Streetwise Professor

January 12, 2023

Just Because It’s Not All Bad Doesn’t Mean It’s All Good, Man

Filed under: Clearing,Derivatives,Economics,Energy,Exchanges — cpirrong @ 12:02 pm

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.

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January 9, 2023

The Least Bad Price Control Ever?

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges — cpirrong @ 4:13 pm

At the very end of last year the European Union finally agreed on a rule capping natural gas prices. And what a strange duck it is–unlike any price cap I’ve seen before, which is probably for the best for reasons I discuss below.

Rather than a simple ceiling on the price of natural gas–which is what many EU nations were clamoring for–the rule limits trading in front month, three month, and one year TTF futures if (a) the front-month TTF derivative settlement price exceeds EUR 275 for two week(s) and (b) the TTF European Gas Spot Index as published by the European Energy Exchange (EEX) is EUR 58 higher than the reference price during the last 10 trading days before the end of the period referred to in (a).  The “reference price” is: “the daily average price of the price of the LNG assessments “Daily Spot Mediterranean Marker (MED)”, the “Daily Spot Northwest Europe Marker (NWE)”, published by S&P Global Inc., New York and of the price of the daily price assessment carried out by ACER pursuant to Article 18 to 22 of Council Regulation .”

So in other words: (a) the TTF price has to be really high for two weeks straight, and (b) the TTF price has to be really high relative to the European LNG price over that period.

In the event the cap is triggered, “Orders for front-month TTF derivatives with prices above EUR 275 may not be accepted as from the day after the publication of a market correction notice.” So basically this is a limit up mechanism applied to front month futures alone that basically caps the front month price alone. Moreover, it will not go into effect until mid-February, meaning that the last two weeks of February would have to be really cold in order to trigger it. (The chart below shows how far below prices currently are below the flat price cap trigger.)

These conditions are so unlikely to be met that one might get the idea that the cap is intended never to be triggered, and if it is, its impact is meant to be limited to front month futures. And you’d probably be right. Some nations definitely wanted a traditional cap on the price of gas inside the EU, but the Germans and Dutch especially realized this would be a potential disaster as it would cause of of the usual baleful effects of price controls, notably shortages.

The rule as passed does not constrain the physical/cash market for natural gas anywhere in the EU. This is the market that allocates actual molecules of gas, and it will continue to operate even if the front month futures market is frozen. The freezing of futures may well interfere with price discovery in the physical/cash market, but regardless, prices there can rise to whatever level necessary to match supply and demand. As a result, the cap will not achieve the objectives of those pressing for a traditional price ceiling, and won’t result in the consequences feared by the Germans and Dutch.

So the cap is unlikely ever to be triggered, and if it does, won’t interfere with the operation of the physical market or have much of an impact on the prices that clear that market. So what’s the point?

One point is political: the Euros can say they have imposed a cap, thereby appeasing the suckers who don’t understand how meaningless it is.

Another point is distributive–which is also political. The document setting out and justifying the rule spends a tremendous amount of effort discussing a very interesting fact: namely, that when prices spiked last year, basis levels got way out of line with historical precedents. Notably, TTF traded at a big premium relative to LNG prices, and to prices at other hubs in the EU. Sensibly, the document attributes these extreme basis levels to infrastructure constraints within the EU, namely constraints on gasification capacity, and pipeline constraints for moving gas within the EU. (Although I note that squeezing the TTF could have exacerbated these basis moves.)

Again, the rule won’t have any impact on the basis levels in the physical market. So again–what’s the point? Well almost in passing the document notes that many natural gas contracts throughout the EU are priced at the TTF front month futures price plus/minus a differential. What the rule does is prevent prices on these contracts from being driven by the TTF front month price when those infrastructure constraints cause TTF to trade at a big premium to LNG or to prices at other hubs. So for example, a buyer in Italy won’t pay the market clearing TTF price when that would have traded at a big premium and high flat price level: instead, the buyer in Italy will pay the capped TTF front month price.

In other words, the mechanism mitigates the impact of a very common pricing mechanism adopted in normal times against the impacts of very abnormal times. A buyer outside of NW Europe takes on basis risk by purchasing at TTF plus a differential, but usually that basis risk is sufficiently small as to be outweighed by the benefits of trading in a more liquid market (with TTF being the most liquid gas market in Europe, just as Henry Hub is in the US). However, the stresses of the past year plus have greatly increased that basis risk. The price cap limits the basis risk on legacy contracts tied to TTF, without unduly interfering with the physical market. The marginal molecules will still be priced in the (unconstrained) physical market.

So there you have it. Beneath all the political posturing and smoke and mirrors, all the rule does is limit the potential “windfall” gains of those who sold gas forward basis front month TTF, and limit the “windfall” losses of those who bought basis front month TTF. If demand spikes and the infrastructure constraints bind (or if someone exploits these constraints to squeeze TTF futures) causing the basis to blow out, the rule will constraint the impact on those who benchmarked contracts to the front month TTF.

In some respects this isn’t surprising. All regulation, in the end, is distributive.

Putting it all together, this is probably the least bad price control I’ve seen. It is unlikely to go into effect, and even if it does its impact is purely distributive rather than allocative.

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November 28, 2022

I Remain DeFiant: DeFi Is Not the Answer (to Price Discovery) in Crypto

The meltdown of FTX continues to spark controversy and commentary. A recent theme in this commentary is that the FTX disaster represents a failure of centralization that decentralized finance–DeFI–could correct. Examples include contributions by the very smart and knowledgeable Campbell Harvey of Duke, and an OpEd in today’s WSJ.

I agree that the failure of FTX demonstrates that the crypto business as it is, as opposed to how it is often portrayed, is highly centralized. But the FTX implosion does not demonstrate that centralization of crypto trading per se is fundamentally flawed: FTX is an example of centralization done the worst way, without any of the institutional and regulatory safeguards employed by exchanges like CME, Eurex, and ICE.

Indeed, for reasons I have laid out going back to 2018 at the latest, the crypto market was centralized for fundamental economic reasons, and it makes sense that centralization done right will prevail in crypto going forward.

The competitor for centralization advocated by Harvey and the WSJ OpEd and many others is “DeFi”–decentralized finance. This utilizes the nature of blockchain technology and smart contracts to facilitate crypto trading without centralized intermediaries like exchanges.

One of the exemplars of the DeFi argument is “automated market making” (“AMM”) of crypto. This article provides details, but the basic contours are easily described. Market participants contribute crypto to pools consisting of pairs of assets. For example, a pool may consist of Ether (ETH) and the stablecoin Tether (USDT). The relative price of the assets in the pool is determined by a formula, e.g., XETH*XUSDT=K, where K is a constant, XETH is the amount of ETH in the pool and XUSDT is the amount of Tether. If I contribute 1 unit of ETH to the pool, I am given K units of USDT, so the relative price of ETH (in terms of Tether) is K: the price of Tether (in terms of Ether) is 1/K.

Fine. But does this mechanism provide price discovery? Not directly, and not in the same way a centralized exchange like CME does for something like corn futures. DeFi/AMM essentially relies on an arbitrage mechanism to keep prices aligned across exchanges (like, FTX once up an time and Binance now) and other DeFi AMMs. If the price of Ether on one platform is K but the price on another is say .95K, I buy ETH on the latter platform and sell Ether on the former platform. (Just like Sam and Caroline supposedly did on Almeda!) This tends to drive prices across platforms towards equality.

But where does the price discovery take place? To what price do all the platforms converge? This mechanism equalizes prices across platforms, but in traditional financial markets (TradFi, for the consagneti!) price discovery tends to be a natural monopoly, or at least has strong natural monopoly tendencies. For example, it the days prior to RegNMS, virtually all price discovery in NYSE stocks occurred on the NYSE, even though it accounted only for about 75-80 percent of volume. Satellite markets used NYSE prices to set their own prices. (In the RegNMS market, the interconnected exchanges are the locus of price discovery.)

Why is this?: the centripetal forces of trading with private information. Something that Admati-Pfleiderer analyzed 30+ years ago, and I have shown in my research. Basically, informed traders profit most by trading where most uninformed traders trade, and the uninformed mitigate their losses to the informed by trading in the same place. These factors reinforce one another, leading to a consolidation of informed trading in a single market, and the consolidation of uninformed trading on the same market except to the extent that the uninformed can segment themselves by trading on platforms with mechanisms that make it costly for the informed to exploit their information, such as trade-at-settlement, dark pools, and block trading. (What constitutes “informed” in crypto is a whole other subject for another time.)

It is likely that the same mechanism is at work in crypto. Although trading consolidation is not as pronounced there as it is in other asset classes, crypto has become very concentrated, with Binance capturing around 75-80 percent of trading even before the FTX bankruptcy.

So theory and some evidence suggests that price discovery takes place on exchanges, and that DeFi platforms are satellite markets that rely on arbitrage directly or indirectly with exchanges to determine price. (This raises the question of whether the AMM mechanism is sufficiently costly for informed traders to insure that their users are effectively noise traders.)

The implication of this is that DeFi is not a close substitute for centralized trading of crypto. (I note that DeFi trading of stocks and currencies is essentially parasitical on price discovery performed elsewhere.) So just because SBF centralized crypto trading in the worst way doesn’t mean that decentralization is the answer–or will prevail in equilibrium as anything more than an ancillary trading mechanism suited for a specific clientele, and not be the primary locus of price discovery.

The future of crypto will therefore almost certainly involve a high degree of centralization–performed by adults, operating in a rigorous legal environment, unlike SBF/FTX. That’s where price discovery will occur. In my opinion, DeFi will play an ancillary role, just as off-exchange venues do today in equities, and did prior to RegNMS.

One last remark. One thing that many in the financial markets deplore is the fragmentation of trading in equities. It is allegedly highly inefficient. Dark pools, etc., have been heavily criticized.

Fragmentation and decentralization is also a criticism leveled against OTC derivatives markets–here it has been fingered as a source of systemic risk, and this criticism resulted in things like OTC clearing mandates and swap execution facility mandates.

It’s fair to say, therefore, that in financial market conventional wisdom, decentralization=bad.

But now, a failure of a particular centralized entity is leading people to tout the virtues of decentralization. Talk about strange new respect!

All of these criticisms are largely misguided. As I’ve written extensively in the past, fragmentation in TradFi is a way of accommodating the diverse needs of diverse market participants. And just because some hopped up pervs found that running a centralized “exchange” was actually a great way to steal money from those blinded by their BS doesn’t mean that centralization is inherently unfitted for crypto because decentralized mechanisms also exist.

If crypto trading is to survive, well-operated centralized platforms will play an outsized role, supplemented by decentralized ones. Crypto is not so unique that the economic forces that have shaped market structure in stocks and derivatives will not operate there.

So don’t overgeneralize from a likely (and hopefully!) extreme case driven by the madness of woke crowds.

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November 16, 2022

Biden’s Latest Energy Brainwave: Engrossing Diesel!

Filed under: Commodities,Derivatives,Economics,Energy,Politics — cpirrong @ 7:38 pm

The latest Biden energy brain wave is a possible requirement that fuel suppliers hold a minimum level of diesel inventory:

US President Joe Biden is considering forcing the nation’s fuel suppliers to keep a minimum level of inventory in tanks this winter as a means of preventing heating oil shortages and keeping prices affordable. It may actually do the opposite. 

Well actually actually, there’s no “may” about it. It will, if the administration indeed forces away.

As I’ve written previously, there are times when economic conditions make it optimal to hold low (and perhaps no) inventories. When the supply/demand balance is expected to improve in the future, holding inventories moves a commodity from when it is relatively scarce, to when it is relatively abundant. It is better to do the opposite. But since you cannot transport future production to meet present consumption, the best thing to do is to draw down inventories–perhaps to zero.

There is no reason to believe that the market has “failed” to respond efficiently to fundamental conditions. There is absolutely no reason to believe that Joe Biden or anyone who works for him has solved the Knowledge Problem and knows how to allocate scarce diesel over time better than the markets do. Do you really think Joe et al know that the supply/demand balance in diesel is actually going to get worse, when the market judgment is the opposite? If you do, seek help.

So yes, if carried out, this action would increase spot prices because the only way to increase inventories is to reduce current consumption, and the only way to increase current consumption is through higher spot prices. Further, this action would tend to depress deferred prices because it will increase future consumption.

So if he does this, it would be totally correct to put one of those “I did that” stickers on a diesel pump.

It’s ironic to note that mandatory government stockholding programs, sometimes seen in agricultural markets, are intended to increase prices (to help farmers, for instance). It’s also ironic that Biden is floating this after months of drawing down on government inventories of crude in the SPR–in order to reduce prices.

What Biden is proposing could be seen as a government run corner: the antitrust case of U.S. v. Patten (1913) identifies one of the salient features of a corner as “withholding [a commodity] from sale for a limited time” with the purpose of “artificially enhancing the price.” Biden is proposing “withholding” diesel from the market.

Or, using more archaic language, it is government run “engrossing” or “forestalling,” something that speculators are often (wrongly) accused of, as Adam Smith wrote about in The Wealth of Nations.

The only good news to report here is apparently market participants think this idea is so stupid that not even this administration will implement it. Diesel flat prices and calendar spreads haven’t moved much after Biden’s announcement.

But it would be much better if the administration actually had some good ideas rather than a stream of bad ones, some of which are so obviously bad that they will never come to fruition.

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October 17, 2022

Clearing Is Not A Harmless Bunny: I Told You That I Told You That I Told You [ad infinitum] That I Told You So

Filed under: Clearing,Derivatives,Economics,Financial crisis,Regulation — cpirrong @ 10:54 am

I have long called myself “the Clearing Cassandra” for my repeated and unheeded warnings about the dangers of letting the Trojan Horse of clearing (and the margining of uncleared trades) into the financial citadel. Specifically, clearing/margining can create financial shocks (and indeed financial crises) rather than preventing them (which is the supposed justification for mandating them).

We have seen several examples of this in the past several years, including the COVID (lockdown) shock of March 2020 (a subject of a JACF article of mine) and the recent energy market tremors. The most recent example, and in many ways the most telling one, is the recent instability in the UK that led the Bank of England to intervene to prevent a full-on crisis. The tumult fed a spike in UK government yields and contributed to a plunge in the Pound.

The instability was centered on UK pension funds engaged in a strategy called Liability Directed Investment (LDI)–which should now be renamed Liquidity Danger Investment. In a nutshell, in LDI defined benefit pension funds hedge the interest rate risk in their liabilities through interest rate swaps that are cleared or otherwise margined daily on a mark-to-market basis, rather than investing in fixed income securities that generate cash flows that match the liabilities. The funds hold non-fixed income assets (sometimes referred to as “growth assets”) in lieu of fixed income. (I discuss the whys of that portfolio strategy below.)

On a MTM basis, the funds are hedged: a rise in interest rates causes a decline in the present value of the liabilities, which matches a decline in the value of the swaps. Even if there is a duration match, however, there is not a liquidity match. A rise in interest rates generates no cash inflow on the liabilities (even though they have declined in value), but the clearing/margining of the swaps leads to a variation margin outflow: the funds have to stump up cash to meet VM obligations.

And this has happened in a big way due to interest rate increases driven by central bank tightening and the deteriorating fiscal situation in the UK (which has been exacerbated substantially by the energy situation, and the British government’s commitment to absorb a large fraction of energy costs). This led to big margin calls . . . which the funds did not have cash to cover. So, cue a fire sale: the funds dumped their most liquid assets–UK government gilts–which overwhelmed the risk bearing capacity/liquidity of that market, leading to a further spurt in interest rates . . . which led to more VM obligations. Etc., etc., etc.

In other words, a classic liquidity spiral.

The BofE intervened by buying gilts in massive amounts. This helped stem the spiral, though the problem was so acute that the BofE had to extend its purchases beyond the period it initially announced.

So yet again, central bank intervention was necessary to provide liquidity to put out fires created by margining.

FFS. When will people who should know better figure this out? How many times is it necessary to hit the mule upside the head with a 2×4?

I just returned from France, and while walking by the Banque de France I thought of a conference held there in the fall of 2013 at which I spoke: the conference was co-sponsored by the BdF, BofE, and ECB. It was intended to be a celebration of the passage and implementation of various post-Crisis regulations, clearing mandates most prominent among them.

I did my buzz kill Clearing Cassandra routine, in which I warned very specifically of the liquidity spiral dangers inherent in clearing as a source of financial instability. I got pretty much the same response as the Trojan Cassandra–a blow off, in other words. Indeed, I quite evidently got under some skins. The next speaker was Benoît Cœuré, a member of the ECB governing council. The first half of his talk was a very intemperate–and futile–attempt at rebuttal. Which I took as a compliment.

Alas, events have repeatedly rebutted Cœuré and Gensler and all the other myriad clearing cheerleaders.

The LDI episode has validated other arguments that I made starting in late-2008. Most notably, clearing was touted as a “no credit” system because the clearinghouse does not extend any credit to counterparties: variation margin/mark-to-market is the mechanism that limits CCP credit exposure. Since one (faulty) narrative of the Crisis was that it was the result of credit extended to derivatives counterparties, clearing was repeatedly touted as a way of reducing systemic risk.

Not so fast! I said. Such a view is profoundly unsystemic because it neglects the fact that market participants can substitute other forms of credit for the credit they no longer get via derivatives trades. And indeed, in the recent LDI episode exemplifies a very specific warning I made over a decade ago: those subject to clearing or margining mandates would borrow on the repo market to fund margin obligations, including both initial margin and variation margin.

And indeed the UK funds did exactly that. This actually increased the connectedness of the financial system (contrary to the triumphant assertions of Gensler and others), and this connectedness via the repo channel was another factor that drove the BofE to intervene.

My beard is not quite this long (though it’s getting there) but this is pretty much spot on:

Clearing is Not a Harmless Bunny

Again: Clearing converts credit risk into liquidity risk. And all financial crises are liquidity crises.

Maybe someday people will figure this out. Hopefully before I snuff it.

And the idiocy of this is especially great with respect to the UK pension funds because they posed relatively little credit risk in the first place. So there was not a substitution of one risk (liquidity risk) for another (credit risk). There was an addition of a new risk with little if any reduction of any other risk.

The LDI strategies were right way risks. Interest rate movements that cause swaps to lose value also increase the value of the funds (by reducing the PV of their liabilities). The funds were not–and are not-leveraged plays on interest rate risk. So the prospects of defaults on derivatives that could be mitigated by clearing were minimal.

Here I have to part ways with someone I usually agree with, John Cochrane, who characterizes the episode as another example of the dangers of leverage. He cites to a BofE document about the LDI episode that indeed mentions leverage, but the story it tells is not the classic lever-up-and-lose-more-when-the-market-moves-against-you one that John suggests. Instead, in figure in the BofE piece that John includes in one of his posts, the increase in interest rates actually makes the pension fund better off in present value terms–even including its LDI-related positions–because its assets go down less in value than its liabilities do. In that sense, the LDI positions are an interest rate hedge. But there is a mismatch in the liquidity impacts.*. It is this liquidity mismatch that causes the problem.

The BofE piece also suggests that the underlying issue here is pension fund underfunding. In essence, the pension funds needed to jack up returns to close their funding gap. So instead of investing in fixed income assets with cash flows that mirrored those of its pension liabilities, the funds invested in higher returning assets like equities. Just investing in fixed income would have locked in the funding gap: investing in equities increased the odds of becoming fully funded. But just investing in equities alone would have subjected the funds to substantial interest rate risk. So the LDI strategies were intended to immunize them against this risk.

Thus, the original sin was the underfunding. LDI was/is not a way of adding interest rate risk through leverage to raise expected returns to close the gap (gambling on interest rate risk for resurrection). Instead it was a way of managing interest rate risk to permit raising returns to close the gap by changing portfolio composition. (No doubt regulators were cool with this because it reduced the probability that pension fund bailouts would be needed, or at least kicked that can down the road, a la US S&L regulators in the 1980s.)

No, the real story here is not the oft-told tale of highly leveraged intermediaries coming to grief when their speculations turn out wrong. Instead, it is a story of how mechanisms intended to limit leverage directly lead to indirect increases in debt and more importantly to increases in liquidity risks. In that way, margining increases systemic risk, rather than reducing it as advertised.

*The BofE document describes an LDI mechanism that is somewhat different than using swaps to manage interest rate risk. Instead, it describes a mechanism whereby positions in gilts are partially funded by repo borrowing. The borrowing is necessary to create a position large enough to create enough duration to match the duration of a fund’s liabilities. But a swap is economically equivalent to a position in the underlying funded by borrowing, so the difference is more apparent than real. Moreover, the liquidity implications of the interest rate hedging mechanism in the BofE document are quite similar to those of a swap.

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September 17, 2022

Gary Gensler Does Crypto. And Clearing (Again). And Climate.

Gary Gensler has long lusted to get his regulatory hooks into cryptocurrency. To do so as head of the SEC, he has to find a way to transform crypto (e.g., Bitcoin, Ether, various tokens) into securities, as defined under laws dating from the 1930s. Although Gensler has stated that crypto regulation is a long way off–presumably because it is no mean feat to jam an innovation of the 2010s into a regulatory framework of the 1930s–he thinks that he may have found a way to get at the second largest crypto, Ether.

Gensler pictured here:

Sorry! Sorry! Understandable mistake! Here’s his actual image:

Crypto Regulation. Excellent!

Ether just switched from a “proof of work” model–the model employed by Bitcoin–to a “proof of stake” model. Gensler recently said that Ether may therefore qualify as a security under the Howey test, established in a 1946 Supreme Court decision–handed down when computers filled large rooms, had no memory, and caused the lights to dim in entire cities when they were powered up.

Per Gensler:

Securities and Exchange Commission Chairman Gary Gensler said Thursday that cryptocurrencies and intermediaries that allow holders to “stake” their coins might pass a key test used by courts to determine whether an asset is a security. Known as the Howey test, it examines whether investors expect to earn a return from the work of third parties. 

“From the coin’s perspective…that’s another indicia that under the Howey test, the investing public is anticipating profits based on the efforts of others,” Mr. Gensler told reporters after a congressional hearing. He said he wasn’t referring to any specific cryptocurrency. 

To call that a stretch is an understatement. A huge one. Because the function of proof of stake is entirely different than the function of a security.

Proof of work and proof of stake are alternative ways of operating an anonymous, trustless crypto currency. As I’ve written in several pieces here and elsewhere, eliminating the need for trusted institutions to guarantee transactions does not come for free. Those tempted to defraud must incur a cost if they do in order to be deterred. A performance bond sacrificed on non-performance or deceit is a common way to do that. Proofs of stake and work both are effectively performance bonds. With proof of work, a “miner” incurs a cost (electricity, computing resources) to get the right to add blocks to the blockchain: if a majority of other miners don’t concur with the proposal, the block is not validated, the proposing miner gets no reward, and sacrifices the expenditure required to make the proposal. Proof of stake is a more traditional sort of bond: you lose your stake if your proposal is rejected.

A security is something totally different, and serves a completely different function. (NB. I favor the “functional model of regulation” proposed by Merton many years ago. Regulation should be based on function, not institution.). The function of a security is to raise capital with a marketable instrument that can be bought and sold by third parties at mutually agreed upon prices.

So with a lot of squinting, you can say that both securities and staking mechanism involve “the efforts of others,” but to effect completely different purposes and functions. The fundamental difference in function/purpose means that even if they have something in common, they are totally different and the regulatory framework for one is totally inappropriate to the regulation of the other.

This illustrates an issue that I often come across in my work on commodities, securities, and antitrust litigation: the common confusion of sufficient and necessary conditions. Arguably profiting from the efforts of others could be a necessary condition to be considered a security. It is not, however, a sufficient condition–as Gensler is essentially advocating.

But what’s logic when there’s a regulatory empire to build, right?

I’m also at a loss to explain how Gensler could think that proof of stake involves the “efforts” (i.e., work) of others, but proof of, you know, work doesn’t.

Gensler’s “logic” would probably even embarrass Sir Bedevere:

“What also floats in water?” “A security!”

Gensler might have more of a leg to stand on when it comes to tokens. But with Bitcoin, Ether, and other similar things, hammering the crypto peg into the securities law hole is idiotic.

But never let logic stand in the way of Gary’s pursuit of his precious:

GiGi is not solely focused on crypto of course. He has many preciouses. This week the SEC released a proposed rule to mandate clearing of many cash Treasury trades.

Clearing of course has always been a mania of Gary’s. His deep affection for me no doubt dates from my extensive writing on his Ahab-like pursuit of clearing mandates in derivatives more than a decade ago. Clearing is Gensler’s hammer, and he sees in every financial problem a nail to be driven.

The problem at issue here is the periodic episodes of large price moves and illiquidity in the Treasury market in recent years, most notably in March 2020 (the subject of a JACF article by me).

Clearing is a mechanism to mitigate counterparty credit risk. There is no evidence, nor reasonable basis to believe, that counterparty credit risk precipitated these episodes, or that these episodes (whatever their cause) raised the risk of a chain reaction via a counterparty credit risk channel in cash Treasuries.

Moreover, as I have said ad nauseum, clearing and the associated margining mechanism is a major potential source of financial instability.

Indeed, as I point out in the JACF article, clearing and margin in Treasury futures and other fixed income securities markets is what threatened to turn the price (and basis) movement sparked by Covid (and policy responses to Covid) into a systemic event that required Fed intervention to prevent.

I note that as I discussed at the time, margining also contributed greatly to the instability surrounding the GameStop fiasco.

Meaning that in the name of promoting financial market stability Gensler and the SEC (the vote on the proposal was unanimous) are in fact expanding the use of the very mechanism that exacerbated the problem they are allegedly addressing.

Like the Bourbons, Gensler has learned nothing, and forgotten nothing. He has not forgotten his misbegotten notions of the consequences of clearing, and hasn’t learned what the real consequences are.

Of course these two issues do not exhaust the catalog of Gensler’s regulatory imperium. Another big one is his climate change reporting initiative. I’ll turn to that another day, but in the meantime definitely check out John Cochrane’s dismantling of that piece of GiGi’s handiwork.

As Gideon John Tucker said famously 156 years ago: “No man’s life, liberty or property are safe while the Legislature is in session.” Nor are they when Gary Gensler heads a regulatory agency.

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September 1, 2022

European Sparks & Darks Tell a Fascinating Story

While writing the post on European electricity prices, I was wondering about the drivers. How much due to fuel prices? How much due to capacity constraints? Risk premia?

Spreads, specifically spark and dark spreads, are the best way to assess these issues. Spark spreads are the difference between the price of electricity and the cost of natural gas necessary to generate it. And no, dark spreads are not the odds that Europe will shiver in the dark this winter–though I’m sure that you can find a bookie that will quote that for you!: a dark spread is the difference between the price of power and the cost of coal required to generate it. In essence, spark and dark spreads tell you the gross margin of generators, and the value of generation capacity. High spreads indicate that capacity is highly utilized: low spreads that capacity constraints are not a maor issue.

Sparks and darks depend on the efficiency of generators, which can vary. Efficiency is measured by a “heat rate” which is the number of mmBTU necessary to generate a MWh of electricity. Efficiency can be converted into a percentage by dividing the BTU content of electricity (3,412,000).

Electricity is a highly “spatial” commodity, with variations across geographic locations due to the geographic distribution of generation and load, and the transmission system (and the potential for constraints thereon). Moreover, since electricity cannot be stored economically (although hydro does provide an element of storability) forward prices for delivery of power at different dates can differ dramatically.

Looking at sparks and darks in Europe reveals some very interesting patterns. For example, comparing the UK with Germany reveals that German day ahead “clean” sparks (which also adjust for carbon costs) are negative for relatively low efficiency (~45 percent) units, and modestly positive (~€35) for higher efficiency (~50 percent) generators. In contrast, UK day ahead sparks are much higher–around €200.

Another example of “identify the bottleneck.” The driver of high spot power prices in Germany is not limitations on generating capacity–it is the high fuel prices. (Presumably the lower efficiency units are offline in Germany now, as their gross margin is negative.) Conversely, generation capacity limits are evidently much more binding in the UK.

But if you look at forward prices, the story is different. Quarter ahead clean sparks in Germany are around €200, while in the UK they are over €300. Two quarter ahead (the depth of winter) are almost €600 in Germany and a mere €300 or so in the UK. (All figures for 50 percent efficiency units).

These suggests that capacity will be an issue in both countries, but especially Germany. Way to go, Germany! Relying on solar in a country with long nights ain’t looking so good, is it?

The wide sparks also undermine attempts to blame it all on Putin. Yes, high gas prices/gas scarcity courtesy of Vova is contributing to high power prices, but that’s not the entire story. Though to be fair, more gas generating capacity wouldn’t help that much if they become energy limited resources due to a lack of Russian gas.

The high forward prices may also reflect a high risk premium. My academic work from the 2000s showed that there is an “upward bias” in electricity forward prices. That is, forward prices are above–and often substantially above–expected future spot prices. My interpretation was that this reflects “spikeaphobia”: power prices can spike up, but they are supported by a floor. This means that being caught short is much riskier than being long. This creates an imbalance between long hedging (to protect against price spikes) and short hedging (to protect against price declines that are likely to be far smaller than upward spikes). This creates “hedging pressure” on the long side: if speculative capital to absorb this imbalance is constrained, this hedging pressure drives up forward prices relative to expected spot prices.

The imbalance is likely exacerbated by the fact that there are large fuel price spike risks too. Moreover, the price and liquidity risks that speculators absorbing the imbalances must shoulder is likely raising the cost of speculative capital in electricity trading, meaning that there is both a demand pull and cost push driving the risk premium. Thus, I conjecture that some portion–perhaps a hefty portion–of the large spark spreads for German and the UK is risk premium. (Back in the days I started to estimate the risk premium in the US markets in the late-90s, the risk premium was as much as 50 percent of the forward price. That decline substantially over the next decade to about 10 percent for summer peak as the electricity markets became more “financialized.” Financialization, by the way, is usually a pejorative, which drives me nuts. Financialization typically reduces the cost of hedging.).

In the aftermath of the mooting of EU proposals to intervene massively in electricity markets, especially through price controls, forward power prices have plummeted: the above figures are from before the collapse. Price controls would impact both the expected spot price and the risk premium–because they take the spikes out of the price. However, as I noted in my prior post, this is not good news: if prices cannot clear the market, rationing will.

Dark sparks also tell a fascinating story. They are HUGE. The German dark spark for 2 quarters ahead (Jan-Mar) is over €1000, and the UK dark spread is over €600. In other words, it’s good to own a coal plant! By the way, these are clean darks, so they take into account the cost of carbon. Meaning that the market is sending a signal that the value of coal generation–even taking into account carbon–is very high. This no doubt explains why despite massive green and renewable rhetoric in China, the Chinese are building coal capacity hand over fist. It also points out the insanity of European policies to eliminate coal generation. Even if you believe in the dangers of carbon, the way to deal with that is to price it, rather than to dictate generation technology.

To give some perspective, the above figures imply that a 500MW coal plant in Germany was anticipated to produce €870 million in value in 23Q3 (24 hours/day x .80 operating rate x 91 days/quarter x 500 MW x €1000/MW). That’s more than the cost of a plant. Even if you cut that in half to take into account today’s power price collapse, it’s a huge number.

Think about that for a minute.

In sum, spreads tell fascinating stories about what is happening in the European electricity market, and in particular the roles of input prices and capacity constraints and risk premia in driving the historically high prices. But perhaps the most fascinating story they tell is the high price that Europe is paying to kill coal.

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August 29, 2022

New European Energy Policy Follies: The Inevitable Consequence of Past European Policy Follies

European power prices are going hyperbolic, with day ahead prices in swathes of the continent varying between €660 and €750/MWh.

For those who want to play at home–spot the congestion!

Even more remarkably, Cal 2023 power prices are around €1000/MWh in German and France:

That’s for baseload, folks. 24/7/365. Peak Cal 2023 French power is currently at €1425. Ooh la la!

This has of course set of a flurry of policy proposals.

None of these proposals will mitigate the fundamental problem–energy supply is extremely scarce. Most of these proposals will actually exacerbate the underlying scarcity.

Instead, these proposals are all about how to distribute the cost of scarcity. They are fundamentally redistributive in nature.

The proposals include price controls (natch), windfall profits taxes, and nationalization.

Price controls always exacerbate the scarcity and create actual shortages by encouraging consumption and discouraging production. They will necessitate rationing schemes. In electricity, rationing often involves brownouts and blackouts. Planned blackouts, such as no power availability at all for some hours of the day.

WIndfall profits taxes attempt to capture the surplus of inframarginal (i.e., low cost) suppliers, and redistribute that surplus (somehow) to consumers. Redistributing through subsidized prices exacerbates scarcity because it increases demand.

Windfall profits taxes may otherwise have few distorting effects in the short run, given that supply from the inframarginal firms is likely to be highly inelastic (they basically operate at capacity). (Ironically, the scheme to hit Russia by capping the prices it receives on oil is predicated on a belief that supply is highly inelastic.). However, windfall profits taxes have very deleterious long run incentives. They deprive those who invest in production capacity of the value of those investments precisely when they are greatest (which really distorts investment incentives). Even the risk that windfall taxes will be imposed in the future depresses investment today. Meaning that although such taxes may not do too much damage in the present, they increase the likelihood of future scarcity.

The reach of windfall profits taxes is also limited. Many of the rents resulting from the current world energy situation accrue to input suppliers (e.g., owners of LNG liquefaction capacity, coal miners that export to Europe) who are beyond the reach of grasping European hands via windfall profits taxes. (And are the Norwegians going to transfer wealth to Europe by imposing windfall taxes on their gas production and writing a check to Brussels? As if: the Norwegians are already talking about limiting energy exports to Europe.)

Nationalization can be a crude form of windfall profits tax: nationalizing low cost producers basically seizes their surplus. Nationalization can also be a form of subsidization: seize unprofitable firms, or firms that can only survive by charging very high prices, and sell the output below cost. Losses from below cost sales are socialized via taxpayer support of loss-making nationalized enterprises (which creates deadweight costs through taxation present and future).

Nationalization of course generates future operational and investment inefficiencies due to low power incentives, corruption, etc. Moreover, to the extent that nationalized entities subsidize prices, they will encourage overconsumption, and thereby create true shortages and necessitate rationing.

All of these policies aim to mitigate the pain that power consumers incur by shifting the costs to others–and in the forms of subsidies funded by general taxation, the overlap between those who receive the subsidies and those who pay them is pretty large. But even this transforms a very visible cost into a much less visible one, and thus has its own political benefit.

The Germans–at least the Green Party ministers in the government–are advocating a fundamental change in the market mechanism, specifically, eliminating marginal cost pricing:

“The fact that the highest price is always setting the prices for all other energy forms could be changed,” Economy Minister Robert Habeck, who is also the vice chancellor in the ruling coalition in Berlin, said in an interview with Bloomberg.

“We are working hard to find a new market model,” he said, adding that the government must be mindful not to intervene too much. “We need functioning markets and, at the same time, we need to set the right rules so that positions in the market are not abused.”

Marginal cost pricing is a fundamental economic tenet: price equal to marginal cost gives the right incentives to produce and consume. Below marginal cost pricing (the cost of the most expensive resource sets the price) encourages overconsumption. Further, unless marginal units are compensated there will be underproduction. Both of these create inefficiencies, exacerbate scarcity, and can lead to actual shortages and the necessity of rationing.

On a whiteboard you could draw up a pricing mechanism that perfectly price discriminates by paying each resource its marginal cost. This effectively appropriates all of the producer surplus which can be redistributed to favored political constituencies. But this doesn’t cover fixed costs and a return on capital, which discourages future investment.

Further, classroom whiteboard exercises are usually impossible even to approximate in reality. Knowing what marginal cost is for each resource in a complicated system is a major problem, especially when you take transmission into consideration. The likely outcome would be some sort of kludge with roughly average cost pricing combined with some Rube Goldberg scheme to compensate producers. This whole system would involve massive redistribution and all of the politicking and corruption attendant to it.

The real problem the Europeans have is that they want to kill the market messenger. The market is signaling scarcity. The scarcity is real, and acute, but they no likey! And by the nature of energy production–capital intensive, with moderate to long lead times to enhance capacity–the scarcity will continue for some time, with little the Europeans can do about it.

In other words, they can’t fix their real problem (scarcity), which is the harvest of their previous policy follies. So they are left to find redistributive schemes to allocate the costs in a politically satisfactory way. These redistributive schemes–price ceilings, windfall profits taxes, nationalization, fundamental restructuring of the market mechanism–all tend to exacerbate scarcity in both the short and longer runs.

The fact is, when you’re screwed, you’re screwed. And Europe is well and truly screwed. What is going on in policy circles in Europe right now is figuring out who is going to get screwed hardest, and who is going to get screwed not so much. And there will be substantial costs, both in the short but especially the longer term, as whatever Frankenstein “market” emerges from these frantic policy stopgaps will wreak havoc in the future, and will be very hard to put down.

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July 13, 2022

A Streetwise Professor Commodities Podcast

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — cpirrong @ 3:55 pm

HC Group were kind enough to include me in their HC Insider podcast. Paul Chapman and I discussed systemic risk issues in commodity markets, which is a hot topic these days given the tumult in commodities since last fall. Central banks and regulators are paying closer attention to commodities now than they ever have.

Here’s a link to the Podcast. As you can see from the categories, we covered a lot of ground. Hope you find it informative.

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July 1, 2022

Get Ready: A Baleful Consequence of Inflation You’ve Heard Too Little About

Filed under: Commodities,Derivatives,Economics — cpirrong @ 6:37 pm

Going away the most entertaining–and in some ways educational–experience of my graduate school days was when the great Sherwin Rosen was lecturing to the 0830 Econ 301 Price Theory course at Chicago the last time that inflation was about where it is now. Sherwin was talking about how relative prices are what really matters, and then startled a somewhat dozy class by slamming his fist into his palm and shouting: “And that’s the problem with inflation! It FUCKS UP relative prices.”

Sherwin Rosen

Since we are entering a new inflationary age, you should pay heed to Sherwin’s wisdom.

The argument, in a nutshell, is that due to transactions costs (interpreted broadly) not all goods and services are traded in auction markets or auction-like markets in which prices respond immediately to shocks, including nominal shocks. Prices (including wages/salaries) are set by contracts, including implicit/informal ones. Different contracts have different degrees of flexibility. Prices (and other terms) in some respond quickly, others not so much.

So when there is a substantial nominal shock (e.g., a surge in the money supply) which in a frictionless, classical world would not affect relative prices, some prices adjust more rapidly than others. This leads to changes in relative prices that are artifacts of the nominal shock, and which distort resource allocation.

Cantillon wrote about this issue in the 18th century, and it is also a component of Austrian business cycle theory. (Interestingly, unlike most at Chicago, Sherwin treated Austrian theory sympathetically. I imagine that his emphatic statement in class so many years ago can be traced to Austrian economics in some way.)

Some practical implications.

First, I expect to see a substantial surge in labor disputes as real wages (i.e., the relative price of labor) fall when some more flexible prices rise and nominal wages don’t. We are already seeing some indications of that (keep an eye on potential strikes at US ports and railroads).

Second, arguing along Coasean lines, I expect that since inflation makes it costlier to rely on the price system, there will be a substitution towards non-price methods of resource allocation, including vertical integration (in lieu of long term contracts where misalignment of prices leads to costly disputes between the parties), and the rationing mechanisms that Dennis Carlton (another former thesis committee member of yours truly) wrote about in the JLE in 1991. (There might be some shifts in the other direction too. Goods that are somewhat commoditized but are currently exchanged under formal or informal contracts with relatively inflexible prices might be amenable to being traded on auction- or auction-like platforms with more flexible prices.) (Dennis wrote many interesting things about allocation mechanisms, price rigidity, and so in in the late-80s early-90s.)

Third, contracts will become shorter in duration, and incorporate various indexing clauses (which mitigate, but do not eliminate, relative price distortions).

Fourth, inflation and the associated relative price volatility can be a boon for futures/derivatives markets. It is not a coincidence, comrades, that a major burst of growth in derivatives markets (both in size and scope) occurred at the time of the last major inflationary period.

This list is not exhaustive by any means. It’s just some things that immediately come to mind.

Any adjustment in contracting practices, or increased cost of using contractual practices that work well when relative prices are not subject to inflation-driven variation, is a real cost of inflation. Misallocations of resources that result when nominal shocks distort relative prices are also a real cost of inflation. Inflation will drive more conflict, more battles over rents, more contract disputes, and on and on and on.

As Sherwin forcefully expressed, inflation is anything but economically benign, something that microeconomists (like Sherwin) are sensitive too, but which macroeconomists too often ignore. (Back in the day, macro types thought that the only real cost of inflation was “shoe leather cost” due to people having to walk to the bank more often.)

I tweeted about this some weeks ago. In the interim, I’ve only seen one article discuss it: this one based on an interview with Ross McKitrick. Definitely worth a read, to get you prepared for what’s coming.

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