Streetwise Professor

April 30, 2021

If You Woke Up With Wood . . . You’re Rich!

Filed under: Commodities,CoronaCrisis,Derivatives,Economics — cpirrong @ 6:33 pm

Especially if it’s lumber. Not so much if it’s timber or logs.

Lumber prices have been on a tear recently. The CME lumber futures price has risen inexorably for weeks:

The softwood lumber PPI has increased 73 percent from April of last year, when Covid cratered all markets (including all commodity markets in particular) to March of this year. As the graph above shows, the price increase in the last month alone will add almost 100 precent to that. The plywood PPI is up 43 percent. The PPI for logs, timber, and pulpwood has not risen nearly as much over the April 2020-March 2021 period–only 7 percent.

So what’s going on? This podcast has a pretty good explanation, which comports with the analysis that follows. My main objection is that it repeatedly refers to the market as “broken.” No. A market is broken when it sends the wrong price signals. It is not broken if it sends the right signals, even if you don’t like them. That’s what’s going on here. Prices are signaling a major change in demand patterns that is straining a productive capacity oriented to the old patterns.

The podcast claims that log and timber prices are down. That’s not consistent with the PPI data, which does demonstrate some uptick in log/timber prices. I have also seen reports that timber/log prices are firm in western Canada. But it is obvious that the spread between lumber and timber has widened dramatically.

Which provides a perfect opportunity to apply what I teach in my commodities classes: Find the bottleneck. In a reasonably competitive market, the spread between two commodities, one that can be transformed into the other, equals the cost of that transformation. Sawmills transform logs into lumber, so if the spread between the prices of these things blows out, that shows you where the bottleneck is–at the mills.

The podcast largely confirms that. The sawmill sector has contracted and consolidated in recent years for a variety of reasons. The Covid-induced economic shock of last year also led to the idling of capacity. Now demand has come roaring back. There is a building boom, driven by an exodus from cities and a substitution of things for services. The turnaround has been so abrupt that sawmill capacity has not been able to adjust to keep up. It of course takes a long time to build new mills, and the decision to do that depends on expectations about long-term demand. It is quicker and more economical to restart idle mills, and to add shifts, and that is happening. But it can’t happen overnight.

A transportation bottleneck is exacerbating the problems. Shortages of railcars and trucks are limiting the ability of sawmills to satisfy demand. These shortages reflect in part a commodities boom generally. Chinese demand for US ag products (which has sent corn prices soaring) is contributing to that, but the transportation sector has been robust generally since its doldrums of a year ago. In that time the Dow Jones Transportation Average is up 128 percent off its Covid bottom, and is 40 percent above its pre-Covid collapse level.

Transportation bottlenecks tend to widen spreads at all levels of the value chain, from timber farm to mill, and from mill to lumber yard.

Lumber inventories are at barebones levels, as one would expect in such circumstances. When the supply-demand balance is tight today relative to what is expected in the future, the efficient thing to do is to draw down inventories and to consume everything that is being produced. This is leading, exactly as theory would predict, to a pronounced backwardation in lumber prices:

Note there’s an almost 30 percent backwardation going out six months. That’s very steep. Very Although I wouldn’t put too much weight in the distant deferred prices (given the absence of volume and open interest) one, it appears that the curve flattens out after the six month point.

So what’s going on is commodity economics 101. A surge in demand after a sharp fall (which led to reductions in transformation capacity) caused the lumber market to hit constraints–constraints in the amount of available inventory, and constraints in the capacity to transform a raw product (timber) into a consumable one (lumber). This in turn caused spreads (calendar spreads and the spread between finished and raw prices) to blow out. Market participants are responding to these price signals. The backwardation suggests that the constraints will ease by the end of the year. That of course is a forecast based on current information. Things could change.

So things ain’t broke. Indeed, what is happening in the lumber and timber markets is a symptom of a robust economic recovery, at least in the housing and goods sectors. It also reflects an apparent ongoing structural shift post-Covid (and post urban disturbances of the last year), namely, a desire to move out of cities driven by the recognition that more people can work remotely, and the declining amenities of cities (largely the result of lockdowns and their aftermath, and an upsurge in crime). Such an abrupt and seismic shift inevitably bumps up against constraints determined by past investments tailored to accommodate the old consumption patterns. That affects prices, and prices signal the need for new investments to alleviate the bottlenecks. This too shall pass, and within some months the bottlenecks will ease, as. participants all along the value change respond to the extraordinary price signals we see today.

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March 15, 2021

Deliver Me From Evil: Platts’ Brent Travails

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — cpirrong @ 6:41 pm

In its decision to change speedily the Dated “Brent” crude oil assessment to include US crude and to a CIF basis, Platts hit a hornets’ nest with a stick and now is running away from the angry hive.

Platts’ attempt to change the contract makes sense. Dated “Brent” is an increasingly, well, dated benchmark due to the inexorable decline in North Sea production volumes, something I’ve written about periodically for the last 10 years or so. At present, only about one cargo per day is eligible, and this is insufficient to prevent squeezes (some of which have apparently occurred in recent months). The only real solution is to add more supply. But what supply?

Two realistic alternatives were on offer: to add oil from Norway’s Johan Sverdrup field, or to add non-North Sea oil (such as West African or US). Each presents difficulties. The Sverdrup field’s production is in the North Sea, but it is heavier and more sour than other oil currently in the eligible basket. West African or US oil is comparable in quality to the current Brent basket, but it is far from the North Sea.

Since derivatives prices converge to the cheapest-to-deliver, just adding either Sverdrup or US oil on a free on board basis to the basket would effectively turn Dated Brent into Dated Sverdrup or Dated US: Svedrup oil would be cheaper than other Brent-eligible production because of its lower quality, and US oil would be cheaper due to its greater distance from consumption locations. So to avoid creating a US oil or Sverdrup oil contract masquerading as a Brent contract, Platts needs to establish pricing differentials to put these on an even footing with legacy North Sea grades.

In the event, Platts decided to add US oil. In order to address the price differential issue, it decided to move the pricing basis from free on board (FOB) North Sea, to a cost, insurance, and freight (CIF) Rotterdam basis. It also announced that it would continue to assess Brent FOB, but this would be done on a netback basis by subtracting shipping costs from the CIF Rotterdam price.

The proposal makes good economic sense. And I surmise that’s exactly why it is so controversial.

This cynical assessment is based on a near decade of experience (from 1989 to 1997) in redesigning legacy futures contracts. From ’89-’91, in the aftermath of the Ferruzzi soybean corner, I researched and authored a report (published here–cheap! only one left in stock!) commissioned by the CBOT that recommended adding St. Louis as a corn and soybean delivery point at a premium to Chicago; in ’95-’96, in the aftermath of a corner of canola, I advised the Winnipeg Commodity Exchange about a redesign of its contract; in ’97, I was on the Grain Delivery Task Force at the CBOT which radically redesigned the corn and beans contracts–a design that remains in use today.

What did I learn from these experiences? Well, a WCE board member put it best: “Why would I want a more efficient contract? I make lots of money exploiting the inefficiencies in the contract we have.”

In more academic terms: rent seeking generates opposition to changes that make contracts more efficient, and in particular, more resistant to market power (squeezes, corners and the like).

Some anecdotes. In the first experience, many members of the committee assigned to consider contract changes–including the chairman (I can name names, but I won’t!)–were not pleased with my proposal to expand the “economic par” delivery playground beyond Chicago. During the meeting where I presented my results, the committee chairman and I literally almost came to blows–the reps from Cargill and ADM bodily removed the chairman from the room. (True!)

The GDTF was formed only because a previous committee formed to address the continued decline of the Chicago market was deadlocked on a solution. The CBOT had followed the tried-and-true method of getting all the big players into the room, but their interests were so opposed that they could not come to agreement. Eventually the committee proposed some Frankenstein’s monster that attempted to stitch together pieces from all of the proposals of the members, which nobody liked. (It was the classic example of a giraffe being a horse designed by committee.). It was not approved by the CBOT, and when the last Chicago delivery elevator closed shortly thereafter, the CFTC ordered the exchange to change the contract design, or risk losing its contract market designation.

Faced with this dire prospect, CBOT chairman Pat Arbor (a colorful figure!) decided to form a committee that included none of the major players like Cargill or ADM. Instead, it consisted of Bill Evans from Iowa Grain, Neal Kottke of Kottke Associates (an independent FCM), independent grain trader Tom Neal, and some outsider named Craig Pirrong. (They were clearly desperate.)

In relatively short order we hashed out a proposal for delivery on the Illinois River, at price differentials reflecting transportation costs, and a shipping certificate (as opposed to warehouse receipt) delivery instrument. After a few changes demanded by the CFTC (namely extending soybean delivery all the way down the River to St. Louis, rather than stopping at Peoria–or was it Pekin?), the design was approved by the CBOT membership and went into effect in 1998.

One thing that we did that caused a lot of problems–including in Congress, where the representative from Toledo (Marcy Kaptor) raised hell–was to drop Toledo as a delivery point. This made economic sense, but it did not go over well with certain entities on the shores of Lake Erie. Again–the distributive effects raised their ugly heads.

The change in the WCE contract–which was also eminently sensible (of course, since it was largely my idea!) also generated a lot of heat within the exchange, and politically within Alberta, Manitoba, and Saskatchewan.

So what did I learn? In exchange politics, as in politics politics, efficiency takes a back seat to distributive considerations. This insight inspired and informed a couple of academic papers.

I would bet dimes to donuts that’s exactly what is going on with Platts and Brent. Platts’ proposal for a more efficient pricing mechanism gores some very powerful interests’ oxen.

Indeed, the rents at stake in Brent are far larger than those even in CBOT corn and beans, let alone tiny canola. The Brent market is vastly bigger. The players are bigger–Shell or BP or Glencore make even 1997 era Cargill look like a piker. Crucially, open interest in Brent-based instruments extends out until 2029: open interest in the ags went out only a couple of years.

My surmise is that the addition of a big new source of deliverable supply (the US) would undercut the potential for delivery games exploiting “technical factors” as they are sometimes euphemistically called in the North Sea. This would tend to reduce the rents of those who have a comparative advantage in playing these games.

Moreover, adding more deliverable supply than people had anticipated would be available when they entered into contracts last year or the year before or the year before . . . and which extend out for years would tend to cause the prices for these longer dated contracts to fall. This would transfer wealth from the longs to the shorts, and there is no compensation mechanism. There would be big winners and losers from this.

It is these things that stirred up the hornets, I am almost sure. I don’t envy Platts, because Dated Brent clearly needs to be fixed, and fast (which no doubt is why Platts acted so precipitously). But any alternative that fixes the problems will redistribute rents and stir up the hornets again.

In 1997 the CBOT got off its keister because the CFTC ordered it to do so, and had the cudgel (revoking contract designation) to back up its demand. There’s no comparable agency with respect to Brent, and in any event, any such agency would be pitted against international behemoths, making it doubtful it could prevail.

As a result, I expect this to be an extended saga. Big incumbent players lose too much from a meaningful change, so change will be slow in coming, if it comes at all.

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February 22, 2021

GameStop: Round Up the Usual Suspects

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — cpirrong @ 7:52 pm

Shuttling between FUBARs, it’s back to GameStop!

Last week there were House hearings regarding the GameStock saga. As is usual with these things, they were more a melange of rampant narcissism and political posing and outright stupidity than a source of information. Everyone had an opportunity to identify and then flog their favorite villains and push their favorite “solutions.” All in all, very few constructive observations or remedies came out of the exercise. I’m sure you’re shocked.

Here are a few of the main issues that came up.

Shortening the securities settlement cycle. The proximate cause of Robinhood’s distress was a huge margin call. Market participants post margins to mitigate the credit risk inherent in a two day settlement cycle. Therefore, to reduce margins and big margin calls, let’s reduce the settlement cycle! Problem solved!

No, problem moved. Going to T+0 settlement would require buyers to stump up the cash and sellers to secure the stock on the same day of the transaction. Almost certainly, this wouldn’t result in a reduction of credit in the system, but just cause buyers to borrow money to meet their payment obligations. Presumably the lenders would not extend credit on an unsecured basis, but would require collateral with haircuts, where the haircuts will vary with risk: bigger haircuts would require the buyers to put up more of their own cash.

I would predict that to a first approximation the amount of credit risk and the amount of cash buyers would have to stump up would be pretty much the same as in the current system. That is, market participants would try to replicate the economic substance of the way the market works now, but use different contracting arrangements to obtain this result.

I note that when the payments system went to real time gross settlement to reduce the credit risk participants faced through the netting mechanism with daily settlement, central banks stepped in to offer credit to keep the system working.

It’s also interesting to note that what DTCC did with GameStop is essentially move to T+0 settlement by requiring buyers to post margin equal to the purchase price:

Robinhood made “optimistic assumptions,” Admati said, and on Jan. 28, Tenev woke up at 3:30 a.m. and faced a public crisis. With a demand from a clearinghouse to deposit money as a safety measure hedging against risky trades, he had to get $1 billion from investors. Normally, Robinhood only has to put up $2 for every $100 to vouch for their clients, but now, the whole $100 was required. Thus, trading had to be slowed down until the money could be collected.

That is, T+0 settlement is more liquidity/cash intensive. As a result, a movement to such a system would lead to different credit arrangements to provide the liquidity.

As always, you have to look at how market participants will respond to proposed changes. If you require them to pay cash sooner by changing the settlement cycle, you have to ask: where is the cash going to come from? The likely answer: the credit extended through the clearing system will be replaced with some other form of credit. And this form is not necessarily preferable to the current form.

Payment for order flow (“PFOF”). There is widespread suspicion of payment for order flow. Since Robinhood is a major seller of order flow, and since Citadel is a major buyer, there have been allegations that this practice is implicated in the fiasco:

Reddit users questioned whether Citadel used its power as the largest market maker in the U.S. equities market to pressure Robinhood to limit trading for the benefit of other hedge funds. The theory, which both Robinhood and Citadel criticized as a conspiracy, is that Citadel Securities gave deference to short sellers over retail investors to help short sellers stop the bleeding. The market maker also drew scrutiny because Citadel, the hedge fund, together with its partners, invested $2 billion into Melvin Capital Management, which had taken a short position in GameStop.

To summarize the argument, Citadel buys order flow from Robinhood, Citadel wanted to help out its hedge fund bros, something, something, something, so PFOF is to blame. Association masquerading as causation at its worst.

PFOF exists because when some types of customers are cheaper to service than others, competitive forces will lead to the design of contracting and pricing mechanisms under which the low cost customers pay lower prices than the high cost customers.

In stock trading, uninformed traders (and going out on a limb here, but I’m guessing many Robinhood clients are uninformed!) are cheaper to intermediate than better informed traders. Specifically, market makers incur lower adverse selection costs in dealing with the uninformed. PFOF effectively charges lower spreads for executing uninformed orders.

This makes order flow on lit exchange markets more “toxic” (i.e., it has a higher proportion of informed order flow because some of the uninformed flow has been siphoned off), so spreads on those markets go up.

And I think this is what really drives the hostility to PFOF. The smarter order flow that has to trade on lit markets doesn’t like the two tiered pricing structure. They would prefer order flow be forced onto lit markets (by restricting PFOF). This would cause the uninformed order flow to cross subsidize the more informed order flow.

The segmentation of order flow may make prices on lit markets less informative. Although the default response among finance academics is to argue that more informative is better, this is not generally correct. The social benefit of more accurate prices (e.g., does that lead to better investment decisions) have not been quantified. Moreover, informed trading (except perhaps, ironically, for true insider trading) involves the use of real resources (on research, and the like). Much of the profit of informed trading is a transfer from the uninformed, and to the extent it is, it is a form of rent seeking. So the social ills of less informative prices arising from the segmentation of order flow are not clearcut: less investment into information may actually be a social benefit.

There is a question of how much of the benefit of PFOF gets passed on to retail traders, and how much the broker pockets. Given the competitiveness of the brokerage market–especially due to the entry of the likes of Robinhood–it is likely a large portion gets passed on to the ultimate customer.

In sum, don’t pose as a defender of the little guy when attacking PFOF. They are the beneficiaries. Those attacking PFOF are actually doing the bidding of large sophisticated and likely better informed investors.

HFT. This one I really don’t get. There is HFT in the stock market. Something bad happened in the stock market. Therefore, HFT caused the bad thing to happen.

The Underpants Gnomes would be proud. I have not seen a remotely plausible causal chain linking HFT to Robinhood’s travails, or the sequence of events that led up to them.

But politicians gonna politician, so we can’t expect high order logical thinking. The disturbing thing is that the high order illogical thinking might actually result in policy changes.

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February 21, 2021

Touching the Third Rail: The Dangers of Electricity Market Design

In the aftermath of the Texas Freeze-ageddon much ink and many pixels have been spilled about its causes. Much–most?–of the blame focuses on Texas’s allegedly laissez faire electricity market design.

I have been intensely involved (primarily in a litigation context) in the forensic analysis of previous extreme electricity market shocks, including the first major one (the Midwest prices spike of June 1998) and the California crisis. As an academic I have also written extensively about electricity pricing and electricity market design. Based on decades of study and close observation, I can say that electricity market design is one of the most complex subjects in economics, and that one should step extremely gingerly when speaking about the topic, especially as it relates to an event for which many facts remain to be established.

Why is electricity market design so difficult? Primarily because it requires structuring incentives that effect behavior over both very long horizons (many decades, because investments in generation and transmission are very long lived) and extremely short horizons (literally seconds, because the grid must balance at every instant in time). Moreover, there is an intimate connection between these extremely disparate horizons: the mechanisms designed to handle the real time operation of the system affect the incentives to invest for the long run, and the long run investments affect the operation of the system in real time.

Around the world many market designs have been implemented in the approximately 25 year history of electricity liberalization. All have been found wanting, in one way or another. They are like Tolstoy’s unhappy families: all are unhappy in their own way. This unhappiness is a reflection of the complexity of the problem.

Some were predictably wretched: California’s “reforms” in the 1990s being the best example. Some were reasonably designed, but had their flaws revealed in trying conditions that inevitably arise in complex systems that are always–always–subject to “normal accidents.”

From a 30,000 foot perspective, all liberalized market designs attempt to replace centralization of resource allocation decisions (as occurs in the traditional integrated regulated utility model) with allocation by price. The various systems differ primarily in what they leave to the price system, and which they do not.

As I wrote in a chapter in Andrew Kleit’s Energy Choices (published in 2006) the necessity of coordinating the operation of a network in real time almost certainly requires a “visible hand” at some level: transactions costs preclude the coordination via contract and prices of hundreds of disparate actors across an interconnected grid in real time under certain conditions, and such coordination is required to ensure the stability of that grid. Hence, a system operator–like ERCOT, or MISO, or PJM–must have residual rights of control to avoid failure of the grid. ERCOT exercised those residual rights by imposing blackouts. As bad as that was, the alternative would have been worse.

Beyond this core level of non-price allocation, however, the myriad of services (generation, transmission, consumption) and the myriad of potential conditions create a myriad of possible combinations of price and non-price allocation mechanisms. Look around the world, and you will see just how diverse those choices can be. And those actual choices are just a small subset of the possible choices.

As always with price driven allocation mechanisms, the key thing is getting the prices right. And due to the nature of electricity, this involves getting prices right at very high frequency (e.g., the next five minutes, the next hour, the next day) and at very low frequency (over years and decades). This is not easy. That is why electricity market design is devilish hard.

One crucial thing to recognize is that constraints on prices in some time frames can interfere with decisions made over other horizons. For example, most of the United States (outside the Southeast) operates under some system in which prices day ahead or real time are the primary mechanism for scheduling and dispatching generation over short horizons, but restrictions on these prices (e.g., price caps) mean that they do not always reflect the scarcity value of generating or transmission capacity. (Much of the rest of the world does this too.) As a result, these prices provide too little incentive to invest in capacity, and the right kinds of capacity. The kludge solution to this is to create a new market, a capacity market, in which regulators decide how much capacity of what type is needed, and mandate that load servers acquire the rights to such capacity through capacity auctions. The revenues from these auctions provide an additional incentive for generators to invest in the capacity they supply.

The alternative is a pure energy market, in which prices are allowed to reflect scarcity value–and in electricity markets, due to extremely inelastic demand and periodic extreme inelasticity of supply in the short run, that scarcity value can sometimes reach the $1000s of dollars.

Texas opted for the energy market model. However, other factors intervened to prevent prices from being right. In particular, heavy subsidies for renewables have systematically depressed prices, thereby undercutting the incentives to invest in thermal generation, and the right kind of thermal generation. This can lead to much bigger price spikes than would have occurred otherwise–especially when intermittent renewables output plunges.

Thus, a systematic downward price distortion can greatly exacerbate upward price spikes in a pure energy model. That, in a nutshell, is the reason for Texas’s recent (extreme) unhappiness.

As more information becomes available, it is clear that the initiator of the chain of events that left almost half the state in the dark for hours was a plunge in wind generation due to the freezing of wind turbines. Initially, combined cycle gas generation ramped up output dramatically to replace the lost wind output. But these resources could not sustain this effort because the cold-related disruptions in gas production, transmission, and distribution turned the gas generators into fuel limited resources. The generators hadn’t broken down, but couldn’t obtain the fuel necessary to operate.

It is certainly arguable that Texas should have recognized that the distortion in prices that arose from subsidization of wind (primarily at the federal level) that bore no relationship whatsoever to the social cost of carbon made it necessary to implement the kapacity market kludge, or some other counterbalance to the subsidy-driven wrong prices. It didn’t, and that will be the subject of intense debate for months and years to come.

It is essential to recognize however, that the underlying reason why a kludge may be necessary is that the price wasn’t right due to government intervention. When deciding how to change the system going forward, those interventions–and their elimination–should be front and center in the analysis and debate, rather than treated as sacrosanct.

There is also the issue of state contingent capacity. That is, the availability of certain kinds of capacity in certain states of the world. In electricity, the states of the world that matter are disproportionately weather-related. Usually in Texas you think of hot weather as being the state that matters, but obviously cold weather matters too.

It appears that the weatherization of power plants per se was less of an issue last week than the weatherization of fuel supplies upstream from the power plants. It is an interesting question regarding the authority of ERCOT–the operator of the Texas grid–extends to mandating the technology utilized by gas producers. My (superficial) understanding is that it is unlikely to, and that any attempt to do so would lead to a regulatory turf battle (with the Texas Railroad Commission, which regulates gas and oil wells in Texas, and maybe FERC).

There is also the question of whether in an energy only market generators would have the right incentive to secure fuel supplies from sources that are more immune to temperature shocks than Texas’s proved to be last week. Since such immunity does not come for free, generator contracts with fuel suppliers would require a price premium to obtain less weather-vulnerable supplies, and presumably a liability mechanism to penalize non-performance. The price premium is likely to be non-trivial. I have seen estimates that weatherizing Texas wells would cost on the order of $6-$9 million per well—which would double or more than the cost of a well. Further, it would be necessary to incur additional costs to protect pipelines and gas processing facilities.

In an energy only market, the ability to sell at high prices during supply shortfalls would provide the incentive to secure supplies that allow producing during extreme weather events. The question then becomes whether this benefit times the probability of an extreme event is larger or smaller than the (non-trivial) cost of weatherizing fuel supply.

We have a pretty good idea, based on last week’s events, of what the benefit is. We have a pretty good idea of the cost of hardening fuel supplies and generators. The most imprecise input to the calculation is the probability of such an extreme event.

Then the question of market design–and specifically, whether weatherization should be mandated by regulation or law, and what form that mandate should take–becomes whether generation operators or regulators can estimate that probability more accurately.

In full awareness of the knowledge problem, my priors are that multiple actors responding to profit incentives will do a better job than a single actor (a regulator) operating under low power incentives, and subject to political pressure (exerted by not just generators, but those producing, processing, and transporting gas, industrial consumers, consumer lobbyists, etc., etc., etc., as well). Put differently, as Hayek noted almost 75 years ago, the competitive process and the price system is a way of generating information and using it productively, and has proved far more effective in most circumstances than centralized planning.

I understand that this opinion will be met with considerable skepticism. But note a few things. For one, a regulator’s mistakes have systematic effects. Conversely, some private parties may overestimate the risk and others underestimate it: the composite signal is likely to be more accurate, and less vulnerable to the miscalculation of a single entity. For another, on the one hand skeptics excoriate a regulator for its failures–but confidently predict that some other future regulator will get it right. I’m the skeptic on that.

Recent events also raise another issue that could undermine reliance on the price system. Many very unfortunately people entered into contracts in which their electricity bills were tied to wholesale prices. As a result, the are facing bills for a few days of electricity running into the many thousands of dollars because wholesale prices spiked. This is indeed tragic for these people.

That spike by the way, is up to $10,000/MWh. $10/KWh. Orders of magnitude bigger than you usually pay.

It is clear that the individuals who entered these contracts did not understand the risks. And this is totally understandable: if you are going to argue that regulators or generators underplayed the risks, you can’t believe that they typical consumer won’t too. I am sure there will be lawsuits relating in particular to the adequacy of disclosure by the energy retailers who sold these contracts. But even if the fine print in the contracts disclosed the risks, many consumers may not have understood them even if they read it.

One of the difficulties with getting prices right in electricity markets which has plagued market design is getting consumers to see the price signals so that they can limit use when supply is scarce. But this will periodically involve paying stratospheric prices.

From a risk bearing perspective this is clearly inefficient. The risk should be transferred to the broader financial markets (though hedging mechanisms, for instance) because the risk can be diversified and pooled in those markets. But this is at odds with the efficient consumption perspective. This is not a circle that anyone has been able to square heretofore.

Moreover, the likely regulatory response to the extreme misfortune experienced by some consumers will be to restrict wholesale prices so that they do not reflect scarcity value. That is, an energy only market has a serious time consistency problem: regulators cannot credibly commit to allow prices to reflect scarcity value, come what may. This means that an energy only market may not be politically sustainable, regardless of its economic merits. I strongly suggest that this will happen in Texas.

In sum, as the title of the book I mentioned earlier indicates, electricity market design is about choices. Moreover, those choices are often of the pick-your-poison variety. This means that avoiding one kind of problem–like what Texas experienced–just opens the door to other problems. Evaluation of electricity market design should not over-focus on the most recent catastrophe while being blind to the potential catastrophes lurking in alternative designs. But I realize that’s not the way politics work, and this will be an intensely political process going forward. So we are likely to learn the wrong lessons, or grasp at “solutions” that pose their own dangers.

As a starting point, I would undo the most clearcut cause of wrong prices in Texas–subsidization of wind and other renewables. Alas, even if stopped tomorrow the baleful effect those subsidies will persist long into the future, because they have impacted decisions (investment decisions) on the long horizon I mentioned earlier. But other measures–such as mandated reserve margins and capacity markets, or hardening fuel supplies–will also only have effects over long horizons. For better or worse, and mainly worse, Texas will operate under the shadow of political decisions made long ago. And made primarily in DC, rather than Austin.

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February 1, 2021

Battle of the Borgs

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Regulation — cpirrong @ 6:39 pm

One metaphor that might shed some light on how seemingly small events can have cascading–and destructive–effects in financial markets is to think of the financial system as consisting of borgs programmed to ensure their survival at all costs.

One type of borg is the clearinghouses/CCP borg. The threat to them is the default of their counterparties. They use margins to protect against these defaults (thereby creating a loser pays/no credit system). When volatility increases, or gap risk increases, or counterparty concentration risk increases–or all three increase–the CCP Borg responds to this greater risk of credit loss by raising margins–sometimes by a lot–in order to protect itself.

This puts other borgs (e.g., Hedge Fund Borgs) under threat. They try to borrow money to pay the CCP Borg’s margin demands. Or they sell liquid assets to raise the cash.

These actions can move prices more–including the prices of things that are totally different from what caused the CCP Borg to raise margins on. This can cause increases in volatility that triggers reactions by other Managed Money Borgs. For example, these Borgs may utilize a Value-at-Risk system to detect threats, and which is programmed to cause the MM Borg to reduce positions (i.e., try to buy and sell stuff) in order to reduce VaR, which can move prices further, triggering more volatility. Moreover, the simultaneous buying and selling of a lot of various things by myriad parties can affect correlations between prices of these various things. And correlation is an input into the borgs’ model, so this can lead to more borg buying and selling.

All of these price changes and volatility changes can impact other borgs. For example, increases in volatilities and correlations in many assets that results from Managed Money Borgs’ buying and selling will feed back to the CCP Borgs, whose self-defense models are likely to require them to increase their margins on many more instruments than they increased margins on in the first place.

This is how seemingly random, isolated shocks like retail trader bros piling into heavily shorted, but seemingly trivial, stocks can spill over into the broader financial system. Borgs programmed to survive, acting in self-defense, take actions that benefit themselves but have detrimental effects on other borgs, who act in self-defense, which can have detrimental effects on other borgs, and . . . you get the picture.

This is a quintessential example of “normal accidents” in a complex system with tightly coupled components. Other examples include reactor failures and plane crashes.

I note–again, reprising a theme of the Frankendodd Years of this blog–that clearing and margins are a major reason for tight coupling, and hence greater risk of normal accidents.

I note further that it is precisely the self-preservation instincts of the borgs that makes it utterly foolish and clueless to say that creating stronger borgs with more powerful tools of self-preservation, and which interact with other borgs, will reduce systemic risk. This is foolish and clueless precisely because it is profoundly unsystemic thinking because it views the borgs in isolation and ignores how the borgs all interact in a tightly coupled system. Making borgs stronger can actually make things worse when their self-preservation programs kick in, and the self-preservation of one borg causes it to attack other borgs.

Why do teenagers in slasher flicks always go down into the dark basement after five of their friends have been horribly mutilated? Well, that makes about as much sense as a lot of financial regulators have in the past decades. Despite literally centuries of bad historical experiences, they have continued to try to make stronger, mutually interacting, borgs. Like Becky’s trip down the dark basement stairs, it never ends up well.

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January 29, 2021

GameStop-ped Up Robinhood’s Plumbing

The vertigo inducing story of GameStop ramped it up to 11 yesterday, with a furore over Robinhood’s restriction of trading in GME to liquidation only, and the news that it had sold out of its customers’ positions without the customers’ permission. These actions are widely perceived as an anti-populist capitulation to Big Finance.

Well, they are in a way–but NOT the way that is being widely portrayed. What is going on is an illustration of the old adage that clearing and settlement in securities markets (like the derivatives markets) is like the plumbing–you take it for granted until the toilet backs up.

You can piece together that Robinhood was dealing with a plumbing problem from a couple of stories. Most notably, it drew down on credit lines and tapped some of its big executing firms (e.g., Citadel) for cash. Why would it need cash? Because it needs to post margin to the Depositary Trust Clearing Corporation (DTCC) on its open positions. Other firms are in similar situations, and directly or indirectly GME positions give rise to margin obligations to the DTCC.

The rise in price alone increased margin requirements because given volatility, the higher the price of a stock, the larger the dollar amount of potential loss (e.g., the VaR) that can occur prior to settlement. This alone jacks up margins. Moreover, the increase in GME volatility, and various adders to margin requirements–most notably for gap risk and portfolio concentration–ramp up margins even more. So the action in GME has led to a big increase in margin requirements, and a commensurate need for cash. Robinhood, as the primary venue for GME buyers, had/has a particularly severe position concentration/gap problem. Hence Robinhood’s scramble for liquidity.

Given these circumstances, liquidity was obviously a constraint for Robinhood. Given this constraint, it could not handle additional positions, especially in GME or other names that create particularly acute margin/liquidity demands. It was already hitting a hard constraint. The only practical way that Robinhood (and perhaps other retail brokers, like TDAmeritrade) could respond in the short run was trading for liquidation only, i.e., allow customers to sell their existing GME positions, and not add to them.

By the way, trading for liquidation is a tool in the emergency action toolbook that futures exchanges have used from time-to-time to deal with similar situation.

To extend the plumbing analogy, Robinhood couldn’t add any new houses to its development because the sewer system couldn’t handle the load.

I remember some guy saying that clearing turns credit risk into liquidity risk. (Who was that guy? Pretty observant!) For that’s exactly what we are seeing here. In times of market dislocation in particular, clearing, which is intended to mitigate credit risk, creates big increases in demand for liquidity. Those increases can cause numerous knock on effects, including dislocations in markets totally unrelated to the original source of the dislocation, and financial distress at intermediaries. We are seeing both today.

It is particularly rich to see the outrage at Robinhood and other intermediaries expressed today by those who were ardent advocates of clearing as the key to restoring and preserving financial stability in the aftermath of the Financial Crisis. Er, I hate to say I told you so, but I told you so. It’s baked into the way clearing works, and in particular the way that clearing works in stressed market conditions. It doesn’t eliminate those stresses, but transfers them elsewhere in the financial system. Surprise!

The sick irony is that clearing was advocated as a means to tame big financial institutions, the banks in particular, and reduce the risks that they can impose on the financial system. So yes, in a very real sense in the GME drama we are seeing the system operate to protect Big Finance–but it’s doing so in exactly the way many of those screaming loudest today demanded 10 years ago. Exactly.

Another illustration of one of my adages to live by: be very careful what you ask for.

Margins are almost certainly behind Robinhood’s liquidating some customer accounts. If those accounts become undermargined, Robinhood (and indeed any broker) has the right to liquidate positions. It’s not even in the fine print. It’s on the website:

If you get a margin call, you need to bring your portfolio value (minus any cryptocurrency positions) back up to your minimum margin maintenance requirement, or you risk Robinhood having to liquidate your position(s) to bring your portfolio value (minus any cryptocurrency positions) back above your margin maintenance requirement.

Another Upside Down World aspect of the outrage we are seeing is the stirring defenses of speculation (some kinds of speculation by some people, anyways) by those in politics and on opinion pages who usually decry speculation as a great evil. Those who once bewailed bubbles now cheer for them. It’s also interesting to see the demonization of short sellers–whom those with average memories will remember were lionized (e.g., “The Big Short”) for blowing the whistle on the housing boom and the bank-created and -marketed derivative products that it spawned.

There are a lot of economic issues to sort through in the midst of the GME frenzy. There will be in the aftermath. Unfortunately, and perhaps not surprisingly given the times, virtually everything in the debate has been framed in political terms. Politics is all about distributive effects–helping my friends and hurting my enemies. It’s hard, but as an economist I try to focus on the efficiency effects first, and lay out the distributive consequences of various actions that improve efficiency.

What are the costs and benefits of short selling? Should the legal and regulatory system take a totally hands off approach even when prices are manifestly distorted? What are the costs and benefits of various responses to such manifest price distortions? What are the potential unintended consequences of various policy responses (clearing being a great example)? These are hard questions to answer, and answering them is even harder in the midst of a white-hot us vs. them political debate. And I can say with metaphysical certainty that 99 percent of the opinions I have seen expressed about these issues in recent days are steeped in ignorance and fueled by emotion.

There are definitely major problems–efficiency problems–with Big Finance and the regulation thereof. Ironically, many of these efficiency problems are the result of previous attempts to “solve” perceived problems. But that does not imply that every action taken to epater les banquiers (or frapper les financiers) will result in efficiency gains, or even benefit those (often with justification) aggrieved at the bankers. I thus fear that the policy response to GameStop will make things worse, not better.

It’s not as if this is new territory. I am reminded of 19th century farmers’ discontent with banks, railroads, and futures trading. There was a lot of merit in some of these criticisms, but all too often the proposed policies were directed at chimerical wrongs, and missed altogether the real problems. The post-1929 Crash/Great Depression regulatory surge was similarly flawed.

And alas, I think that we are doomed to repeat this learning the wrong lessons in the aftermath of GameStop and the attendant plumbing problems. Virtually everything I see in the public debate today reinforces that conviction.

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January 25, 2021

LNG Skyrockets: Is Excessive Reliance on Spot Markets to Blame, and Will This Cause Contracting Practices to Change?

Filed under: China,CoronaCrisis,Derivatives,Economics,Exchanges,LNG — cpirrong @ 8:26 pm

After languishing in the doldrums in the Covid era, and at times touching historic lows, the price of LNG delivered to Asia skyrocketed in recent weeks before plunging almost as precipitously:

As always happens with such big price moves, there has been an effort to round up suspects. Here, since the visible price increase occurred in the spot market, the leading culprit is the spot market–something that has been growing rapidly in recent years, after being largely non-existent prior to 2014 or so.

For example, Reuters’ Clyde Russell writes:

What is more likely is that some buyers misjudged the availability of spot cargoes, and when hit with a surge in demand found themselves unable to secure further supply, thus bidding up the prices massively for the few cargoes still available.

Frank Harris of Wood Mackenzie opines:

“Buyers are going to become aware that you may not always be physically able to source a cargo in the spot market regardless of price,” Mr Harris says. “The most likely outcome is it shatters some of the complacency that’s crept into the market over the last 12-18 months.”

It is incorrect to say that a shortage of spot cargoes per se is responsible for the price spike registered in the spot market. It is the supply of LNG in toto, relative to massive increase in demand due to frigid weather, that caused the price increase. How that supply was divided between spot and non-spot trades is a secondary issue, if that.

The total supply of LNG, and the spatial distribution of that supply, was largely fixed when the cold snap unexpectedly hit. So in the very short run relevant here (days or weeks), supply in Asia was extremely inelastic, and a demand increase would inevitably cause the value of the marginal molecule to rise dramatically. Price is determined at the margin, and the price of the marginal molecule would be determined in the spot market regardless of the fraction of supply traded in that market. Furthermore, the price of that marginal molecule would likely be the same regardless of whether 5 percent or 95 percent of volume traded spot.

If anything, the growing prevalence of spot contracting in recent years mitigated the magnitude of the price spike. Traditional long term contracts, especially those with destination clauses, limited the ability to reallocate supplies efficiently to meet regional demand shocks. The more LNG effectively unavailable to be reallocated to the buyers that experienced the biggest demand shocks, the less elastic supply in the spot market, and the bigger the price increase that occurs in response to a given demand shock. That is, having less gas contractually committed, especially under contracts that limited the ability of the buyers to sell on to those who value it more highly, mitigates price spikes.

That said, the fundamental factors that limit the total availability of physical gas, and constrain the ability to move it from low demand locations to high demand locations in the short time frames necessary to meet weather-driven demand changes (ships can’t magically and instantaneously move from the Atlantic Basin to the Far East), mean that regardless of the mix of spot vs. contract gas prices would have spiked.

Some have suggested that the price spike will lead to less spot contracting. Clyde Russell again:

The question is whether utilities, such as Japan’s JERA, continue with their long-term vision of moving more toward a spot and short-term market, or whether the old security blanket of oil-linked, but guaranteed, supplies regains some popularity.

It’s likely LNG buyers don’t want a repeat of the recent extreme volatility, but perhaps they also don’t want to return to the restrictive crude-linked contracts that largely favoured producers by guaranteeing volumes at relatively high prices.

The compromise may be the increasing popularity of short-term, flexible contracts, which can vary from a few months to a few years and be priced against different benchmarks.

Well, maybe, but color me skeptical. For one thing, contracts require a buyer and a seller. Yes, buyers who didn’t have long term contracts probably regretted paying high spot prices–but the sellers with uncommitted volumes really liked it. The spike may increase the appetite for buyers to enter long term contracts, but decrease the appetite of sellers to enter them. It’s not obvious how this will play out.

I note that the situation was reversed in 2020–buyers regretted long term contracts, but sellers were glad to have them. Ex post regret is likely to be experienced with equal frequency by buyers and sellers, so it’s hard to see how that tips contracting one way or the other.

This conjecture about the price spike leading to more long term contracting also presupposes that the only way of managing price risks is through fixed price contracts (or oil-indexed) contracts for physical supply. But that’s not true. Derivatives allow the separation of who bears price risk from the physical contracting decision. A firm buying spot (and who is hence short LNG) can hedge price risk by purchasing JKM swaps. This has the additional advantage of allowing the adjustment of the size of the hedge in response to more timely information regarding likely quantity requirements, price projections, and risk appetite than is possible with a long term contract. That is, derivatives permit unbundling of price risk from obtaining physical supplies, whereas long term contracts bundle those to a considerable degree. Moreover, derivatives plus short term/spot acquisition of physical supplies allows more flexible management of supply, and management of supply based on shorter term forecasts of need: these shorter term forecasts are inherently more accurate than forecasts over contracting horizons of years or even decades.

So rather than lead to more long term contracts, I predict that this recent price spike is more likely provide a fillip to the LNG derivatives market. Derivatives are a more flexible and cheaper way to manage price risk than long term contracts.

This is what happened in the pipe gas market in the US post-deregulation. Spot/short term volumes grew dramatically even though price spikes were a regular feature of the market: market participants used gas futures and swaps and options to manage these price risks, and benefited from the greater flexibility and precision of obtaining supplies on a shorter term basis. This shifted a lot of the price risk to the financial sector–which is the great benefit of the much bewailed “financialization” of commodity markets.

The same is likely to occur in LNG.

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December 17, 2020

Water, Water Everywhere–and Don’t Let the UN Anywhere Near It

Filed under: Commodities,Derivatives,Economics,Politics,Regulation — cpirrong @ 2:04 pm

For a perfect illustration of why the UN (and most NGOs and most of those talking about Great Resets and the like) represent a grave threat to the lives, health, and livelihoods of those whom they claim to want to help, consider this ignorant drivel on the introduction of water futures on the CME from  Pedro Arrojo-Agudo, the UN’s “special rapporteur on the human rights to safe drinking water and sanitation.” (Hey! He’s not just an everyday run of the mill rapporteur! He’s a special rapporteur!).

According to Bloomberg, water futures “risks a price run-up for a resource that ‘belongs to everyone’ and is a vital tool in combating the Covid-19 pandemic.” Further:

“The news that water is to be traded on Wall Street futures market shows that the value of water, as a basic human right, is now under threat,” Arrojo-Agudo said in a statement. “It is closely tied to all of our lives and livelihoods, and is an essential component to public health.”

Beyond the fact that the reference to “Wall Street futures market” is ignorant (and an offense to Chicagoans!), this short statement is packed with more substantive economic ignorance.

Oh, the blather sounds good: water is “a human right” that “belongs to everyone.” Yay! But it’s exactly this kind of crypto-socialist blather that wreaks great harm when put into actual policy.

For one thing, something that “belongs to everyone” ends up belonging to no one. Or more precisely winds up being grossly misallocated or misused or wasted. Those who don’t own have no incentive to utilize wisely. They have too little incentive to avoid polluting. They have little incentive to increase availability or quality. Indeed, I warrant that many–and arguably the lion’s share–of the problems that Mr. Arrojo-Agudo is rapporteuring about (or whatever it is that rapporteurs do) are directly attributable to the lack of property rights in water, or grossly suboptimal rights. Relatedly, they are directly attributable to the lack of market mechanisms built on property rights to allocate a scarce resource–clean water–and the reliance on political mechanisms plagued by rent seeking and corruption to do so.

It’s not easy to design and enforce property rights for water, for a variety of reasons. Some of these reasons inhere in the nature for water. For example, designing and enforcing rights to an aquifer are challenging. But many of the problems are political, and public choice in nature. Look at the conflicts over water in the American West for myriad illustrations.

But grasping the nettle of these challenges, and even doing it imperfectly, is distinctly preferable to the policies that arise from an “it belongs to everyone” attitude. That is a recipe for dissipation, waste, and pollution. Water socialism works just as badly as all the other kinds.

As for the “speculative bubble” fears, such creatures are far more common in the fevered imaginations of the likes of UN rapporteurs, NGO nudniks, etc., than in the wild. They hysteria over an oil price bubble in 2007-2008 is an example. This is something that even Paul Krugman and I agree on. Show me a commodity price bubble, and I have a high degree of confidence that it can be explained by fundamental factors. Indeed, interventions intended to combat these bubbles almost always lead to less efficient resource utilization than the alleged bubbles themselves. Price “bubbles” in commodities are usually simply the bearers of bad fundamental tidings.

That is, attempting to suppress “price run-ups” makes things worse, not better.

I’ve already opined that I consider it unlikely that the CME/Nasdaq water futures will register much trading volume, for relatively technical reasons. The same reasons apply to other possible water futures contracts. So Mr. Arrojo-Agudo should direct his nervous energy to other subjects.

But the anti-property, anti-market mindset that the UN rapporteur embodies is a grave threat to prosperity and health. This mindset makes people poorer and more miserable wherever it rules policy. Which is why the UN, NGOs, Great Resetters, and the like pose a far greater danger than all the speculative bubbles ever stacked one atop the other.

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October 22, 2020

VOLT Redux

Filed under: Clearing,Derivatives,Economics,Exchanges,Regulation — cpirrong @ 6:44 pm

The very first substantive post on this blog, almost 15 years ago, was about a failure of the electronic trading system at the Tokyo Stock Exchange.

Whoops, they did it again!

Apparently believing that misery loves company, Euronext has also experienced failures.

Euronext’s problems seem quite more frightening, because they involve the out-trade from hell: reversing the polarity on transactions:

“It has been identified that some of the 19/10 trades sent yesterday to the CCPs (central counterparty clearing house) had the wrong buy/sell direction”, Euronext said.

Thought you were long? Hahahahahaha. You’re short, sucker!

I hate it when that happens! (Yes, Euronext reversed the trades after it realized the problem.)

The lessons of my “Value of Lost Trade” (“VOLT”) piece still hold. It is inefficiently costly to drive the probability of a failure to zero. Whether exchanges have the efficient probability of failure (or really, the efficient vector of failure probabilities, because there are multiply types of failure) depends on the value of foregone trades when a system is down (or the cost of other types of errors, such as reversing trade direction).

Meaning that system failures will continue to occur, and long after this blog fades away.

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September 26, 2020

Water, Water, Not Everywhere and Still Not a Drop to Drink, Or, The Very Natural State

Filed under: Climate Change,Derivatives,Economics,Exchanges,Politics,Regulation — cpirrong @ 2:53 pm

The WSJ reports that the CME Group is launching a cash-settled futures contract on California water, with Nasdaq providing the cash price index. I predict, with a high degree of confidence, that this will not be a commercial success. That is, it will not generate substantial trading volume.

Why not? For the same reason that listed weather derivatives hardly ever trade. Information flow is a necessary (but not sufficient) condition to make people want to trade. For weather derivatives, there is very little information flow until shortly prior to the pricing month. For example, what information arrives between today and tomorrow that leads to updates in forecasts about what the weather in Chicago will be in December 2020, let alone December 2021? Virtually none. Given the nature of weather dynamics, information flow occurs almost exclusively quite close to the contract date (e.g., in late-November 2020 or 2021, if not in December itself). There is little information that arrives today that would motivate people to trade today contracts with payoffs contingent on future weather, even for a future only months away.

So they don’t.

I predict a similar phenomenon for water derivatives. Most of the fundamental shocks are weather-driven, and those will be concentrated close to the pricing month, leading to little demand to trade prior thereto.

Moreover, successful futures contracts rest on functional physical markets. As this recent article from The American Spectator summarizes, it is a travesty to characterize the means of allocating water in California as “a market.” Instead, it is an intensely politicized process.

If you don’t consider the AmSpec reliable, do a little digging into the scholarly literature about water allocation in the West, notably things written by my friend Gary Libecap. The conclusions are depressingly similar.

The politicization of water allocation is not new. It has existed since the beginning not just in California, but the West generally. Control of water confers enormous political power. You think politicians are going to give that up?

Again, this is not a new thing. Read up on the “California Water Wars.” Or, for a more entertaining take, watch Chinatown, which is a fictionalization/mythologization of the conflict of visions between William Mulholland and Frederick Eaton over water in Los Angeles. Spoiler: the romantic vision died (literally drowned), and the corrupt vision prevailed.

California politicians will become charismatic Catholics before they give up control over water. In a way, it reminds me of the effect of sanctions in say Saddam’s Iraq. Restrictions on supply resulting from sanctions empowered the regime. It could use its power to grant access to a vital resource in order to obtain obeisance. Similarly, California politicians can use their power to grant access to the vital resource of water to obtain political support, and exercise political power.

In a way, this is the quintessence of something I used to write about in regards to Russia: “the natural state.” Here, the analogy is even more trenchant, given that it relates to a natural resource.

The natural state operates by creating artificial scarcity, which in turn creates rents. The natural state allocates those rents in exchange for political patronage.

To do things that would undermine the rents–that is, to alleviate the scarcity–would undermine political power. That will NOT happen voluntarily. Markets for water would be a good thing–which is precisely why they don’t exist, and are unlikely to exist, especially in places like California where water is scarce and hence real markets would be most beneficial.

So CME/Nasdaq California water futures face two huge obstacles. First, even if even a simulacrum of a cash market for water existed, the nature of information flows is not conducive to active trading of water futures. Second, there is not even a simulacrum of a water market in California. What exists in place of a market is a political, and highly politicized, mechanism. That is also inimical to building a successful futures contract on top of it.

PS. Riffing of the Rime of the Ancient Mariner in the title provides an opportunity for another Python reference!


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