Streetwise Professor

March 24, 2022

The London Mulligan Exchange

Filed under: China,Clearing,Commodities,Derivatives,Economics,Regulation — cpirrong @ 3:58 pm

The LME restarted trading of nickel. Well, sort of. In the first five sessions prices were limit down, and trading stopped as soon as the limits were hit. The LME deemed two subsequent sessions “disrupted” and declared the trades in these sessions “null and void.”

In other words: more mulligans after the trade cancellations that followed the spike to $100K/tonne prices. The LME should change its name to the London Mulligan Exchange. Which is not a good look.

Departing LME CEO Matthew Chamberlain tried to shift blame last week, claiming that the problem was that the exchange did not have visibility into risk due to the fact that approximately 80 percent of Tsingshan’s nickel position was in the form of OTC trades with big banks, such as JP Morgan. This is weak excuse. It is highly likely that the banks hedged their Tsingshan exposure on the LME, so the exchange saw the positions, but just didn’t know for sure exactly who was behind them. But the LME has known for months (years actually) that Tsingshan was the elephant in the nickel ring, and that the banks who were short the LME were almost certainly hedging an OTC exposure. The LME should have been able to add two and two.

The price increases today and in the previous session suggest that the short covering is ongoing, and that the “I’m going to hang on to my position” rhetoric from Tsingshan, and the insinuations that the banks were allowing it to extend and pretend, are therefore not correct. It (and perhaps other shorts) are trying to reduce positions. Continued gyrations are therefore likely, and a default that would make recent “disruptions” look like child’s play is not out of the question. The fear of this is likely what is causing the LME to take actions (voiding trades) that only further blacken its already dusky reputation. To a fox caught in a trap, chewing off a leg is the best option.

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March 16, 2022

The Current Volatility Is A Risk to Commodity Trading Firms, But They are Not Too Big to Fail

The tumult in the commodity markets has led to suggestions that major commodity trading firms, e.g., Glencore, Trafigura, Gunvor, Cargill, may be “Too Big to Fail.”

I addressed this specific issue in two of my Trafigura white papers, and in particular in this one. The title (“Not Too Big to Fail”) pretty much gives away the answer. I see no reason to change that opinion in light of current events.

First, it is important to distinguish between “can fail” and “too big to fail.” There is no doubt that commodity trading firms can fail, and have failed in the past. That does not mean that they are too big to fail, in the sense that the the failure of one would or could trigger a broader disruption in the financial markets and banking system, a la Lehman Brothers in September 2018.

As I noted in the white paper, even the big commodity trading firms are not that big, as compared to major financial institutions. For example, Trafigura’s total assets are around $90 billion at present, in comparison to Lehman’s ~$640 billion in 2008. (Markets today are substantially larger than 14 years ago as well.). If you compare asset values, even the biggest commodity traders rank around banks you’ve never heard of.

Trafigura is heavily indebted (with equity of around $10 billion), but most of this is short term debt that is collateralized by relatively liquid short term assets such as inventory and trade receivables: this is the case with many other traders as well. Further, much of the debt (e.g., the credit facilities) are syndicated with broad participation, meaning that no single financial institution would be compromised by a commodity trader default. Moreover, trading firm balance sheets are different than banks’, as they do not engage in the maturity or liquidity transformation that makes banks’ balance sheets fragile (and which therefore pose run risk).

Commodity traders are indeed facing funding risks, which is one of the risks that I highlighted in the white paper:

The extraordinary price movements across the entire commodity space have resulted in a large spike in funding needs, both to meet margin calls (which at least in oil should have been reversed with the price decline in recent days–nickel remains to be seen given the fakakta price limits the LME imposed) and higher initial and maintenance margins (which exchanges have hiked–in a totally predictable procyclical fashion). As a result existing lines are exhausted, and firms are either scrambling to raise additional cash, cutting positions, or both. As an example of the former, Trafigura has supposedly held talks with Blackstone and other private equity firms to raise $3 billion in capital. As an example of the latter, open interest in oil futures (WTI and Brent) has dropped off as prices spiked.

To the extent margin calls were on hedging positions, there would have been non-cash gains to offset the losses on futures and other derivatives that gave rise to the margin calls. This provides additional collateral value that can support additional loans, though no doubt banks’ and other lenders terms will be more onerous now, given the volatility of the value of that collateral. All in all, these conditions will almost certainly result in a scaling back in trading firms’ activities and a widening of gross margins (i.e., the spread between traders’ sale and purchase prices). But the margin calls per se should not be a threat to the solvency of the traders.

What could threaten solvency? Basis risk for one. For examples, firms that had bought (and have yet to sell) Russian oil or refined products or had contracts to buy Russian oil/refined products at pre-established differentials, and had hedged those deals with Brent or WTI have suffered a loss on the blowout in the basis (spread) on Russian oil. Firms are also likely to handle substantially lower volumes of Russian oil, which of course hits profitability.

Another is asset exposure in Russia. Gunvor, for example, sold of most of its interest in the Ust Luga terminal, but retains a 26 percent stake. Trafigura took a 10 percent stake in the Rosneft-run Vostok oil project, paying €7 billion: Trafigura equity in the stake represented about 20 percent of the total. A Vitol-led consortium had bought a 5 percent stake. Trafigura is involved in a refinery JV in India with Rosneft. (It announced its intention to exist the deal last autumn, but I haven’t seen confirmation that it has.). If it still holds the stake, I doubt it will find a lot of firms willing to step up and pay to participate in a JV with Rosneft.

It is these types of asset exposures that likely explain the selloff in Trafigura and Gunvor debt (with the Gunvor fall being particularly pronounced.). Losses on Russian assets are a totally different animal than timing mismatches between cash flows on hedging instruments and the goods being hedged caused by big price moves.

But even crystalization of these solvency risks would likely not lead to a broader fallout in the financial system. It would suck for the owners of a failed company (e.g., Torben Tornqvuist, who owns ~85 percent of Gunvor) but that’s the downside of the private ownership structure (something also discussed in the white papers); Ferrarri and Bulgari sales would fall in Geneva; banks would take a hit, but the losses would be fairly widely distributed. But in the end, the companies would be restructured, and during the restructuring process the firms would continue to operate (although at a lower scale), some of their business would move to the survivors (it’s an ill wind that blows no one any good), and commodities would continue to move. Gross margins would widen in the industry, but this would not make a huge difference either upstream or downstream.

I should also note that the Lehman episode is likely not an example of a domino effect in the sense that losses on exposures to Lehman put other banks into insolvency which harmed their creditors, etc. Instead, it was more likely an informational cascade in which its failure sent a negative signal about (a) the value of assets held widely by other banks, and (b) what central banks could or would do to support a failing financial institution. I don’t think those forces are at work in commodities at prsent.

The European Federation of Energy Traders has called upon European state bodies like European Investment Bank or the ECB to provide additional liquidity to the market. There is a case to be made here. Even though funding disruptions, or even the failure of commodity trading firms, are unlikely to create true systemic risks, they may impede the flow of commodities. Acting under the Bagehot principle, loans against good collateral at a penalty rate, is reasonable here.

The reason for concern about the commodity shock is not that it will destabilize commodity trading firms, and that this will spill over to the broader financial system. Instead, it is that the price shock–particularly in energy–will result in a large, worldwide recession that could have financial stability implications. Relatedly, the food price shocks in particular will likely result in massive civil disturbances in low income countries. A reprise of the Arab Spring is a serious possibility.

If you worry about the systemic effects of a commodity price shock, those are the things you should worry about. Not whether say Gunvor goes bust.

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March 11, 2022

Direct Clearing at FTX: A Corner Solution, and Likely a Dead End With Destabilizing Potential

In a weird counterpoint to the LME nickel story, another big clearing-related story that is causing a lot of consternation in derivatives circles is FTX exchange’s proposal to move to a direct clearing model that would dispense with FCMs as intermediaries. Instead of having an FCM interposed between a customer and the clearinghouse, the customer interfaces directly with the FTX Derivatives Clearing Organization (DCO).

What is crucial here is how this is supposed to work: FTX will utilize near real time mark-to-market and variation margin payments. Moreover, the exchange will automate the liquidation of undermargined positions, again basically in real time.

The mechanics are described here.

FTX describes this as being the next big thing in the derivatives markets, and a way of addressing systemic risks. Basically the pitch is simple: “real time margining allows us to operate a pure no credit/loser pays system.”

FTX touts this as a feature, but as the nickel experience demonstrates (and other previous episodes demonstrate) it is not. Margining generally can be destabilizing, especially during stressed market conditions, and the model FTX is advancing exacerbates the destabilizing potential of margining.

The mechanical means of addressing margin shortfalls on a real time frequency increases the tight coupling on the exchange, and is tailor made to create destabilizing positive feedback loops: prices move a lot leading to margin shortfalls in real time that trigger real time trades that accentuate the price movement. It is like seeding the market with huge numbers of stop orders, which are inherently destabilizing. Further, they can create incentives to manipulate. Anyone who can get some idea of where the stops are can “gun the stops” and trigger big price moves.

This instability potential can be exacerbated by the ability of traders to hold collateral in the form of the “underlying” (i.e., crypto, at present). Well, the collateral value can fluctuate, and that can contribute to margin shortfalls which again trigger stops.

Market participants can mitigate getting stopped out by substantially over-margining, i.e., holding a lot of excess margin in their FTX account. But this is a cash inefficient way of trading.

It’s not clear to me whether FTX will pay interest on collateral. It seems not. Hmmm. Implementing a model that incentivizes holding a lot of extra cash at FTX and not paying interest. Cynic that I am, that seems to be a great way to bet on higher interest rates! Maybe that’s FTX’s real game here.

I would also note that the “no leverage” story here reflects a decidedly non-systemic view (something that I pointed out years ago in my critiques of clearing mandates). Yes, real time margining plus holding of substantial excess margin reduces to a small level the amount of leverage extended by the CCP/DCO. But that is different than reducing the amount of margin in the system as a whole. People who have borrowing capacity and optimal total leverage targets can fund their deposits at FTX with leverage from other sources. They can offset the leverage they normally obtain from FCMs by taking more leverage from other sources.

In sum, FTX is arguing that its mechanism of direct clearing and real time margining creates a far more effective “no credit” clearing system than the existing FCM-intermediated structure. That’s likely true. But as I’ve banged on about for years, that’s not necessarily a good thing. The features that FTX touts as advantages have very serious downsides–especially in stressed market conditions where they tend to accelerate price moves rather than dampen them.

Insofar as this being a threat to the existing intermediated system, which many in the industry appear to fear, I am skeptical. In particular, the cash inefficiency of this mechanism will make it unattractive to many market participants. Not to be Panglossian, but the existing intermediated system evolved as it did for good economic reasons. It trades off credit risk and liquidity risk. It does so in a somewhat discriminating way because it takes into account the creditworthiness of market participants (something that FTX brags is unnecessary in its system). FTX is something of a corner solution that the market has not adopted despite the opportunity to do so. As a result, I don’t think that corner solution will have widespread appeal going forward.

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A Nickel is Now Worth a Dime: Is the LME Too?

Filed under: China,Clearing,Commodities,Derivatives,Economics,Energy,Regulation,Russia — cpirrong @ 12:18 pm

If you use the official LME nickel and copper prices from Monday, before the exchange stopped trading of nickel, you can determine that the value of the metal in a US nickel coin is worth a dime. As the shutdown lingers, one wonders whether the LME is too.

The broad contours of the story are understood. A large Chinese nickel firm (Tsingshan Holdings, largest in the world) was short large amounts of LME nickel, allegedly as a hedge. But the quantity involved seems very outsized as a hedge, representing something like two years of output. And if the position was concentrated in nearby prompt dates (e.g., 3 months) it involved considerable curve risk.

The Russian invasion juiced the price of nickel, not surprising given Russia’s outsized presence in that market. That triggered a margin call (allegedly $1 billion) that the firm couldn’t meet–or chose not to. That led its brokers to try to liquidate its position in frenzied buying on Monday evening. This short covering drove the price from the close of around $48,000 to over $100,000.

That’s where things got really sick. The LME shut the nickel market. It was supposed to reopen today, but that’s been kicked down the road. But the LME didn’t stop there. It decided that these prices did not “[reflect] the the underlying physical market,” and canceled the trades. Tore them up. Poof! Gone!

Now in a Back to the Future moment echoing the 1985 Tin Crisis, the LME is trying to get the longs and shorts to set off their positions. “Can’t we all just get along?” Well likely not, because it obviously requires agreeing on a price. Which is obviously devilish hard, if not impossible given how much money changes hands with every change in price. (In my 1995 JLE paper on exchange self-regulation, I argued that exchanges historically did not want to intervene in this fashion even during obvious manipulations because of the rent seeking battles this would trigger.)

So the LME remains closed.

Some observations.

First, told ya. Seriously, in my role as Clearing Cassandra during the Frankendodd era, I said (a) clearing was not a panacea that would prevent defaults, and (b) the clearing mechanism was least reliable precisely during periods of major market stress, and that the rigid margining mechanism is what would threaten its ability to operate. That’s exactly what happened here.

Second, clearing is supposed to operate under a “loser pays/no credit” model. That’s really something of a misconception, because even though the clearinghouse does not extend credit, intermediaries (brokers/FCMs) routinely do to allow their clients to meet margin calls. But here we evidently have a situation in which the brokers (or Tsingshan’s banks) were unwilling or unable to do so, which led to the failure of the loser to pay.

Third, by closing the market, the LME is effectively extending credit (“you can pay me later”), and giving Tsingshan (and perhaps other shorts) some time to stump up some additional loans. Apparently JPM and the Chinese Construction Bank have agreed in principle to do so, but a deal has been hung up over what collateral Tsingshan will provide. So the market remains closed.

For its part, Tsingshan and its boss Xiang “Big Shot” Guangda are hanging tough. The company wants to maintain its short position. Arguably it has a strong bargaining position. To modify the old joke, if you owe the clearinghouse $1 million and can’t pay, you have a problem: if you owe the clearinghouse billions and can’t pay, the clearinghouse has a problem.

The closure of the market and the cancelation of the trades suggests that the LME has a very big problem. The exact amounts owed are unknown, but demanding all amounts owed now could well throw many brokers into default, and the kinds of numbers being discussed are as large or larger than the LME’s default fund of $1.2 billion (as of 3Q21 numbers which were the latest I could find).

So it is not implausible that a failure to intervene would have resulted in the insolvency of LME Clear.

The LME has taken a huge reputational hit. But it had to know it would when it acted as it did, implying that the alternative would have been even worse. The plausible worst alternative would have been a collapse of the clearinghouse and the exchange. Hence my quip about whether the exchange that trades nickel is worth a dime.

Among the reputational problems is the widespread belief that the Chinese-owned exchange intervened to bail out Chinese brokerage firms and a Chinese client. To be honest, this is hard to differentiate from intervening to save itself: the failure of the brokerages are exactly what would have brought the exchange into jeopardy.

I would say that one reason Xiang is hanging tough is that the CCP has his back. Not CCP as in central counterparty, but CCP as in Chinese Communist Party. That would give Tsingshan huge leverage in negotiations with banks, and the LME.

So the LME is playing extend and pretend, in the hope that it can either strongarm market participants into closing out positions, or prices return to a level that reduce shorts’ losses and therefore the amounts of variation margin they need to pay.

I seriously wonder why anyone would trade on the open LME markets (e.g., copper) for reasons other than reducing positions–and therefore reducing their exposure to LME Clear. The creditworthiness of LME Clear is obvious very dodgy, and it is potentially insolvent.

Fourth, in an echo of the first point, this episode demonstrates that central clearing, with its rigid “no credit” margining system is hostage to market prices. This is usually presented as a virtue, but when markets go wild it is a vulnerability. Which is exactly why it is–and always was–vain to rely on clearing as a bulwark against systemic risk. It is most vulnerable precisely during periods of market stress.

All commodity markets are experiencing large price movements that are creating extraordinary variation margin flows, potential positive feedbacks, and the prospect for troubles at other clearers. Further, the broader economic fallout from the Ukraine war (which includes, for example, a large recession resulting from the commodity price shocks, or a Russian debt default) has the real potential to disrupt equity and bond markets. This would put further strains on the financial markets, and the clearing system in particular. Central Banks–notably the Fed–had to supply a lot of liquidity to address shocks during the Covid Panic of March 2020. Two years later, they may have to ride to the rescue again.

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November 26, 2021

Boris’ Big Short

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — cpirrong @ 8:09 pm

Due to the immovable object of price caps and the irresistible force of spiking natural gas and power costs, about 20 retail energy suppliers in the UK have gone toes up. Most of these have been addressed using what is called the Supplier of Last Resort (SoLR) mechanism, whereby customers of the failed firm are transferred to another supplier. (SoL sounds about right!) This mechanism effectively socializes losses:

Energy suppliers that rescue customers via the supplier of last resort can recoup their costs through an industry levy that is funded by bills.

Although the foregoing suggests that all UK energy consumers share in the costs, energy market regulator Ofgem suggests that the customers of failed firms may bear some of the costs:

Could bills go up?

When we appoint a new supplier using the Supplier of Last Resort process, we try to get the best possible deal for customers.

Suppliers we appoint will likely put you on a special ‘deemed’ contract when they take on your supply. This means a contract you haven’t chosen. A deemed contract could cost more than your old tariff, so your bills could go up. However, they are covered by the energy price cap Ofgem sets, which ensures you get a fair price if you are put on one. 

When contacted by the new supplier, it’s best to ask to be put on their cheapest tariff or shop around if you want to. You won’t be charged exit fees. This is a challenging time in the market and we know that there may not be many tariffs available when shopping around right now.

Deemed contracts can cost more because the supplier takes on more risk. For example, they might have to buy extra wholesale energy at short notice for new customers. So they charge more to cover these costs.

Up to last week, all the failures had been dealt with using this mechanism. But the failure of Bulb (Dim Bulb?) was evidently too big for Ofgem to deal with using the SoL mechanism. Instead, it resorted to a “Special Administration Regime” which basically nationalizes Bulb. This regime permits the government to “make grants and loans to the company in administration and may also give guarantees for any sum borrowed while it is in administration.”

That is, SAR is essentially a bailout/nationalization of losses and risk.

Ofgem notes:

The energy price cap, which sets a maximum price for customers on standard default tariffs, will remain in place to protect millions of people from the sudden increases in global gas prices. 

(Aside: It is impossible to protect millions of people from the sudden increase in global gas prices. It is only possible to determine–based on political mechanisms–which millions pay and how much. So this statement is typical government bullshit.)

Thus, given the price cap and the fact that Bulb is now owned by the UK government, Boris now has a big short position in natural gas. So how is he going to manage it?

I have heard that the government approached Vitol, which told them to fuck off. So . . . what next?

The company still has to procure energy at market prices and sell them at fixed prices. Since the government is now the residual claimant, it has a short exposure and can take this exposure on the balance sheet, as it were, and essentially run a naked short.

Or it can try to hedge by buying gas forward. But this is not a trivial problem. This is not a position of fixed size that faces only price risk that could be hedged using fixed quantities of swaps/forwards/futures. There is volumetric risk as well: cold weather increases both the price of gas and the amount of gas that must be supplied. A sophisticated hedge would involve both forward fixed price purchases and weather derivatives. Or through the purchase of a sophisticated structured product that has payoffs that depend on both volumetric and price variables.

I’m guessing that the government is not into sophistication, or frankly, capable of it. As a result, it is likely to be at a severe disadvantage in negotiating a price on a structured product or weather derivatives or long dated forwards.

It is also likely sweating out the hedger’s hindsight dilemma. If it doesn’t hedge and prices spike it will catch hell because of the large losses passed on to taxpayers. But if it hedges and prices don’t spike or in fact decline, it will catch hell too: you idiots overpaid!!!! Both of these judgments are based on hindsight, but even though hedging decisions should be evaluated ex ante on the basis of how they effect risk, inevitably they are evaluated ex post based on how they pan out.

Consider California in the aftermath of its 2000-2001 electricity crisis. It entered into long term contracts at what retrospectively was the height of the crisis, and thus paid higher prices than it would have had it procured on a short term basis. Of course, California attempted to recover by suing the contract sellers, claiming it was a nefarious manipulative scheme. Alas, it succeeded to some degree.

The best solution would be to do what clearinghouses do when a big member collapses–auction off the positions. This is what NYMEX did when the hedge fund Amaranth collapsed due to natural gas futures and swap losses in 2006: JP Morgan and Citadel assumed the positions in exchange for consideration. Similarly, when Lehman collapsed in 2008, the CME auctioned off its futures portfolio.

Even in these situations, however, there is always controversy about whether the price is right. Assertions that the buyers of Lehman’s futures positions received a windfall (i.e., bought on the cheap) led to litigation (filed by the Lehman bankruptcy trustee) and considerable controversy. (Here’s my take on the issue.)

Note that the factors mentioned above mean that the pricing in any putative auction of Bulb obligations is likely to be more discounted, and thus subject to more controversy, than the Lehman positions. As in the Lehman case, the positions will be auctioned in a stressed market. Moreover, as noted above, the exposures are far more complex and difficult to manage than Lehman’s rather vanilla (though large) futures positions. That complexity will bring a discount. Furthermore, apropos California circa 2001, the bidders realize that they are subject to government attempts to clawback any gains that result ex post due to favorable fundamentals (e.g., an unexpectedly warm winter). That is, the bidders may fear that the government will actually acquire a long option position, and hence they will be short an option: if prices spike, the auction “winner” will bear the brunt, but if they don’t the government will claim that it was exploited and over payed.

That is, unless the government can credibly commit to adhering scrupulously to the results of the auction, the auction may well fail to attract any bidders.

NB: credible commitment is not one of most modern governments’ strong suits. (This is likely one of the reasons Vitol told the government to bugger off. It realized that it was assuming a totally skewed position–heads they lose, tails they don’t win.).

According to the FT article linked above (amazingly factual and informative for a current day FT article, BTW) the government rejected two offers to assume the Bulb portfolio. I surmise that the bids were discounted heavily to reflect the factors mentioned above and Ofgem accordingly rejected them.

So I’m guessing the government will wear the risk. Perhaps it will try to manage it–and do it badly. Or more likely it will just let it ride. Maybe it will bet on Covid, thinking that the new variant or the new variant after that or the new variant after that will cause governments (stupidly) to lockdown again and crater economic activity and hence gas demand.

I note that Bulb might not be the end of the story. As noted above, the price caps remain in force, meaning that other suppliers may fail in the future–including those that have already gone through the SoL process. The government would be the ones SoL then. That is, the government not only has the Bulb liability–it has a big contingent liability that could dwarf Bulb.

Ofgem has already hinted at this:

In a letter to Kwarteng justifying the decision to pursue a special administration for Bulb, published on Wednesday, Ofgem’s chief executive Jonathan Brearley said the supplier of last resort mechanism was already “under considerable” strain from managing the failure of 20-plus other energy companies in recent months.

So Boris’s already big short could get bigger.

And perversely, it could influence government policy on COVID. Doing something (like lockdowns) that would crush energy demand would benefit its short energy position (existing and contingent). Talk about moral hazard.

Good luck with that Boris! Or should I say, good luck with that, Limeys?

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October 2, 2021

Today’s 70s Acid Flashback: Energy Crisis Edition

Filed under: Commodities,Derivatives,Economics,Energy,History,Politics,Regulation — cpirrong @ 1:15 pm

Back oh-so-long ago, during the California electricity crisis and its aftermath, I would say that California wanted to deregulate its power market in the worst way, and succeeded. (Wanting to keep up my ESG score, I recycled this line to describe Gibbering Joe’s Afghanistan exit.)

The main design failure of California’s restructuring (a more accurate description than deregulation) of its power market was that it capped retail prices for the two largest utilities in the state (SoCal Edison and PG&E) while requiring them to acquire power at market-determined wholesale spot prices. (San Diego Gas and Electric had met criteria to allow it to enter into long term forward purchase contracts and as I recall was not subject to the same retail price cap.). Thus, SCE and PG&E were massively short wholesale (spot) power. When those prices spiked, due mainly to fundamental factors, the utilities hemorrhaged cash and hurtled towards bankruptcy. Their financial distress led to further dislocations in the California market (and the western US power markets generally).

The world is currently undergoing what is being called an “energy crisis,” focused on power markets, and their inputs, mainly natural gas and coal. There are two parts to this “crisis,” one fundamentally driven, the other driven by ill-conceived regulatory and political factors redolent of California circa 1999-2001.

The most pronounced indicator of the fundamental-driven stress is the price of liquified natural gas (LNG), which has reached dizzying heights.

That price spike is in early “shoulder” months, boys and girls. Lord knows what the peak demand months have in store.

And that’s the nub of the problem: storage.

Historically, natural gas has been a “spikey” commodity. The shale boom mitigated spikeness in US natural gas prices, but periodic price spikes are an inherent feature of storable commodities. The truly motivated can read about it in my book, but the CliffsNotes version is this. It is optimal for inventories to run out periodically: if inventories were never exhausted, some of the commodity would never be consumed, which makes no sense. So “stockouts” will occur periodically. When they do, it is impossible to accommodate demand increases or supply declines by drawing down on inventory. Instead, prices bear the entire burden of adjusting to a demand shock (for example). Thus, periodically stocks will be tight, and when they are, a demand increase causes prices to rise dramatically (because inventories can’t cushion the blow).

The cover illustration in my book, based on a purely theoretical model of a storable commodity market, illustrates the point. Note the periodic spikes.

That is, price spikes are inherent in storable commodities.

The magnitude of the price spikes is amplified by the nature of natural gas production and consumption. Both demand and supply are extremely inelastic. The inelasticity effects optimal storage decisions, but when natty inventory constraints bind, inelasticity means that price impacts of shocks are extreme.

This is why going short natural gas (or shorting the calendar spread especially in the winter) is referred to as a “widow maker” trade.

There are lots of widows out there today. In essence, a hard winter of 2020/2021 depleted stocks. The 2020 COVID demand collapse and subsequent price crash (JKM traded at $2.20/mmBTU in May 2020) cratered drilling, constraining current supply (as wells drilled then would have been producing now) making it difficult to build stocks. Warm summer weather in 2021 drained stocks and impeded stock build. Outages in Norwegian production, and a wind drought in the UK (which required greater utilization of gas generation) stoked demand. Stocks are now at historically low levels, setting the stage for even bigger spikes this winter.

The gas market–due to LNG–is now international, meaning that shocks in any region impact prices around the world. Asia (especially China) and Europe are now playing tug of war for gas, and prices are spiking in both places.

Since gas and coal are substitutes, the price spike in gas is resulting in a price spike in coal:

Oil can also be used to generate power, although this has become relatively rare in recent years. However, the spikes in gas and coal are making fuel switching to oil more attractive, and additional gas/coal price spikes in the winter will likely result in more use of oil in electricity generation, which will put upward pressure on oil prices too.

This is all fundamentals driven, and exactly what occurs periodically in storable commodities. There’s nothing really that can be done about it, policy wise. But that won’t stop governments from trying.

You’ve no doubt read of energy “shortages” in recent days and weeks. Well, low supplies and high prices are not a “shortage” per se. A true shortage is a failure for a market to clear, resulting in queueing for the good. That is, a shortage occurs when the price is kept to low, leading to a gap between the quantity demanded and the quantity supplied.

Think gasoline lines in the US in the 1970s.

That’s where regulation comes in. Various regulations, adopted for political economy reasons, create shortages and the other dysfunctions currently observed in world energy markets.

Take China. The authorities have implemented power rationing. The reason commonly given is a “coal shortage.” Yes, coal prices are high in China (and the world), but that doesn’t create a true shortage. What has? Power prices are capped. The big increase in input costs (both coal and LNG) mean that Chinese generators can’t sell profitably, so they restrict output, leading to a true shortage.

What this means is that the shadow price of power–the price that market participants would be willing to pay for an additional megawatt–is (a) above the regulated price, and (b) above the market clearing price. Consumption would be higher in the absence of the price cap.

High coal prices do not reflect a “shortage”, properly defined. Yes, they represent constrained supplies, but that is not a shortage.

And do not forget that China’s coal supply constraints (and high prices) are in large part a result of their brilliant central planners. China imposed quotas on coal production some years back. The reason was–wait for it–coal prices were too low. Now the government is winking at the quotas in order to encourage production–because prices are too high.

India is another country where the Californiaesque capped power price/uncapped input price problem is rearing its ugly head.

France is going to cap gas and power retail prices, but make suppliers whole (though how it will do so remains unstated as of now). Compensating suppliers (effectively having the government pay the difference between marginal cost and the capped price) will prevent true shortages, but will have the perverse effect of exacerbating the spikes in gas and coal prices because at the capped price consumers will not internalize the true scarcity of fuel, and will overconsume.

The UK is experiencing another echo of California. Several of its retail gas suppliers have imploded because they are required to sell at a capped price and chose to cover their sales commitments by purchasing wholesale spot. The price cap made no sense: competition among retail suppliers would have kept prices in line. Adding the price cap just put the competitive retailers at risk of bankruptcy. (Admittedly, such can occur when retail prices are not capped if retailers offer fixed prices to consumers and don’t hedge, as occurred in Texas this last winter. But price caps make that outcome more likely.)

The UK is also suffering a true shortage of gasoline–excuse me, petrol–a la the US in the 1970s. A true shortage, because there are lines:

Scarcity of truck drivers to distribute fuel is at the root of the problem. But that can’t lead to a true shortage–lower supplies and higher prices yes, but not a shortage with people waiting in line. So what gives?

Apparently there was an information cascade about impending shortages, which led to a panicked run for gas stations. This evidently started with a leak (probably politically motivated) of cabinet deliberations.

A sudden demand increase of this magnitude can lead to true shortages–queueing–if prices do not rise to clear the market. This raises the question of why petrol sellers didn’t increase prices. I’m not aware of formal caps, but I surmise that fear of allegations of “gouging” led retailers to choose to allow customers to pay the high price implicitly (through the time cost of sitting in line) rather than raise price to reflect the sudden (and perhaps contrived) scarcity.

For storable commodities like natural gas, coal, and refined petroleum products, price spikes can last for some time. That’s what we are experiencing today: it’s just one of those spikes like on the cover of my book that happen in commodity markets. Given that we are going into a peak demand season with constrained supplies, the prospect for a continuing spike–and indeed, a higher spike–is very real indeed.

Governments can’t change this fundamental reality. Market prices are sending a signal about underlying conditions. Governments don’t like the message the prices are sending, and will try to do something about it. Alas, their knee-jerk response–to shoot the messenger by capping prices–will make things worse, not better. But because governments can’t help themselves, look for many 1970s energy market flashbacks in the coming months.

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July 29, 2021

Timmy!’s Back!

Former Treasury Secretary Timothy Geithner–better known as Timmy! to loooooongtime readers of this blog–is back, this time as Chair of the Group of 30 Working Group on Treasury Market Liquidity. The Working Group was tasked with addressing periodic seizures in the Treasury securities market, most notoriously during the onset of the Covid crisis in March 2020–something I wrote about here.

This is a tale of two reports: the diagnosis is spot on, the prescription pathetic.

The report recognizes that

the root cause of the increasing frequency of episodes of Treasury market dysfunction under stress is that the
aggregate amount of capital allocated to market-making by bank-affiliated dealers has not kept pace with the very rapid growth of marketable Treasury debt outstanding

In other words, supply of bank market making services has declined, and demand for market making services has gone up. What could go wrong, right?

Moreover, the report recognizes the supply side root cause of the root cause: post-Financial Crisis regulations, and in particular the Supplemental Leverage Ratio, or SLR:

Post-global financial crisis reforms have ensured that banks have adequate capital, even under stress, but certain provisions may be discouraging market-making in U.S. Treasury securities and Treasury repos, both in normal times and especially under stress. The most significant of those provisions is the Basel III leverage ratio, which in theUnited States is called the Supplementary Leverage Ratio (SLR) because all banks in the United States (not just internationally active banks) are subject to an additional “Tier 1”leverage ratio.

Obviously fiscal diarrhea has caused a flood of Treasury issuance that from time to time clogs the Treasury market plumbing, but that’s not something the plumber can fix. The plumber can put in bigger pipes, so of course the report recommends wholesale changes in the constraints on market making, the SLR in particular, right? Right?

Not really. Recommendation 6–SIX, mind you–is “think about doing something about SLR sometime”:

Banking regulators should review how market intermediation is treated in existing regulation, with a view to identifying provisions that could be modified to avoid disincentivizing market intermediation, without weakening overall resilience of the banking system. In particular, U.S. banking regulators should take steps to ensure that risk-insensitive leverage ratios function as backstops to risk-based capital requirements rather than constraints that bind frequently.

Wow. That’s sure a stirring call to action! Review with a view to. Like Scarlett O’Hara.

Rather than addressing either of what itself acknowledges are the two primary problems, the report recommends . . . wait for it . . . more central clearing of the Treasury market. Timothy Geithner, man with a hammer, looking for nails.

Clearing cash Treasuries will almost certainly have a trivial effect on market making capacity. The settlement cycle in Treasuries is already one day–something that is aspirational (don’t ask me why) in the stock market. That already limits significantly the counterparty credit risk in the market (and it’s not clear that counterparty credit risk is a serious impediment on market making, especially since it existed before the recent dislocations in the Treasury market, and therefore is unlikely to have been a major contributor to them).

The report recognizes this: “Counterparty credit risks on trades in U.S. Treasury securities are not as large as those in other U.S. financial markets, because the contractual settlement cycle for U.S. Treasury securities is shorter (usually one day) and Treasury security prices generally are less volatile than other securities prices.” Geithner (and most of the rest of the policymaking establishment) were wrong about clearing being a panacea in the swap markets: it’s far less likely to make a material difference in the market for cash Treasuries.

The failure to learn over the past decade plus is clear (no pun intended!) from the report’s list of supposed benefits of clearing, which include

reduction of counterparty credit and liquidity risks through netting of counterparty exposures and application of margin requirements and other risk mitigants, the creation of additional market-making capacity at all dealers as a result of recognition of the reduction of exposures achieved though multilateral netting

As I wrote extensively in 2008 and the years following, netting does not reduce counterparty credit risk or exposures: it reallocates them. Moreover, as I’ve also been on about for more than a fifth of my adult life (and I’m not young!), “margin requirements” create their own problems. In particular, as the report notes, as is the case in most crises the March 2020 Treasury crisis sparked a liquidity crisis–liquidity not in terms of the depth of Treasury markets (though that was an issue) but liquidity in terms of a large increase in the demand for cash. Margin requirements would likely exacerbate that, although the incremental effect is hard to determine given that existing bilateral exposures may be margined (something the report does not discuss). As seen in the GameStop fiasco, a big increase in margins in part driven by the central counterparty (ironically the DTCC, the parent of the FICC which the report wants to be the clearinghouse for its expanded clearing of Treasuries) was a major cause of disruptions. For the report to ignore altogether this issue is inexcusable.

Relatedly, the report touches only briefly on the role of basis trades in the events of March 2020. As I showed in the article linked above, these were a major contributor to the dislocations. And why? Precisely because of margin calls on futures.

Thus, the report fails to analyze completely its main recommendation, and in fact its recommendation is based on not just an incomplete but a faulty understanding of the implications of clearing (notably its mistaken beliefs about the benefits of netting). That is, just like in the aftermath of 2008, supposed solutions to systemic risk are based on decidedly non-systemic analyses.

Instead, shrinking from the core issue, the report focuses on a peripheral issue, and does not analyze that properly. Clearing! Yeah, that’s the ticket! Good for whatever ails ya!

In sum, meet the new Timmy! Same as the old Timmy!

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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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