Streetwise Professor

The old, old game of Pin the Tail on the Speculator has been updated. According to Bloomberg, the speculators who now “disrupt” the oil markets are not human: they are bots. Specifically, bots operated by Commodity Trading Advisors (CTAs).

This argument consists of two parts. The first being that the crude oil futures markets have been disrupted. The second being that the CTAs are the cats behind the disruption. Both plinths are defective.

Insofar as disruption is concerned, Bloomberg claims “Trading oil has perhaps never been more of a roller coaster ride than it is today.” Further:

Just in the past two months, prices threatened to reach $100 per barrel, only to whipsaw into the $70s. On one day in October, they swung as much as 6%. And so far in 2023, futures have lurched by more than $2 a day 161 times, a massive jump from previous years.

Bloomberg

Never more of a roller coaster ride? Well, let’s do something crazy. Like look at historical data.

The conventional measure of the wildness of the ride is volatility. The annualized daily volatility of crude oil during the alleged Rule of the Bots (the last two years) is 41.62 percent. The historical volatility (2010-2020) is 41.2 percent. (This omits 4/20/20 and 4/21/20, the day of the negative oil price and the following day.) Excluding the COVID months of 2020 produces a somewhat lower vol of 36 percent, not that much smaller than in the last two years. Further, extended excursions of realized volatility to above 40 percent are not unusual in the historical record. So to say that oil prices have been more volatile recently than has historically the case is categorically false.

With respect to the big daily moves, the Bloomberg analysis is fatally flawed because it looks at dollar price moves: big dollar price moves are more likely when prices are high than they are low, and by historical standards oil prices have been high in the last several years. It is appropriate instead to focus on percentage price changes (which is how vols are calculated, btw).

Rather than count the number of times an arbitrary threshold (like $2/bbl) is breached, it is more rigorous to look at a statistical measure of the frequency of extreme events: the “kurtosis.” Kurtosis bigger than zero means a distribution has fat tails relative to a Gaussian (“normal”) distribution, i.e., extreme moves up or down are more likely than under a normal distribution. The bigger the kurtosis, the more likely extreme moves are, i.e., the fatter the tails of the distribution.

Looking at the kurtosis of daily percentage changes rubbishes the Bloomberg analysis. The kurtosis in the last two years is 4.15, whereas from 2010-2020 it was 27.9! That is, the frequency of extreme daily price moves in years of alleged CTA disruption is far, far smaller than was the case prior to their alleged emergence as the dominant force in the. markets.

Interestingly, the kurtosis of dollar price changes is not that different between eras: 6.9 post-2020 vs. 7.2 2010-2020. So even extreme dollar price moves are less frequent in the alleged CAT era than previously. The difference is smaller, which demonstrates the need to take into account the level of prices in an analysis of “extremes.”

So the predicate for the article–that oil prices have been unusually volatile and unusually susceptible to extreme moves in the past couple of years–is not supported by the data.

As for the alleged causal factors, the dominance of CTAs is not evident in the data. CTAs are included in the “Managed Money” category of the CFTC’s Commitment of Traders Report. Here is a graph of the net position of Managed Money going back to 2006:

There was a peak in 2017-2018–a drilling boom in the US, to which I will return shortly–followed by a decline–a drilling drought–followed by a rebound to levels comparable to the 2017-2018 levels. Indeed, managed money net positions have actually been relatively low in the past year (with the exception of a recent spike) as compared to the post-2015 period as a whole. Certainly no Alice to the moon spike in CTA presence apparent here.

Bloomberg claims that the CTAs have become dominant in large part due to a sharp decline in producer hedging:

That coincided with the collapse of another source of futures and options trading: oil-production hedging. During the heyday of shale expansion about a decade ago, drillers would lock in futures prices to help fund their growth. But in the aftermath of the pandemic-induced price crash, a chastened US oil industry increasingly focused on returning cash to investors and eschewed hedging, which can often limit a company’s exposure to the upside in a rising market. By the first quarter of this year, the volume of oil that US producers were hedging by using derivatives contracts had fallen by more than two-thirds compared with before the pandemic, according to BloombergNEF data.

It should be noted that this claim that CTAs have achieved greater dominance due to an ebbing of hedging is implausible on its face. Futures are in zero net supply. If producers have reduced their net positions, necessarily non-hedgers–including CTAs–must have reduced their net positions.

Hedging has indeed declined. In the oil market, much (if not most) producer hedging is via the swaps market rather than direct producer participation in the futures market. Banks buy swaps from producers, and then hedge their exposure by selling futures. Here is a chart of net Producer and Merchant Plus Swap Dealer exposure from the CFTC COT data:

Note that there was a big increase in hedging activity (by this measure) in 2017-2018 that was reversed, followed by a partial resurgence, but in the last couple of years hedging activity has indeed ebbed, and reverted to its 2016 levels.

But note that this pattern of hedging mirrors closely Managed Money net positions. As is necessarily the case. If there is less hedging, speculators necessarily hold smaller positions. Meaning that this statement is nonsensical:

The recent wave of dealmaking by US oil producers threatens to further accelerate the decline in hedging. And it’s highly likely that CTAs will continue to fill the vacuum left by those traditional market players.

It’s not as if CTAs–or speculators generally–are “fill[ing] a vacuum.” If hedgers reduce positions, speculators do too.

The Bloomberg writers may dimly glimpse the truth, though they don’t realize it.

How did CTAs come to become so dominant? Like many current phenomena, the answer starts in the depths of the pandemic.

As shutdowns engulfed the world in 2020, fuel consumption collapsed by more than a quarter. All hell broke loose in the crude market. The benchmark US oil price briefly dropped to minus $40 a barrel and investors were in wholly new territory. Some funds that took longer-term views based on supply-and-demand fundamentals quickly pulled out.

Such bear markets proved to be “extinction events” for traditional funds, which made way “for algo supremacy,” the bulk of which are CTAs, said Daniel Ghali, senior commodity strategist at TD Securities. Russia’s invasion of Ukraine gave the CTAs another foothold. Spiking volatility in the futures market drove many remaining traditional investors to the exits, and open interest in the main oil contracts tumbled to a six-year low.

So if CTAs have indeed become more prevalent, it is because they have supplanted other speculators who exited the market. Futures are risk transfer markets. If some of those who previously took on the risk from hedgers have exited the market, either hedgers must hedge less or other speculators must step in. It seems that both things have been happening.

That’s not some ominous development–it’s markets at work. And CTAs shouldn’t be damned–they should be praised for stepping into the breach.

And another paragraph in the Bloomberg article suggests at what is actually happening here:

The unpredictability of this year’s market swings haven’t been kind to human traders, many of whom are making less money on oil than they did last year when they raked in record gains, according to market participants.

What is likely driving this story is whinging by the traditional specs, who have been outcompeted by the bots. “No fair! They are making money and I’m not! They must be cheating.”

Reminds me of my epigram from my manipulation book, where riffing on Ambrose Bierce’s Devil’s Dictionary I wrote something to the effect that a market is manipulated when it moves against me.

Again, this is markets at work. The fact that bots are doing well relatively to trad specs means that they are better at predicting market movements, or have lower costs of bearing risk, or both.

It does not mean that they are making the markets move.

So this Terminator Tackles the Oil Market narrative is really nothing more than Luddism. A new technology outcompetes the old. The incumbents complain. End of story.

Gary Gensler has been a menace to the market system for as long as he has been in government. Those of you who have followed this blog for a long time know that I relentlessly criticized him during his tenure as CFTC chairman. He apparently took notice, because he banned me from the CFTC building. I also consider it extremely likely that he was the moving force behind the 2013 NYT supposed hit piece on me–for which I should probably thank him, because on net that has turned out to be a major positive.

Gary Gensler. (Though this is how I like to think of him.)

At CFTC, Gensler was merely an Igor implementing the Frankendodd creation of his congressional masters. As head of the SEC, however, Gensler has become a full-fledged Dr. Frankenstein, stitching together regulatory monsters that threaten to stalk the landscape leaving economic devastation in their path.

I have already written several times about the SEC’s misguided Treasury clearing mandate. But that is only one of Gensler’s Monsters. There are many others.

Perhaps the most monstrous is the SEC’s proposed rule on climate-related disclosures. This would mandate that public companies disclose their carbon emissions–and those of their suppliers. This is at best vast speculative endeavor, and and worst an impossibility. It’s main concrete effect will be to provide a pretext for lawsuits against companies targeted by activists who will allege that the companies’ calculations were wrong, or were lies because alternative internal calculations came up with numbers that differed from those reported in their 10Ks.

The regulation would also require companies to make fulsome disclosures of their climate risks. Another speculative endeavor that cannot produce any meaningful or useful information. It requires each company to characterize the interaction between one complex system–climate–and another complex system–the economy–to predict the adverse consequences of this interaction for it, a small part of the economic system allegedly impacted by climate. Prognostications about climate are themselves wildly uncertain–indeed, arguably the biggest risk is model risk. Predicting how climate will impact economic outcomes at the company level under myriad possible climate scenarios is a mug’s game.

And indeed, it is even worse than that. For there is another element to the problem–government policy. This introduces an element of reflexivity that is particularly devilish. Government policy will respond to climate and economic outcomes as well as interest group pressure, and will affect economic outcomes (though whether these policies will actually affect climate outcomes is dubious). This is arguably by far the biggest risk that companies face.

Meaning that if the regulation comes into force, I recommend the following boilerplate disclosure for all companies: “We face the risk that some government agency will adopt a boneheaded policy that will dramatically raise our cost of doing business or eliminate the markets we service.”

This will also be a boon to lawyers. “Company X failed to disclose the risk associated with [insert climate scenario here] described in [poorly executed paper published in obscure journal].”

I could go on. But in Congressional testimony John Cochrane did a lot of the heavy lifting for me, so I direct you there.

And I ask: how will this information improve the allocation of capital? It is more likely that this will just add noise that impedes efficient capital allocation, rather than actionable information that improves it. The hive mind of investors is likely far more adept at evaluating the effects of the climate-economics-policy nexus than the managers of corporations.

I further note that this obligation’s burdens are greater for small companies than big ones. Meaning that it will likely lead to exit and consolidation, and greater concentration. Which other parts of this administration–notably Lina Khan’s FTC–think is a great evil. Ironic, that. Ironic, but not humorously so.

Moving right along, the trendy Gary has targeted the New Thing, Artificial Intelligence. In public statements Gensler has made the at least somewhat plausible argument that interactions between very similar AIs can produce destabilizing positive feedback mechanisms. But the SEC’s proposed AI regulation instead focuses on potential agency problems:

Today’s predictive data analytics models provide an increasing ability to make predictions about each of us as individuals. This raises possibilities that conflicts may arise to the extent that advisers or brokers are optimizing to place their interests ahead of their investors’ interests. When offering advice or recommendations, firms are obligated to eliminate or otherwise address any conflicts of interest and not put their own interests ahead of their investors’ interests. I believe that, if adopted, these rules would help protect investors from conflicts of interest — and require that, regardless of the technology used, firms meet their obligations not to place their own interests ahead of investors’ interests.”

The SEC remedy for this litany of horrors?

But under the guise of minimizing conflicts of interest, the SEC now proposes requiring advisers and broker-dealers to write new internal procedures and to log all uses of technologies relating to predictive data analytics for agency review. If left unchallenged, the new rules would hamper the American financial industry’s world-beating innovation.

The definition of what must be disclosed is comprehensive:

“an analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes in an investor interaction.” 

This would basically encompass EVERY analytical function performed by covered entities, including e.g., quant traders’ algorithms, portfolio optimizers, and on and on and on. Basically any use of statistical methods is implicated (note the reference to “correlation matrix”).

Perhaps the “investor interaction” language will limit this to principle-agent applications (as bad as that would be), but it is so broad that it is highly likely that the SEC will interpret it to cover, say, an HFT firms algorithms to predict and analyze order flows. That involves “an investor interaction.”

This all brings to mind previous regulatory initiatives to require disclosure of all trading algorithms–something that was mercifully killed.

And what will the SEC do with this information? This would represent a massive amount of highly technical information that the SEC would not have the capacity or expertise to analyze proactively, and information that would metastasize inexorably. Hell, even storing the information would be a challenge.

Again, like the climate reg, this seems all pain no gain. This disclosure would entail massive cost. And for what? To find an agency violation needle in a massive informational haystack? Agency violations (such as trading ahead) that could not be detected using existing methods?

But that’s not all!

Gensler also looks askance at exchange volume discounts. Why? Because NO FAIR:

“Currently, the playing field upon which broker-dealers compete is unlevel,” said SEC Chair Gary Gensler. “Through volume-based transaction pricing, mid-sized and smaller broker-dealers effectively pay higher fees than larger brokers to trade on most exchanges. We have heard from a number of market participants that volume-based transaction pricing along with related market practices raise concerns about competition in the markets. I am pleased to support this proposal because it will elicit important public feedback on how the Commission can best promote competition amongst equity market participants.”

Volume discounts are obviously pervasive throughout the economy in the US and indeed the world. So why should these be somehow so nefarious in stock trading as to require their elimination?

Let’s apply some economics–which alas is an alien concept to Gensler. There are two basic reasons for volume discounts.

One is that it is cheaper to service bigger customers. In which case volume discounts are efficient, and banning them would be unambiguously bad.

Another is that it is a form of price discrimination. For example, big intermediaries may find it easier/cheaper to shift business between exchanges than smaller intermediaries, in which case their demand for the services of a particular exchange would be more elastic than the demand of the smaller firms. Exchanges would then rationally charge lower prices to the more elastic demanders.

The welfare effects of this type of price discrimination are ambiguous, making the case for banning it–even if it can be established that the volume discounts are demand-elasticity-driven discrimination vs. cost-based discrimination–ambiguous as well.

With respect to “concerns about competition,” well, elasticity-based discrimination requires that inter-exchange competition not be perfect in the textbook sense. But if that is what is driving the volume discounts, outlawing them treats a symptom of market power rather than market power itself, and how “imperfectly competing” exchanges will price when they can’t price discriminate is very much an open question–and exactly why the welfare effects of price discrimination are ambiguous.

Gensler seems to be channeling discredited Robinson-Patman like logic that protected the high cost against competition from the low cost. That is anti-competitive, not pro-competitive.

These are only some of the monsters the Frankensteinian Gensler is assembling in his DC laboratory. I could go on, but you get the idea.

There is hope, however. Whereas Gensler’s CFTC actions were largely rooted directly in very specific statutory directives, his work as Dr. Frankenstein is based on extremely expansive interpretations of the SEC’s statutory authority dating back to the 1930s. Such expansive interpretations–not just by the SEC, but many other agencies–are currently being challenged in the courts, including cases pending before the Supreme Court.

It is possible therefore, and indeed to be fervently hoped, that the Supreme Court will hand down decisions that demote Gensler back to Igor implementing very specific Congressional mandates, and end his career as regulatory Frankenstein.

And the benefits of such decisions would extend beyond reining in the SEC, for as bad as it is that agency is probably not the worst offender–the EPA probably is, but the competition for this dubious honor is intense. The administrative state–the American Mandarinate, as I like to think about it–needs to be culled. And with extreme prejudice, and as soon as possible.

The Treasury basis trade continues to be in the news, with one of the biggest basis traders–Citadel’s Ken Griffin–complaining that the SEC should regulate hedge fund basis trading, but should instead make sure that banks aren’t supplying too much leverage to . . . well, hedge funds mostly. This seems like a raising rival’s costs gambit. No doubt restrictions on leverage would hit Griffin’s competitors harder, whereas SEC regulation might have a more even impact.

Regardless, one question that hasn’t been asked in all the to-ing and fro-ing about Treasury basis trades is why they exist at all, let alone why they get so big. This graph (courtesy of FTAlphaville, based on CFTC data) provides a major clue:

Note the mirror image between leveraged funds (mainly hedged funds) and asset managers (ostensibly non-leveraged funds–the reason for the “ostensibly” will become clear shortly).

To the extent that hedge funds’ short positioning reflects basis trades, the graph suggests the following. Hedge funds take a leveraged market neutral position, buying bonds, funding them via repo, and selling futures. Futures are in zero net supply: the graph shows that the longs on the other side of the hedge funds’ futures short are asset managers.

Most asset managers do not, and in some cases even cannot, take leverage directly. So for example they are constrained in their ability to just buy Treasuries with borrowed money (e.g., via repo). But the basis trade allows them to lever up via futures. So in some sense, the basis trade is just an additional link in a chain of intermediation. Laundering leverage, if you will.

(A more complete picture might add swap dealers to the picture. Some managed money, such as leveraged ETFs, enter into swaps with dealer banks. The dealer banks in turn can hedge by taking offsetting futures positions.)

The hedge funds expect to earn a small margin on the trade–on average, though there is risk. The market is pretty competitive, so to a first approximation that margin (the difference between the actual futures price and the theoretical futures price derived from bond prices, bond vols and correlations, and repo rates) equals hedge funds’ marginal cost of supplying this intermediation. The asset managers on the long side of the futures trade are willing to pay “too high” a futures price (relative to bond prices) because this is a cheaper way of achieving a leverage target than via the available alternatives.

The March 2020 experience shows that the basis trade can be a fragile one that creates some systemic risk: this is why regulators are concerned about basis trades now, to Ken Griffin’s chagrin. Providing this leverage intermediation/laundering creates tail risks for the hedge funds that do so. This raises the question of whether there are regulatory constraints that inefficiently constrain the ability of asset managers to take leverage more directly, rather than via a longer dealer (or money market) to hedge fund to asset manager chain. If so, such constraints could give rise to unnecessary (systemic) risks.

If regulators are concerned about the systemic risks in basis trades, they should take a systemic approach–and understand more fully why basis trades exist in the first place, and why they have periodically become so large. Looking at individual links in the chain (hedge funds, or by Griffin’s lights, banks) can be misleading because it begs the question of why the chain exists in the first place. The link that is driving the process is likely the one that has escaped discussion so far–the asset managers at the end of the chain. Why do they want leverage and why is the basis trade the most cost effective way of supplying a lot of it? Could it be the most cost effective because other, more directly intermediated sources of leverage are unduly expensive because of regulatory or institutional constraints? Definitely worth regulators’ attention.

In March, 2020 the Federal Reserve injected massive amounts of liquidity into the markets in response to a blow-up in Treasury basis trades. I wrote about it here.

In recent weeks, the Fed, the BIS, and the BoE have raised red flags about the renaissance of this trade and the resulting potential for systemic risk a la 2020. Not all are convinced. Goldman Sachs in particular is in Alfred E. Neuman mode: What? Me worry?

FT Alphaville quotes Goldman’s rates strategy team as follows:

We do not think the trade poses a major risk to Treasury markets in the near term . . . Leverage in the system is materially lower than it was in 2019/20 as a result of a series of [initial margin] increases (and price declines). The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near term, we expect to migrate to a less volatile rate regime.

This assessment is based on a fundamental error that I went on about ad nauseam in the post-Great Financial Crisis clearing debate, specifically, concluding that if leverage goes down in one part of the system it goes down systemically. Wrong. Wrong. Wrong.

Yes, the ostensible purpose of higher margins is to reduce leverage in the margined trades. But especially for the hedge funds and other sophisticated entities who engage in the Treasury basis trade at scale, they can substitute one form of leverage for another.

As a first approximation, a fund has a leverage target or a level of debt capacity, it can fund the higher margin in the less leveraged futures trade by increasing leverage elsewhere. The funds will typically evaluate leverage holistically, not on a trade-by-trade basis.

It is therefore fundamentally logically flawed to conclude that “leverage in the system” (which is in fact source of systemic risk) has declined because it has gone down in one piece of it.

If there are constraints on funds’ ability to offset mandated leverage reductions in one type of trade by increasing leverage elsewhere, that would increase the cost of engaging in that type of trade and would impact the scale of that trade. But what has alarmed the central bankers is exactly that the scale of the trade has increased and now exceeds its 2020 level:

Note that leveraged funds’ Treasury futures shorts are currently substantially larger now than in 2020. Thus, despite higher margins, the scale of the trade is subsantially larger–and it is the scale–and the concentration–of the trade that poses systemic risks.

This bigger scale could be because raising margins doesn’t really constrain the ability of funds to lever up to engage in basis trades. Or it could be that even though the higher margins raise the cost of the trade, the spread has widened sufficiently to offset, or more than offset the higher cost. For example, constraints on dealer balance sheets that impair liquidity in the cash market could depress cash prices relative to futures prices.

Goldman’s errors don’t end there. One thing that could spark a margin spiral is an increase in initial margins that induces mass liquidations that lead to changes in the basis that lead to large variation margin obligations–something that Goldman doesn’t mention.

Alfred E. chimes in again here: “The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near term, we expect to migrate to a less volatile rate regime.” That is, Goldman’s conclusion is essentially based on a very benign view on Treasury volatility.

There are myriad reasons to take a different view. The US’s acute fiscal situation and the accompanying periodic debt limit dramas. The constrained balance sheets of dealers that limit their ability to supply liquidity to the Treasury market. The prospect for an extremely chaotic election year. And geopolitics, with now two major disturbances ongoing (Ukraine and Israel/Gaza) with one continually on the boil in the background (China/Taiwan). And highly unsettled geopolitics with a feckless and befuddled administration at the tiller.

That is, it isn’t the level of margins that really matters. It is the possibility that margins may increase due to higher volatility. Goldman/Neuman isn’t worried. I think that’s unduly optimistic. Furthermore, an assessment of systemic risk must be based on the likelihood that Goldman’s don’t-worry-be-happy opinion is wrong.

And remind me: did Goldman predict the increase in Treasury volatility in 2019 or 2020? Stuff happens. Unknowns and unknowns and all that.

Furthermore, higher volatility->higher IM->liquidation of basis positions->margin spiral isn’t the only potential source of systemic risk. Other economic shocks can cause leveraged funds to slash positions and leverage, leading to liquidations of basis positions and the triggering of a margin cascade. That is, there is the possibility of fire sales.

These shocks can be systematic–a broad decline in stock or bond markets–or concentrated at a few funds, or even one, due to bad trades in other markets.

The 30 25 year anniversary last month of the LTCM collapse brings the latter to mind. Bad bets on convergence trades forced LTCM to liquidate and delever. Understandably, it attempted to unload its most liquid positions–including short Treasury futures. Treasuries had a massive rally on LTCM day that was not matched by a similar rally in the underlying, less risky Treasuries.

A squeeze–not unheard of in government debt futures markets–can also impose losses on basis trades, leading to liquidations that can exacerbate the price impact. Or a Treasury flash crash (in yields, and hence a flash spike in prices) like on 15 October 2014.

In sum, size does matter. Basis trades have become big again, and the factors that lead Goldman to parrot Alfred E. Neuman are hardly persuasive. From a systemic risk perspective, basis trades represent dry tinder that can explode into flame. Can does not mean will. But the possibility is there, and the effect if the right spark hits the tinder depends on the size of trade. The big scale and concentration of this trade thereby justify far more concern than Goldman expresses.

Texas governor Greg Abbot has extended an invitation to the CME Group to relocate from Chicago to Texas. The exchange group may well be moveable because the city’s new mayor, Let’s Go Brandon Johnson, has mooted a $1 or $2 per transaction tax on futures, options, and securities transactions in order to fill the city’s gaping fiscal hole–despite the fact that this is currently illegal under Illinois law.

Now you might not think that a buck is a big deal, given that a T-note or crude oil contract has a nominal value of around $100 grand. But it is a big increment to the cost of executing a contract. For example, the bid-ask on a crude oil futures trade is usually about $10, and the brokerage commission adds on only a few bucks. So the tax would increase transactions costs on the order of 5 or 10 percent.

I note that the industry fought for years at efforts to impose a 15 cent futures transaction tax. What Johnson is proposing is substantially greater than that.

Now, if Johnson’s objective was actually to raise revenue, this would be an incredibly stupid idea. Rule one of taxation: tax what can’t move. Although in the floor days uprooting the exchange and taking it outside the city or the state would have been very difficult, that’s not the case in the electronic era.

Have servers, will travel. Yes, CME Group (and CBOE–which given recent developments might end up in CME) has corporate employees there, but if any city should understand that is no impediment to relocation, Chicago should given the exodus of several major corporate HQs from the Chicago area in recent years–Caterpillar, Boeing, and Tyson Foods being prominent examples.

Moreover, even before the CME says hasta la vista motherfuckers, it faces competition in some of its products from ICE, and a tax would shift business there.

Numerous trading firms (notably Citadel) have fled Chicago for reasons–namely the marked decay of the city. (And I do mean marked: even in the last two years the decline has accelerated dramatically.) The CME has certainly already put those factors on the scale when making its decision, and a sizable transaction tax would almost certainly tip the balance heavily in favor of joining the exodus.

Notice that I framed my analysis as a conditional statement: if Johnson’s objective was actually to raise revenue. One cannot be too sure these days. Mayors of city after city have taken actions, or failed to take actions, that seem designed to drive out all but the underclass and turn the polities they govern (I use the term loosely) into crime-ridden, drug infested wastelands. In fact, it’s hard to name a big city whose elected officials haven’t done that or aren’t doing it.

American Spectator writer Scott McKay calls it “weaponized government failure:” “deliberate refusal to perform the basic tasks of urban governance for a specific political purpose.” The “specific political purpose” being to drive out middle class voters who pose the main political threat to the Brandon Johnsons and their ilk.

Framed as a hypothesis, I’m hard pressed to come up with contrary evidence.

Whether that’s the true purpose behind Johnson’s transaction tax brainwave, if he moves forward with it it’s a near lock that CME will hit the road. An electronic exchange is footloose and fancy free and not beholden to any place. Where once there were “locals” whose physical presence was necessary to operate an exchange, there are now what may be called “globals” who can and do supply liquidity from anywhere.

And if it moves, Texas is a good place. No income tax for one thing. Reasonable housing costs. And as for the weather, as I told my late mom when she fought coming here: “Look, you spent four months a years indoors in Chicago. You’ll spend four months a year indoors in Houston. Just different months.”

So come on down, Terry Duffy. I’ll be here to greet you. With bells on.

Saudi Arabia is fussed at the low level of oil prices. So true to form with those unsatisfied with price, they are rounding up the usual suspects. Or in this case, suspect–speculators!

I’m sure you never saw that coming, right?

As the world’s biggest oil producers gather here Sunday to decide on a production plan, the spotlight is on the cartel kingpin’s fixation on Wall Street short sellers. Abdulaziz has lashed out repeatedly this year against traders whose bets can cause prices to fall. Last week he warned them to “watch out,” which some analysts saw as an indication that the Organization of the Petroleum Exporting Countries and its allies may reduce output at their June 4 meeting. A production cut of up to 1 million barrels a day is on the table, delegates said Saturday. 

Claude Rains is beaming, somewhere.

I’m so old that I remember when oil prices were beginning their upward spiral in 2007-8 (peaking in early-July), in an attempt to deflect attention from OPEC and Saudi Arabia, one of Abdulaziz’s predecessors blamed the price rise on speculators too.

Is there anything they can’t do?

Not that I’m conceding that speculators systematically or routinely cause the price of anything to be “too high” or “too low,” but if you do think that they influence price, they should be Abdulaziz’s best buddies. After all, they are net long now and almost always are. (Cf. CFTC Commitment of Traders Reports.)

If the Saudis (and other OPEC+ members) have a beef with anybody, it is with their supposed ally, Russia. Russia had supposedly agreed to cut output in order to maintain prices, but strangely enough, there is no evidence of reductions in Russian supplies reaching the world market, even despite price caps on Russian oil and the fact that they are selling it at a steep discount to non-Russian oil. Perhaps Russia has really cut output, but (a) that doesn’t really boost the world oil price if Russian exports haven’t been cut, and (b) it would mean that Russian domestic consumption is down, which would contradict Moscow’s narrative that the economy is hunky-dory, and relatively unscathed by sanctions.

But I think that the more likely story is that Russia is playing Lucy and the football with OPEC.

Which would be a return to form: see my posts from years ago. And I mean years ago. Apparently Won’t Get Fooled Again isn’t on Abdulaziz’s play list.

The other culprit behind lower oil prices is China: its tepid recovery is weighing on all commodity prices–not just oil. A fact that Abdulaziz should be able to understand.

But it’s much easier to shoot the messenger, and that’s what speculators are now–and almost always are. Venting at them probably makes Abdulaziz feel better, but even if he were to get his way that wouldn’t change the fundamental situation a whit.

Bashing speculators is what people who don’t like the price do. And since there’s always someone who doesn’t like the price (consumers when it’s high, producers when it’s low) bashing speculators has been and will continue to be the longest running show in finance and markets.

The Fed and the SEC have expressed concerns about Treasury “basis trades” wherein a firm purchases a cash Treasury security funded by repo-ing it out and sells Treasury futures. Their concern is somewhat justified. As mentioned in the linked article, and analyzed in detail in my paper in the Journal of Applied Corporate Finance (“Apocalypse Averted“) the spike in the cash-futures Treasury basis caused by COVID (or more accurately, the policy response to COVID) caused a liquidity crisis. The sharp basis change led to big margin calls (thereby creating a demand for liquidity) and also set off a feedback loop: the unwinding of positions exacerbated the basis shock, and thereby reinforced the liquidity shock.

This is just an example of the inherent systemic risk created by margining, collateralization, and leverage. The issue is not a particular trade per se–it is an inherent feature of a large swathe of trades and instruments. What made the basis trade a big issue in March 2020 was its magnitude. And per the article, it has become big again.

This is not a surprise. Treasuries are a big market, and leveraging a small arb pickup is what hedge funds and other speculators do. It is a picking-up-nickels-in-front-of-a-steamroller kind of trade. It’s usually modestly profitable, but when it goes bad, it goes really bad.

All that said, the article is full of typical harum-scarum. It says the trade is “opaque and risky.” I just discussed the risks, and its not particularly opaque. That is, the “shadowy” of the title is an exaggeration. It has been a well-known part of the Treasury market since Treasury futures were born. Hell, there’s a book about it: first edition in 1989.

Although GiGi is not wrong that basis trades can pose a systemic risk, he too engages in harum-scarum, and flogs his usual nostrums–which ironically could make the situation worse:

“There’s a risk in our capital markets today about the availability of relatively low margin — or even zero margin — funding to large, macro hedge funds,” said Gensler, in response to a Bloomberg News inquiry about the rise of the investing style.

Zero margin? Really? Is there anyone–especially a hedge fund–that can repo Treasuries with zero haircut? (A haircut–borrowing say $99 on $100 in collateral is effectively margin). And how exactly do you trade Treasury futures without a margin?

As for nostrums, “The SEC has been seeking to push more hedge-fund Treasury trades into central clearinghouses.” Er, that would exacerbate the problem, not mitigate it.

Recall that it was the increase in margins and variation margins on Treasury futures, and the increased haircuts on Treasuries, that generated the liquidity shock that the Fed addressed by a massive increase in liquidity supply–the overhang of which lasted beyond the immediate crisis and laid the groundwork for both the inflationary surge and the problems at banks like SVB.

Central clearing of cash Treasuries layers on another potential source of liquidity demand–and liquidity demand shocks. That increases the potential for systemic shocks, rather than reduces it.

In other words, even after all these years, GiGi hasn’t grasped the systemic risks inherent in clearing, and still sees it as a systemic risk panacea.

In other words, even though I agree with Gensler (and the Fed) that basis trades are a source of systemic risk that warrant watching, I disagree enough with GiGi on this issue that the apocalypse that could result from our complete agreement on anything will be averted–without the intervention of the Fed.

As the periodic debt ceiling game of chicken proceeds, you might read about the credit default swap (CDS) rate on US government debt. This is commonly (even by economists) used to quantify the market’s estimate of probability that the US government will default. Although it is related to this probability, it is not a direct measure of the “true” probability. So interpret with extreme care. Especially in the case of US government debt.

As a little background, a CDS is a contract that pays off if the underlying entity–in this case, the US government–defaults on its obligations. In that event, the purchaser of protection receives the face value of the debt minus the price of the defaulted security. If the defaulted security is worth 40 cents on the dollar at default, the “recovery rate” is 40 percent and the protection buyer receives 60 cents on the dollar.

If the protection currently costs X, you might reason that your expected payoff is p(1-R), where p is the probability of default and R is the recovery rate. Thus, you can estimate p=X/(1-R).

The problem with this logic is that p is not the real world–“physical measure” or “true”–probability of default. It is the probability of default in the so-called “equivalent measure.” Roughly speaking, this p includes a risk adjustment, a risk premium if you will. In theory the p estimated this way could be less than the actual probability of default, meaning that the premium is negative. But usually the p implied this way will be above the objective probability of default. Put simply, just like when you insure your car you will pay a premium that exceeds your expected claims, with CDS the protection purchaser will pay a premium that exceeds the expected payoff.

Indeed, the risk premium embedded in Treasury CDS is likely to be quite large. The reason is that this type of CDS will pay off in bad states of the world–and likely very bad states of the world. That is, if the US government defaults, economic chaos and a recession (perhaps a severe one) is a likely outcome. The marginal utility of income (or wealth) is high when income (or wealth) is low, as during a large recession. Thus, protection sellers are required to perform on their contracts when the marginal utility of income/wealth is higher, so they are going to charge a high price in order to assume such an obligation. The worse the economic consequences of default, the higher the risk premium, and hence the price, that they will charge.

That is, the USG CDS price must exceed the expected payout, likely by a lot, because the payouts occur in bad economic times.

Corporate CDS spreads tend to be “upward biased” measures of default rates for companies, precisely because payoffs tend to be more likely during bad economic times because that’s when companies default. This bias is likely to be especially great for USD CDS precisely because a default will likely cause a severe economic contraction.

Another way to visualize this is to realize that there is considerable “systematic risk” in USG CDS. The risk in CDS payouts cannot be diversified away, and are highly correlated with the overall financial markets. Put differently, a US government default is not really an insurable risk. Classic insurance works by diversification and pooling of independent risks. That is not possible with USG CDS.

There’s another factor at play here–counterparty risk. How much would you pay for insurance from a financially shaky insurance company? Probably not much, because it may not be around to pay when you need it.

Since a US government default is likely to have severe consequences for the financial sector, there is a material probability that the seller of protection will be unable to perform in the event of a USG default.

This would tend to work in the opposite way as the risk adjustment described earlier, that is, it would tend to reduce the cost of protection. The protection is worth less because of the risk it would not be there when you need it. This reduces your willingness to pay for it.

These risk adjustment and counterparty risk issues are likely to be particularly acute for US Treasuries, given the potentially serious economic consequences of a government default. Meaning that USG CDS rates are very unreliable measures of the likelihood of a government default: they are impacted by both the probability of default and the economic consequences thereof.

Yes, a rising CDS spread–like we’ve seen recently–likely reflects a rising estimate of the true probability of a default. But you just can’t back out that probability from the rate.

In response to the liquidity crunch in the commodity trading sector (especially in energy trading) last year, the European Union is looking to regulate commodity traders more like banks:

For decades, Europe’s commodity traders have avoided being regulated on par with other financial firms. A new proposal currently working its way through the European Union legislative system could change that.

To close “loopholes,” dontcha know:

The loophole allows industrial companies like utilities and food processors — but also commodity trading houses — to take derivative positions without the scrutiny facing investment firms. Designed to reduce the burden of managing price risk, it also means that traders aren’t subject to rules on setting aside capital or limiting positions the same way banks and hedge funds are. 

2022 certainly saw unprecedented liquidity pressures in the commodity trading sector, as firms that had sold derivatives (especially on gas and power) to hedge their exposures from supplying the European market saw huge margin calls that greatly strained credit lines and led a coalition of traders to request ECB support (which the ECB declined).

The crucial part of the previous paragraph is “to hedge.” The danger of restricting or increasing the cost of such activities through regulation of the type that is apparently under consideration is that it will constrain hedging activities, thereby (a) making these firms more vulnerable to solvency, as opposed to liquidity problems, and (b) raising the costs of commodity intermediation.

Note that the companies that received state support that are mentioned in the article are not commodity traders qua commodity traders, e.g., Vitol or Trafigura or Gunvor. They are energy suppliers who were structurally short gas and did not hedge, and hence were facing serious solvency issues when gas prices exploded in late-2021 (before the Russian invasion) and winter and spring 2022 (when the invasion occurred). That is, firms that didn’t hedge were the ones that faced insolvency and received state support. (Curiously, Uniper is missing from the list of companies in the Bloomberg article, although Fortum Oyj was collateral damage from Uniper’s collapse.)

The relevant issue in determining whether commodity trading firms should be regulated like banks or hedge funds is not whether the traders can go bust: they can. It is whether (a) they are financially fragile like banks, and (b) whether they are systemically important.

These are exactly the same issue I addressed in my Trafigura white papers in 2013 and especially 2014. To summarize, commodity trading firms engage in completely different transformations than banks and many hedge funds. Commodity traders transform commodities in space, time, and form: banks engage in liquidity and maturity transformations. The difference is crucial.

Liquidity and maturity transformations are inherently fragile–they are the reasons that bank runs occur, as the recent failures of SVB, First Republic, and Signature Bank remind us. That is, the balance sheets of banks are fragile because they finance long term, illiquid assets with liquid short term liabilities.

Commodity traders’ balance sheets are completely different. The “pure” asset light traders especially: they fund short term (“self-liquidating”) relatively liquid assets (commodity inventories) with short term relatively liquid liabilities. Further, hedging is a crucial ingredient in this structure: banks are willing to finance the inventories because the price risks can be hedged.

This is not to say that commodity traders cannot fail–they can. But they do not face the same kinds of fragility (vulnerability to runs) that entities that engage in maturity and liquidity transformations do. It is this fragility that provides the rationale for bank capital requirements and limitations on the scope of their activities. This rationale is lacking for commodity trading firms. They are intermediaries, but not all intermediaries are alike.

Further, as I also pointed out almost a decade ago, major financial firms dwarf even the largest commodity trading firms. Even a Trafigura, say, is not remotely as large or systemically important as, say, Credit Suisse. Yes, a bankruptcy of a big trader would inflict losses on its lenders, but these losses would tend to be spread widely throughout the global banking sector given that most loans and credit lines to commodity traders are widely syndicated. And the potential for these kinds of losses are exactly reason that banks hold capital and that it is prudent to impose capital requirements on banks.

As I noted in the 2014 study, virtually the entire merchant energy sector in the United States imploded in 2002-3. Lenders ate losses, but the broader economic effect was minimal, the assets of the failed firms continued to operate, and the lights stayed on.

In sum, analogizing commodity traders to banks is seriously intellectually flawed, and what’s good or justified for one is not necessarily for the other because of the huge differences between them.

Pace Bloomberg, the events of 2021-2022 did not “expose” some new, unknown risk. The liquidity risk inherent in hedging has long been known, and I analyzed it in the white papers. Indeed, it’s been a focus of my research for years, and is the underlying reason for my criticism of clearing and collateral mandates–including those embraced enthusiastically by the EU.

Thus, a more constructive approach for Europe would be not to apply mindlessly regulatory restrictions found in banking to commodity firms, but to investigate ways to facilitate liquidity supply to commodity traders under extreme situations. Direct access of commodity traders to central bank funding is inadvisable, but central bank facilitation of bank supply of margin funding to commodity traders during such extraordinary circumstances worthy of investigation.

Recall that the Federal Reserve’s response to a funding crisis originating in the Treasury futures markets was instrumental in containing the systemic risks arising from COVID in March 2020 (as described in my Journal of Applied Corporate Finance article, “Apocalypse Averted“). The Fed’s actions were extemporized (just as they were during the 1987 Crash). The EU and ECB would do well to use that experience, and that of 2021-2022, to devise contingency arrangements in advance of future shocks. That would be a more constructive approach to the risks inherent in commodity risk management than to impose regulations that could impede risk management.

It is important to note that making hedging costlier instead of making it cheaper increases the risk of extreme price disruptions. Constraining risk management means that commodity traders will supply less intermediation especially during high risk periods. This will swell margins and make commodity supply less elastic, both of which will tend to exaggerate price movements during periods of stress.

I always wonder about the political economy of such regulatory proposals. Yes, no doubt regulatory reflex is a driver: “We have to do something. Let’s take something off the shelf and make it fit!” But my experience in 2012-2014 also motivates a more cynical take.

The genesis of the Trafigura white papers was an abortive white paper I wrote for the Global Financial Markets Association, a banking industry group. The GFMA approached me to investigate the systemic riskiness of commodity trading firms, and I came up with the wrong answer, so they spiked the study. Somehow or another Trafigura got wind of this, and that was the genesis of the influential (if I do say so myself) papers I wrote for the firm.

The point being that in 2012 the banks were pushing to regulate commodity trading firms with capital requirements and the like in order to raise the costs of competitors, and were looking for intellectual cover for that endeavor–cover I did not provide after a deep dive into the commodity trading sector.

Hence, I wonder if this reprise of the ideas that were largely shelved in the mid-2010s is an example of “let no crisis go to waste,” i.e., whether there are interests in Europe pressing to regulate commodity firms for shall we say less than public spirited reasons.

The proposals are apparently very protean at this stage. But it will be interesting to see where they progress from here. And I’ll weigh in accordingly.

A coda to my previous post. The EU natural gas price regulation avoids many of the faults of price controls, largely as a result of its narrow focus on a single market: TTF natural gas futures. That said, the fact that it potentially applies to one market means that there are still potentially negative consequences.

These negative consequences are not so much to the allocation of natural gas per se, but to the allocation of natural gas price risk. Futures markets are first and foremost markets for risk, and the price regulation has the potential to interfere with their operation.

In particular, the prospect of being locked into a futures position when the price cap binds will make market participants less likely to establish positions in the first place: traders dread being stuck in a Roach Motel, or Hotel California (you can check out but you can never leave). Thus, less risk will be hedged/transferred, and the market will become less liquid. Relatedly, price caps can lead to perverse dynamics when the price approaches the cap as market participants look to exit positions to avoid being locked in. This can lead to enhanced volatility which can perversely cause the triggering of the cap.

Caps also interfere with clearing. There is a potential for large price movements when the cap no longer binds. Thus, in the EU gas situation, ICE Clear Europe has said that it will have to charge substantially higher initial margins (an estimated $33-47 billion more), and indeed, may choose to exit the EU.

These negative effects are greater, the closer prices are to the cap. Europe’s good luck with weather this winter has provided a relatively large gap between the market price and the cap, so the negative impacts are relatively unlikely to be realized. But that’s a matter of luck rather than a matter of economic principle.

Risk transfer is a vital economic function that generates substantial economic value. The cost of interfering with this mechanism is material, and should not be ignored when evaluating the EU policy. That policy avoids many of the standard problems with price caps, but its narrow focus to the futures market means that it has the potential to create economic costs not typically considered in evaluations of price controls. Meaning that not even Saul Goodman would come to its defense.