. As Judge Frank Easterbrook once wrote, an undetected manipulation is an unsuccessful manipulation. A successful manipulation distorts prices–and everybody in the market can observe it. Moreover, most manipulators are well heeled, and can pay legal judgments levied against them.

By waiting to act until after a putative manipulation runs its course, regulatory or judicial authorities–or private plaintiffs harmed by the manipulation–can rely on the best information available on the price impact of the manipulation–including the “burying the corpse” effect–and on the alleged manipulator’s actions. Thus, there should be fewer errors (incorrect convictions, or incorrect acquittals) after the fact than when regulators attempt to intervene during a suspected manipulation.

Litigation is expensive, to be sure. But the expenditures can be targeted, and only incurred when the harm occurs. Position information need only be collected via discovery when the evidence of a manipulation is manifest, and from the likely culprits (who can be identified pretty easily, as there is a lot of information about who is doing what is floating around the markets, and some manipulative behavior is hard to miss, e.g., who ends up owning all the deliverable supply.) This is cheaper than collecting information from everybody (virtually all of whom are completely innocent of anything) all the time (when usually nothing amiss is happening).

So, in a nutshell, deterrence rules, and position limits/reporting are for fools. And guess which way Congress and the CFTC are moving? Draw your own inferences, people; do I have to draw a map?

Ironically, the news about the Levin bill and the CFTC advocacy thereof comes almost simultaneously with the announcement that BP has agreed to pay $300 million(!) (subscription required) to settle civil charges that it manipulated the propane market in 2004, and that four BP traders are facing criminal charges (ditto) arising out of the same incident. I have mixed feelings about the criminal aspect of this case, but the imposition on a hefty fine on BP is the way to go as a way to deter this sort of conduct going forward. Three hundred large large is some major change–especially considering that the alleged (and I guess now admitted) BP corner attempt was apparently unprofitable because the company ended up with a much bigger corpse to bury than it had anticipated. Surely any trader contemplating cornering, squeezing, or hugging a market in the future will think once, twice, and a few more times, before squeezing the next time. It should also be noted that all this activity took place in the OTC market, and that it did not take place on ICE, or to my knowledge, any electronic trading platform. Nonetheless, the manipulation was identified, the culprit fingered, and the hammer brought down. No need for watching everybody all the time, most of said watching effort being completely unnecessary because much of the time manipulation isn’t a serious worry.

For those of you with way too much time on your hands, I have a much expanded analysis of the deterrence vs. prevention debate in my book The Economics, Law, and Public Policy of Market Power Manipulation. (Shameless plug! Now up to #1,302,119 on Amazon! Only 3 copies left! Order soon!) I also presented some rigorous numerical analysis of the power of detection ex post vs. ex ante in the working paper version of what eventually turned into my 2004 ALER article on the Ferruzzi squeeze. I think that version is still posted on my UH web page.

One last comment. I find the obsession with energy market manipulation to be somewhat curious. The US government has manipulation problems much closer to home–the US Treasury securities market. Manipulation problems in this market became so chronic in the early-2000s that two high ranking Treasury officials raised the subject in public speeches, and the FRBNY called bond market heavyweights to a Come-to-Jesus meeting, where the assembled congregation was sternly warned to go away and sin (that is, manipulate) no more. Despite the importance of the Treasury markets, and their size, Congressional interest in this problem seems de minimus as compared to the constant hyperventilating over energy market manipulation. Presumably this has to do with the fact that energy prices affect pretty much everybody, whereas the Treasury markets (especially the repo market) are pretty much inside baseball; Congress has to be seen Doing Something about energy prices even though there is little if any connection between persistently high energy prices and the kinds of manipulation that are allegedly the targets of legislation, and even though (as discussed above) the legislation is an inefficient way to reduce those kinds of manipulation.

I was thinking of inserting an apposite Mark Twain quote here (you probably know the one I’m thinking of), but won’t gild the lily. Like Mom says, if you can’t say anything nice . . . I know I’ve broken that rule a lot already in this post, but I’ll follow it just this once.

Correction. I wrote that to my knowledge, none of BP’s propane transactions were consummated on an electronic system. I took another look at the CFTC’s civil complaint against BP, and noticed that market participants utilized an electronic trading platform called Chalkboard to trade propane. I don’t know the breakdown of volume between voice brokers and Chalkboard.

The FT reports that Russia is moving towards price controls on food:

Russia is introducing Soviet-style price controls on some basic foods in an effort to prevent spiralling prices from denting the Putin administration’s popularity ahead of parliamentary polls in December.

The country’s biggest food retailers and producers have reached an agreement, expected to be signed with the Russian government on Wednesday, to freeze prices at October 15 levels on selected types of bread, cheese, milk, eggs and vegetable oil until the end of the year.

The consequences of this move are drearily predictable: shortages, empty shelves, lines in stores, black markets in foodstuffs. I expect that these developments will lead, in turn, as day follows night, to publicity/propaganda campaigns against “speculators” and “hoarders,” likely accompanied in today’s increasingly shrill and paranoid political environment by some physical attacks on enterprising black marketeers (most likely ethnic minorities.)

What is to explain this economic stupidity? Is it another manifestation of nostalgia for Soviet days, of a piece with excavations of long-buried statues of Stalin, or Brezhnev chic? Likely not, but it does reflect the economic ignorance that is the legacy of Soviet days, though it should be noted that price controls wreaked havoc in pre-Communist Russia as well. Indeed, Tsarist imposition of price controls on food during WWI was the primary cause of food shortages in St. Petersburg (and other cities) that in turn sparked the civil unrest that culminated in revolution. (See this review of Peter Gatrell’s “Russia’s First World War” for a concise overview of this history.) It also reflects the Russian populace’s longstanding hostility to market mechanisms, a hostility unfortunately reinforced by the experiences of the 1990s.

In this environment, price controls will receive popular support–at least for awhile. And maybe that’s all that Putin and the power structures are looking for–a temporary expedient that will get them past the parliamentary elections in December and March’s presidential “contest.”

But the respite will only be temporary. Price controls do not address the forces driving Russian inflation; the huge demand stimulus resulting from booming energy prices, distributed in part through increasingly generous benefits, and the conscious decision to prevent the ruble from appreciating too much in response to the rise in energy export revenues. The only way to keep the ruble from appreciating is to increase the money supply, thereby feeding inflation. But letting the ruble rise will reduce the competitiveness of domestic Russian industry. So the energy price boom is not all wine and roses for Vlad and Co. It forces adjustments that will discomfit one important political constituency or another. Price controls may kick the political can down the road a ways, but sooner or later a reckoning is inevitable.

And there is one other predictable consequence of price controls that deserves comment: corruption. Underpricing food creates opportunities for the politically powerful, the economically connected, and law enforcement personnel to enrich themselves. Price controls mean that the “official” price of food will be less than the price that consumers are willing to pay. The connected disproportionately will be able to buy at the “official” prices and resell at black market prices, with less risk of prosecution, and profit accordingly. As bad as corruption is in Russia, these controls will only make it that much worse.

I wonder whether the siloviki consider the prospect of increased corruption a bug–or a feature. Indeed, to them it may be a “twofer”; a political palliative that defuses popular discontent for awhile, which at the same time expands their opportunities to line their pockets. Cynical? Yes, indeed. But when dealing with Russia’s current rulers, one must keep in mind Lily Tomlin’s immortal words: “No matter how cynical you become, it’s never enough to keep up.”

James Hamilton is a great econometrician, and has written importan tpapers on the relation between oil and the economy. He blogs periodically on the oil market. Yesterday he posted this piece on backwardation. Like my piece, he discusses Ann Davis’s WSJ piece. Overall, I think Hamilton’s take is reasonable, although he does engage in one of my pet peeves, by attributing the increase in storage to the contango in the market. As I noted yesterday, prices and inventories are both endogenous, and determined simultaneously. As the Welfare Theorems show, in a competitive market prices adjust to induce agents to take the first best actions. Therefore, saying that “storage increased because the market moved into contango” is an incomplete analysis. One must push the analysis back one step to understand what economic forces made it optimal to increase the amount of oil in inventory. When talking about forward curves, the key forces are market tightness today relative to expected future tightness.

Hamilton’s post reproduces the graph of oil forward curves (from last week and a year prior) that ran in the WSJ. The interesting thing about the graph is that when the market was in contango a year ago, distant dated forward prices were substantially lower than they are today when the market is backwardated. This illustrates an important point; it is not the level of market tightness per se that drives backwardation or contango. It is tightness today relative to what is expected in the future.

In “Care to Dance the Contango?” I analyzed in some detail the movement of the oil into contango–where prices for future delivery are above nearby “spot” prices. Consistent with the theory of storage, the move to contango coincided with massive increases in the amount of oil in storage.

Now, the market for oil has moved into backwardation–the typical state of the market since the birth of crude futures trading in the early-1980s. And, surprise, surprise, inventories of oil have fallen. The theory of storage strikes again.

This movement in oil inventories and prices was discussed in a recent WSJ article (subscription only). There are glimpses of economic sense in the article, but there is a lot of nonsense too. I doubt that the lay reader could make heads or tails on why inventories have fallen. One problem is that prices and quantities are determined simultaneously, but author Ann Davis makes statements about price structures causing inventory levels. Most importantly, the article Rounds Up the Usual Suspects–speculators–and attributes the movements between contango and backwardation to their whims.

Speculators participate in the market, and big financial firms such as Morgan Stanley have staked out big positions in the physical oil business. But speculators are responding to fundamental economic conditions, not dictating prices to move contrary to levels and structures justified by fundamentals.

As I noted in “Care to Dance,” the move to contango was a rational response to fundamental market conditions. The oil forward curve goes into contango when the current supply is abundant relative to expected future supply (or, put differently, when the current supply/demand balance is less tight than anticipated supply/demand balance.) Given the widespread anticipation in late-2005 of repeated hurricane-caused supply interruptions in the Gulf of Mexico; geopolitical unrest in the Middle East, Nigeria, and Venezuela in 2005-2006; and expectations of robust world growth in the future, as tight as supply conditions were in fall 2005, it was reasonable to believe that supply conditions would become even tighter in the future. Under these conditions, holding higher precautionary inventories was economically efficient; inventories rose accordingly; and the market moved into contango.

In recent months, the most acute fears of future supply disruptions due to hurricanes, political unrest, etc., have dissipated, and the subprime crisis has reduced expectations for future economic growth. Under these conditions, precautionary stocks needn’t be as large. Hence, we’ve seen the drawdown in stocks and the concomitant move of the forward curve into backwardation.

Speculators are an important part of this process. It is their job to assess market conditions and take positions accordingly. They are essentially conveyor belts that transform diffuse information about current and future supply and demand fundamentals into real economic decisions that affect prices and quantities. They are not always right of course, when viewed retrospectively, but that’s because the world is an unpredictable place and the best information today only imperfectly forecasts the future. But speculators are responding to market conditions, and the market is a harsh taskmaster. There are rich rewards to being right, and harsh punishments for being wrong. So, rather than lazily attributing any movement in prices and quantities to the deus ex machina of speculators, it would be far better if journalists and other analysts would think a little more thoroughly about the fundamental economic forces that really drive markets–and speculators.

I write this on the plane (Business First is the way to go!) returning from a 2 week stay in Beijing, where I taught a course in energy risk management to executives from the two largest Chinese oil companies, Sinopec and PetroChina. My involvement with these two national oil companies (NOCs) sparked some thinking about NOCs in general, and the future role of the private integrated oil majors (IOMs).

It is well known that NOCs are playing an increasingly important role in the world oil and gas markets. Indeed, they increasingly control the reserves, and the access thereto. It is also well known that the NOCs lack the technical expertise of the IOMs, especially when it comes to exploring, developing and operating more challenging fields (e.g., deep water offshore) which will be the source of an increasing fraction of the world’s growing energy needs. Absent access to the technical expertise of IOMs, NOCs will be unable to produce as much oil, with predictable—and unpleasant—implications for oil prices.

Can NOCs obtain the requisite technical expertise under contracts that do not provide an equity share to output? (This is what Russia is trying to do, as with its recent announcement of the deal with Total to develop the Shtokman field.) They can obtain some technical expertise in this way, no doubt, but there are compelling reasons to believe that vertical integration is efficient in oil exploration, development and production. As a result, there will be a substantial efficiency loss when NOCs produce and own output, and acquire technical support via contracts with IOMs that do not extend equity rights to the latter.

Integration is efficient due to the nature of the process of exploring for and developing oil reserves. Especially with regards to technically challenging projects, such as deepwater fields, oil exploration and development are informationally intensive. Moreover, a good deal of this process involves identifying and exploiting real options. As information is produced during the process of exploration and development, it is used to make decisions about how to proceed going forward. The IOM has a substantial advantage not only in generating the information, but in knowing how to utilize that information to make better decisions about the exercise of real options.

There is no way in hell to write a contract that provides the owner of the technical expertise (e.g., an IOM) with the incentive to utilize this information optimally. This is true for a variety of reasons. First, the contingencies are too numerous and too difficult to specify ex ante, hence any contract will be incomplete. Moreover, even if the parties were to attempt to specify such contingencies, due to the technical complexities, they would be nigh impossible for third parties to verify. It is well known that the inability to verify also contributes to incompleteness.

Integration greatly mitigates this problem. The owner of the knowledge captures the value of using it efficiently because it also owns the output—the oil and gas. It internalizes the benefits of better decisions.

It should also be noted that there are arguably far more imposing barriers to transferring information across firm boundaries than within firms (although transfer within firms is not free either.) Again, issues of verifiability and completeness confound addressing information transfer by contract.

Thus, we are confronted with a dispiriting state of affairs. Those who own the reserves are loath to provide equity rights therein to those with the information and expertise. Maximizing the value of those reserves requires allowing those with the information and expertise to utilize that information to exercise the myriad real options in an oil or gas project efficiently. Equity ownership of production—integration—is an efficient way of providing incentives to those with the information and expertise to use it effectively. The incentives are inherently much weaker when the reserve owning NOCs merely contract for services from the IOMs with the information and knowledge. This translates into lower output and higher prices.

Not that equity ownership is a panacea when opportunism is unchecked. Equity rights have never been secure, and they are less so now (witness the expropriations in Russia and Venezuela.)

Is integration gone forever? Probably not. The deadweight losses that will arise as NOCs attempt to acquire IOM expertise without giving equity rights will provide an incentive for a major rethink. For instance, Mexico’s autarkic energy policy is leading the country’s oil industry to a precipice with dire financial consequences for the government. Resource nationalism may feel good, but it don’t pay the bills. Even when this realization dawns on even the most reflexive nationalist demagogue, and reserve owners permit some form of equity participation by those with the know-how, we won’t be in Nirvana due to the tenuous nature of these equity rights when expropriation is a threat.

This all has interesting implications for another subject of interest—energy policy as a response to purported anthropogenic climate change. Proposals for taxation of hydrocarbons (or direct controls on consumption through cap-and-trade or CAFÉ-type policies) are premised on the assumption that it is necessary to raise the costs of oil consumption to offset the effects of environmental/climate externalities. But hydrocarbons are already heavily taxed. Moreover, the foregoing argument implies that the insecurity of property rights in energy production and the inefficiencies of acquiring exploration and development expertise through contract are reducing oil output, and will reduce it even more in the future. These inefficiencies in property rights and organization are effectively implicit taxes on hydrocarbon production. It may well be the case that even when one takes environmental impacts into account, oil and gas output is too low today because the explicit and implicit taxes are bigger than the efficient tax. Certainly, arguing for higher hydrocarbon taxes based on a tacit assumption that environmental externalities are the only distortion in energy production and consumption (which seems to be the case, as existing explicit and implicit taxes are almost never mentioned in this debate) is bad economics.

The distortions arising from insecure and inefficient property rights in oil exploration, development, and production are real, and likely to become larger in the future. These costs should be accounted for in any policy decisions on carbon taxes. So far, I have seen no evidence that this subject has even been mooted, let alone considered seriously. This bodes ill for effective energy policy in an age of climate change hysteria.

Today from Reuters:

IntercontinentalExchange Inc.’s (ICE.N: Quote, Profile, Research) bid for the Chicago Board of Trade may have been fomented by a broker backlash against the potential power of a combined CBOT Holdings Inc. (BOT.N: Quote, Profile, Research) and original suitor Chicago Mercantile Exchange Holdings Inc. (CME.N: Quote, Profile, Research).

Atlanta-based ICE, virtually unknown in the futures business just a few years ago, stunned the industry in March with an unsolicited bid that would give CBOT shareholders a majority stake in the combined company.

Banks that are among the largest futures players have signed on to advise ICE, whose innovative proposal for CBOT has at the least created a roadblock to the consummation of a marriage between the two largest U.S. futures markets, each of which has called Chicago home for decades.

“ICE may be getting support from some some of the brokers who were critical of the CME-CBOT deal,” said Keefe, Bruyette & Woods analyst Richard Herr. “The development of ICE’s bid for CBOT speaks to a further intensification of the brokers versus exchanges.”

Last week ICE said that UBS AG (UBSN.VX: Quote, Profile, Research) and Societe Generale (SOGN.PA: Quote, Profile, Research), parent of brokerage Fimat Group, had joined Morgan Stanley (MS.N: Quote, Profile, Research) as co-advisers in its offer for CBOT, which is the parent of the No. 2 U.S. futures exchange.

Oh now I remember. I advanced this hypothesis the day the ICE deal was announced.

Although the Reuters story focuses on “brokers”–implying FCMs–it is also important to emphasize the point (raised somewhat parenthetically in the story, he said parenthetically) that these FCMs are arms of big banks that dominate the OTC derivatives market. Methinks that the OTC desks of the big banks is where the real source of the opposition lies.

The story quotes a FIMAT exec providing a rationale for the FCM/bank opposition to the merger:

“Separately, both the CBOT and CME already have virtual monopolies for most derivatives contracts they offer to the public,” wrote Fimat general counsel Gary DeWaal in a November editorial in the Financial Times.

“Naturally the new entity would have significant pricing power and … unparalleled power effectively to inhibit real competition.”

I agree completely with the first statement. The second one is highly arguable, and depends on implicit assumptions that are highly dubious. Merging two monopolies would increase pricing power only to the extent that the monopoly products are substitutes (in which case the businesses aren’t really monopolies–hence something of a contradiction in Mr. DeWaal’s reasoning). I have seen no explicit estimates of cross-elasticities of demand for CME and CBT products, but doubt they are large, and suspect they might not even be positive. That is, as I have pointed out before, it may well be the case that the products traded on the two exchanges are complements, rather than substitutes. (This would imply negative cross-elasticities). This is because the exchanges’ products are traded in spreads (e.g., Treasuries vs. Eurodollars, corn vs. live hogs). In this case, the exchanges will engage in double marginalization/markup because neither takes into account the impact of its pricing on the sales of the complementary product. Merger would actually improve the efficiency of pricing in this case. Add in the effect of cost savings, and the welfare improvement resulting from the merger could be large indeed.

In any event, its good to see that the press is finally catching onto the possibility that support for the ICE effort is not all Mom and Apple Pie, but likely reflects the very intense commercial interests of large financial players looking to protect their own turf.

ICE posted its presentation outlining its case for the CBT merger. Reading it raises the question (always central to economists): “Compared to what?”

In brief, ICE makes the case that a CBT-ICE combination would reduce costs and achieve some netting benefits in clearing. This is likely true–compared to a no-merger scenario. But that’s not the relevant comparison. The relevant comparison is to the competing offer on the table from the CME. IMHO, for every category (notably technology, clearing, and OTC potential), CME-CBT is almost certain to dominate the ICE-CBT. This is especially true with respect to clearing and OTC prospects.

ICE does offer some bangles that may be attractive to the CBT’s owners: a pledge to maintain the floor and an open ended commitment to fight for the retention of CBOE exercise rights. The former pledge has a sentimental appeal, but is unlikely to be decisive since even the ag markets are going electronic. The latter commitment is not particularly credible.

CME surprised me by not budging on price. There is an interesting poker game going on here. Is CME bluffing? Probably just being smart. They have the option to up their offer later if it looks like things are running against them. I think they have a stronger case on the merits that the CME-CBT combination will offer more value. If that case seems to be prevailing, why bid against yourself? Conversely, if it appears that it’s all about the Benjamins at the front end and the CBT holders look like they are about to okay the ICE deal because of the higher price, CME can jack up its offer and throw a monkey wrench into ICE’s plans–turnabout being fair play.

One key issue is the clearing piece, and particularly the ability of ICE to scale up NYBOT clearing to handle the substantial increase in business that a CBT merger would bring. ICE announced plans to increase NYBOT clearing capacity (subscription required) by a factor of 10. This is an admission that NYBOT’s clearinghouse currently is not up to the task. It’s not just about systems though. It’s also about people (management especially) and financial soundness. Ramping up scale like this is not a trivial task, and ICE can say what it will about its success in integration with IPE and NYBOT, but this is a whole different level of expansion, and ICE didn’t even own/operate IPE clearing (which was/is done by LCH.Clearnet). Missteps are almost inevitable. It would also be interesting to see how the credit agencies would rate an ICE clearinghouse if it succeeds in buying the CBT. Somehow I doubt that they would rate it as highly as the CME’s, due to both operational and financial risk considerations. The CME clearinghouse has a proven track record operating at the scale and in the products of the merged CME-CBT entity. ICE/NYBOT does not.

This raises another question. Heretofore all of the discussion of regulatory issues has focused on the DOJ. However, given the CBT’s prominent role in the Treasury market, it seems likely that the Department of the Treasury and the Federal Reserve (especially FRBNY) are taking special interest in how this plays out. I would imagine they have concerns about any transaction that would raise performance (and hence systemic) risks; movement of CBT contracts to a new clearing platform that arguably poses greater operational and financial risks would naturally raise such concerns. I don’t know what explicit authority DOT or the FRB would have to get involved, but I am sure that they can wield a lot of “soft power” even if they don’t have explicit jurisdiction.

As Yogi said, it’s not over ’til it’s over. In my mind, however, ICE has only one way to win the hand–if the DOJ opposes the CME bid. As I said in my original post on the merger, the stakes in the game are big enough for ICE to ante up to see if that card gets dealt. If it doesn’t, I would expect them to fold rather quickly and the CME to walk away with the pot.

Commentor (and former student) Samir makes several excellent points, but I’ll focus on one. Specifically, the uncoordinated European response to Gazprom.

One of the points that Gazprom and its acolytes attempt to use to gull the lazy minded is that there is a symmetry between Europe and Russia/Gazprom. Europe has one major supplier–Russia–but Russia has only one consumer–Europe. I have even seen the term “bilateral monopoly” used in this context. Relatedly, Gazprom constantly retorts “security of demand” whenever Europeans have the temerity to question the security of their Russian supplies, suggesting that Gazprom is as vulnerable to opportunistic behavior by its customers as are its customers to a gas shutoff by Gazprom.

Strike up another chorus of “I don’t wanna hear it!” Europe is not a monolithic entity in the same way Gazprom is. Not only are there several handfuls of European countries, each of whom pursue their own interests (EU rhetoric to the contrary), but even within most European countries there are multiple consumers of gas, including utilities and industrial consumers. That is, the demand side is relatively fragmented and competitive compared to the supply side. Moreover, Gazprom is a past master at playing off one European government against the other, and European companies against one another. Divide and conquer is an old game, and Gazprom/Russia play it well. Sad to say, they are aided in this by short sighted, cynical European governments. As Samir notes, the French just cut their own deal with Gazprom. Germany has been a major enabler, although Angela Merkel is pulling back somewhat. The question remains, however, as to whether she can overcome the influence of the German banking and industrial establishment, which has a long history of cynical dealings with Russia (as during the early Bolshevik period immediately following Brest-Litovsk). The Italians have also been major collaborators.

Thus, there is no symmetry between the monolithic Russian supply side and the fragmented European demand side, and Putin’s/Gazprom’s repeated attempts to assert such balance where none exists is further evidence of their disingenuousness. Actually, I can tolerate that; I don’t blame the wolf for its nature. What I cannot tolerate is the failure to think by those in the west who parrot such nonsense.