Streetwise Professor

June 13, 2019

Debunking A Valiant–But Failed–Defense of Frankendodd

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — cpirrong @ 7:40 pm

I have known CFTC Commissioner Dan Berkovitz for almost 20 years, when he was a senior staffer on the Senate Permanent Subcommittee on Investigations, and he reached out to me for guidance on market manipulation issues. I think it’s fair to say that we disagree on most important issues. He supports many regulations I strongly oppose, but despite that our relationship has been cordial and mutually respectful.

Dan’s recent speech at the FIA Commodities Symposium in Houston focuses on issues that we happen to disagree on, and needless to say, I am unpersuaded. Indeed, I think his remarks demonstrate quite clearly the fundamental intellectual failings with the regulatory measures he favors.

He focuses on two issues: competition in OTC derivatives, and speculative position limits. With respect to OTC derivatives, he says

There are now 105 swap dealers and 23 swap execution facilities registered with the Commission. Almost 89% of interest rate swaps and 96% of broad index credit default swaps are cleared through a central clearinghouse. Nearly 98% of all swap transactions involve at least one registered swap dealer. The CFTC’s swap trading rules have led to more competition, more electronic trading, better price transparency, and lower spreads for swaps traded on regulated platforms

But then he contradicts himself on competition:

Despite this progress, we have seen an increase in concentration in the trading and clearing of swaps among the bank swap dealers.  [Emphasis added.] Although we have more competition in the swaps market since the passage of Dodd-Frank, in the form of tighter bid-ask spreads and lower transaction costs, we have fewer competitors.  [Which makes me question whether the tighter spreads are the result of more competition, or other factors.] High levels of concentration present systemic risks and provide fewer choices for end-users.  [But wasn’t the point of DFA to reduce systemic risk by reducing concentration? GiGi sure said so.] One of the purposes of the Commodity Exchange Act (“Act” or “CEA”) is to promote fair competition.  The Commission therefore has an obligation to address this issue.

How concentrated are our derivative markets?  For swaps trading, five registered bank swap dealers are party to 70% of all swaps and 80% of the total notional amount traded. And for clearing services, the five largest FCMs—all affiliated with large banks—clear about 80% of cleared swaps.[  The eight largest firms clear 96% of cleared swaps.  I am concerned about what could happen if one of those providers fails.  I am also concerned about the impact on the price of derivatives for end users.

Even prior to Frankendodd, I predicted that the regulations would lead to greater concentration, precisely because regulatory burdens create fixed costs, which favor scale. The concentration among FCMs is particularly worrisome from a systemic risk perspective, and has been exacerbated by the way clearing regulations have been implemented. Not all of these are the CFTC’s fault: it has attempted to push back on the Fed’s implementation of the liquidity ratio, which creates unnecessary capital charges associated with segregated margins. Dan alludes to that issue thus: “We must find ways to increase bank capital standards without discouraging the availability of clearing and other risk-management tools available to end users.” But the basic conclusion remains: measures intended to reduce concentration in order to reduce systemic risk have not achieved that objective, and have in fact likely increased concentration.

The biggest weakness in Dan’s speech is his valiant, but tellingly and painfully strained, justification for position limits.

The CFTC has a long history with speculative position limits, and their benefits to the market are well established.  Section 3 of the Act identifies risk management and price discovery as fundamental purposes of U.S. derivatives markets. Meaningful position limits coupled with appropriate hedge exemptions are crucial to advancing those purposes.  Position limits help prevent corners, squeezes, and other forms of manipulation.  They prevent distortions in the prices of many major commodities in interstate commerce—ranging, for example, from wheat to gold to coffee to oil.  The Hunt brothers’ attempts to corner the silver market, the Ferruzzi squeeze of the soybean market, and the Amaranth hedge fund’s excessively large positions in the natural gas futures and swaps markets are clear examples of why position limits are needed to prevent the price distortions and real-world impacts that can result from excessive speculation.  Episodes such as these validate Congress’ and the CFTC’s long-held view that position limits are “necessary as a prophylactic measure” to deter sudden or unreasonable price fluctuations and preserve the integrity of price discovery and risk mitigation on U.S. derivatives markets.

Insofar as prevention of market power manipulations (squeezes and corners) are concerned, this can be achieved through spot month limits and does not require restrictions on the positions held prior to the delivery month, and across all months, as the Commission’s previous proposals would impose. Meaning that the proposed regulations are over-inclusive and an unduly restrictive means of achieving their stated objective.

Further, insofar as the examples are concerned, they provide no support for the types of expansive limits that have been proposed. None.

As I’ve said repeatedly about the Hunt episode (the CFTC’s favorite go-to example): when do we get to the Trojan War? That episode is ancient history, and is more the exception that proves the rule than a warning of a clear and present danger. I have said this repeatedly only because the CFTC brings up the example repeatedly. If they stop, I will!

Ferruzzi is interesting, because Ferruzzi cornered a market with position limits, from which the company had an exemption. Indeed, it was the CFTC’s and CBOT’s revocation of Ferruzzi’s hedge exemption during the spot month that broke the company’s corner (and launched my academic career in commodities!–thanks to all!) I can think of other examples in which long hedgers with exemptions executed market power manipulations, and indeed, long hedgers with exemptions are the most dangerous manipulators. Meaning that position limits on speculators are beside the point when it comes to addressing market power manipulation.

With regards to Amaranth, Dan states

The Amaranth episode provides another clear example of how large speculative positions can distort market prices.  At one point, Amaranth held 100,000 natural gas contracts, or approximately 5% of all natural gas used in the U.S. in a year. “Amaranth accumulated such large positions and traded such large volumes of natural gas futures that it distorted market prices, widened the spreads, and increased price volatility.”

The quotations are to a Senate Permanent Subcommittee report (which Dan was an author) . I can say definitively that the analysis underlying those conclusions is completely unpersuasive, and would fail to pass muster in any manipulation litigation. The analysis lacks statistical rigor, and demonstrates neither “artificial” prices or that Amaranth caused these artificial prices (intentionally or otherwise).

Indeed, the CFTC did not pursue Amaranth for distorting natural gas prices through its immense OTC derivatives positions (the 100,000 contracts Dan refers to) outside the delivery month. Instead, it (and FERC) went after the fund and its head trader Brian Hunter for three “bang the close” manipulations in 2006. (Full disclosure: I was an expert for plaintiffs on those manipulations in a private lawsuit.) Position limit regulations would not have prevented those manipulations.

Indeed, other manipulation cases the CFTC has pursued, including bang the settle type cases against Optiver and Parnon and Moore Capital (which I was also an expert in in related private litigation) also would not have been impacted by position limits. That is, limits would not have prevented them. In another recent CFTC case (just settled, and again, I am an expert in related private litigation), the party accused by the CFTC (Kraft) was a long hedger with a hedge exemption.

In brief, neither Dan nor anyone else has presented an example of a post-Trojan War alleged manipulation that position limits would have prevented.

So what’s the point? Can position limits reduce the risk of distortion arising from something non-manipulative?

Dan has an answer, and the answer is “no!” (though he says “record before us demonstrates that the answer is ‘yes.'”)

What speculative position limits are intended to do is to prevent a single market participant from moving markets away from fundamentals of supply and demand through the accumulation of large speculative positions.  [Emphasis added.] In this regard, it’s important to note that speculative position limits focus on the positions held by a single trader or trading entity, not on the overall level of speculation in a market.  The Commission’s task in setting speculative position limits is not to determine how the collective level of speculation in a market might affect prices.  [Emphasis added.] Nor is it to try to determine the “correct” level of speculation that should be permitted in a market.  Instead, the Commission must focus on the single speculator and the impact of large speculative positions on the market.

But this demolishes the argument for limits that was made with increasing intensity around 2006, and peaking (along with oil prices) in mid-2008. Those advocating position limits then could point to no single large trader that was distorting prices. Instead, they blamed (to use Dan’s phrase) “the collective level of speculation” to justify limits–which is exactly what Dan (rightly) says the limits won’t and can’t constrain. Meaning that the CFTC’s proposed limits represent a bait-and-switch: by a limit supporting CFTC commissioner’s own admission, the proposed limits won’t address the supposed ill that led Congress to legislate them in the first place.

To summarize: Position limits outside the spot month are unnecessary to prevent market power manipulations (and other deterrent measures can enhance spot month limits); position limits won’t prevent other kinds of manipulation (e.g., bang the settlement); there are no examples in decades of distortions that position limits of the type proposed might have mitigated; the examples that have been proposed are wrong; the most likely market power manipulators (long hedgers) would be exempted from limits; limits would not have prevented the specific manipulations the CFTC has alleged in recent years; and the limits the CFTC has proposed would not touch the kinds of allegedly multi-trader “collective” excess speculation that caused Congress to mandate position limits in the first place.

Other than that, the case for position limits is rock solid!

Dan Berkovitz manfully attempts justify limits but achieves just the opposite. The arguments and evidence he brings to bear demonstrate how bankrupt the case for limits truly is.

Given that limits will involve substantial compliance costs, and bring no benefits, the song remains the same: position limits are all pain, no gain.

Print Friendly, PDF & Email

June 3, 2019

Renewables VPPAs: An Interesting Pricing Problem For Aspiring Scholars

Filed under: Climate Change,Commodities,Derivatives,Economics,Energy — cpirrong @ 7:13 pm

Virtual Power Purchasing Agreements (VPPAs) have been around for a while, and play a particularly important role in securing financing for renewable energy projects, as this article from Reuters regarding VPPAs in Europe indicates. They are essentially long term swaps whereby one party (e.g., a wind or solar operation) receives a fixed price for power, and pays a floating price, usually based (in the US) on the spot price in an RTO/ISO market (e.g., PJM, or MISO).

These contracts present interesting pricing issues because of the unique nature of electricity as a commodity, and the unique nature of renewable generation in particular. Electricity is not an asset per se, and electricity price risk is not hedgeable, even theoretically, through a dynamic trading strategy in the way that the price risk in a stock option is. This means that electricity markets are “incomplete,” and that Black-Scholes-Merton-like formulas that derive prices that do not depend on risk premia do not exist for power derivatives.

The risk premia embedded in power prices can be large, though they have been falling over the years. I wrote extensively about this subject for about 10 years (late-90s to late-00s), including this article. That paper provides a way of extracting risk premia from the prices of traded claims (e.g., monthly power forward contracts). One virtue of that approach is that the primary state variable in the model is not price, but load (which is translated into price via the supply curve). Thus, the relevant price of risk is the price of load risk, which can be used in the valuation of load-dependent claims. Such claims could be full requirements deals, for example.

One challenge to the approach is that the realistic horizon of the market price of risk function estimate is that of the visible forward curve, which is typically far less than the maturity of long term electricity deals. The prices in such contracts effectively reflect a market price of risk negotiated between the two parties, in the absence of corresponding forward curve data.

Renewables VPPAs face an even bigger challenge: the variability of the output of a renewables asset. There is not only price risk (or market load risk) associated with a given region: there is the output risk of the facility, which may be material given the vicissitudes of wind and sun. Thus, the dimensionality of the pricing problem is higher, which is a problem given that the methods I employed in my 2008 paper (co-authored by Martin Jermakyan) are subject to “the curse of dimensionality.”

Furthermore, given the joint dependency on market price (or load) and project output, these are correlation-dependent claims. That is, what is the dependence between market price and wind output? This could be a particularly big issue given that high wind output is often associated with negative prices. Guaranteeing a fixed price therefore involves something of a wrong way risk.

The long tenor of VPPAs makes these issues even more devilish, given that pricing involves forecasting the relevant dynamics and parameters (including those associated with dependence among the state variables) over long horizons–horizons over which entry can occur and technology can change, making historical data of little relevance in estimation. Indeed, there is an element of endogeneity: the prices in VPPAs can affect the economics of entry, which can affect future price behavior, which is (theoretically, anyways) an input into the “right” VPPA fixed price.

All in all, a very interesting and challenging pricing problem, that like the simpler problems Martin and I tackled some years ago, require the use of advanced pricing techniques, numerical methods, and econometrics even to conceptualize, let alone solve. Sounds like an interesting problem–or problems–for aspiring scholars in energy pricing.

Print Friendly, PDF & Email

April 25, 2019

A Barbarous Relic, Indeed

Filed under: Commodities,Derivatives,Economics,Energy — cpirrong @ 3:37 pm

In my 2014 whitepaper, I called oil-indexing of LNG contracts a “barbarous relic.” The basic idea is that since oil prices and gas prices are driven by very different supply and demand fundamentals (and increasingly so), oil values and gas values diverge systematically, by large and varying amounts. This means that oil-indexed contracts sent misleading signals that lead to misallocations of consumption and production. These divergences also lead to disputes between the contracting parties, resulting in transactions and renegotiation costs.

A Reuters article from today illustrates that the distorting effects of oil indexation are real, and causing the kinds of dislocations I wrote about 5 years ago:


Asia’s liquefied natural gas market is being distorted as the cost of LNG bought under long-term contracts linked to oil prices jumps to double spot gas cargoes amid tighter U.S. sanctions on Iran’s crude exports and cuts in OPEC oil supply.


The price gap between LNG traded in the spot market and term cargoes linked to benchmark Brent crude oil has stretched to its widest in about 8 years, driving some buyers locked in to term deals to try to delay shipments or look to adjust contracts.

That is, oil-specific fundamentals (OPEC, Iran sanctions waivers) push oil up at the same time that abundant supplies and seasonal factors push LNG prices down.

This is leading to changes in consumption that are almost certainly inefficient because they are a response to crazy price signals:


The price distortion is driving some buyers in China and Japan to request delays in term cargoes, several industry sources told Reuters, although they added that producers had so far resisted making large concessions.
Others are looking to utilize so-called downward quantity tolerances (DQT) in their term contracts from LNG sellers, three of the sources said, requesting anonymity as they were not allowed to talk about the specifics of contracts in public.

Note too the negotiations, and the related transactions costs.

With the growing liquidity in various gas benchmarks (JKM, TTF) and the integration of the world LNG with an existing highly liquid benchmark in the US (Henry Hub), oil indexing is getting to be more of a relic, and more barbarous by the day.

Reuters recently ran another article that identifies a factor that will further encourage the development of LNG spot trade, and gas-on-gas pricing:


The world’s biggest liquefied natural gas (LNG) producers including Shell, Total and Petronas are increasingly selling from global supply pools instead of dedicated projects as buyers leverage a fuel surplus to force ever more flexible deals.


This marks an accelerated turning from traditional long-term contracts that lock customers into taking regular volumes from specific projects under oil-linked pricing formulas.


Global oversupply that has pulled spot LNG prices LNG-AS down by more than 50 percent over the past half-year has producers succumbing to consumer demands for fuel on shorter notice and without sourcing or destination restrictions.


“A more dynamic and liquid LNG market, and the need for greater flexibility by traditional LNG buyers, is providing opportunities for shipping optimisation and trading, and enabling new entrants such as LNG traders,” said Saul Kavonic, head of energy research for Australia at Credit Suisse.

Majors like Shell, Total, Exxon and Chevron are moving aggressively into LNG. (One motive for the Chevron bid for Anadarko was the latter’s Mozambique LNG project.) Aramco is also moving into the market. Large players like this do not need to rely on project finance that banks and the capital markets are willing to supply only if the price risk can be managed via long term contracts with prices that can be hedged on the oil market. It is feasible for them to sell out of a portfolio of projects on a shorter-term or gas indexed basis.

This will make the LNG look even more like the oil market, in which the majors (and national oil companies) supply the market out of a portfolio of production sources. Indeed, in some respects LNG is even more amenable to a portfolio-based strategy. LNG is far more physically homogeneous than oil, allowing a given project to serve a larger fraction of demanders. Moreover, the seasonality of gas demand, and the susceptibility of gas demand to big but rather localized shocks (e.g., the effects of Fukushima, a drought in the Amazon that reduces hydroelectric supply) creates a need for flexibility that is best met through gas portfolios that provide locational and timing optionality.

Such developments will make oil-linking even more of a barbarous relic than it already is–which is saying something.

Print Friendly, PDF & Email

April 15, 2019

Chartering Practices in LNG Shipping: Deja Vu All Over Again

Filed under: Commodities,Derivatives,Economics,Energy — cpirrong @ 7:28 pm

One of the strands of thought that combined in my analysis of the evolution of LNG market structure is the idea of temporal and contractual specificities. This traces back to my dissertation, in what was published in a JLE article titled “Contracting Practices in Bulk Shipping Markets.” In that article, I addressed something that is a puzzle from the context of transactions costs economics: since the most common forms of asset specificity (especially site specificity) are not present for ships, why are many bulk carriers subject to arrangements that TCE posits address specificity problems, specifically long term contracts or vertical integration?

My answer was that even with mobile assets the parties could find themselves in small numbers bargaining situations and vulnerable to holdup due to temporal specificities: I need a ship at place X NOW, and maybe there is only 1 ship nearby. Or, I have a ship at place Y, but maybe there is only one viable cargo there. Long term contracts can mitigate this problem, but they create a form of externality. If most ships suitable for a given cargo are tied up under long term contracts, and most shippers have contracted for vessels for an extended period, the number of free ships and cargoes at any time will be small, thereby creating opportunism problems in spot contracting, which leads to more long term contracting. In essence, there is a spot (“voyage chartering”) equilibrium where most ships are traded on a spot basis, or a long term contracting equilibrium where they are not.

The article posits that these problems depend primarily on the specificity of the ship to particular cargoes and the “thickness” of trade routes. Cargoes suitable for standard bulk carriers on heavily-transited routes should sail on a spot charter basis: cargoes requiring specialized ships, and/or those on relatively isolated routes, are likely to require longer term ship chartering arrangements, or vertical integration.

By and large, the cross-sectional and time series variations in contracting practices line up with these predictions. One interesting case study that in the time series is crude oil. Prior to the development of spot markets in crude, most of it was shipped on oil company owned ships, or tankers obtained under long term charters. The development of spot markets for crude reduced the potential for holdup by freeing up cargoes. The ability to buy oil spot to replace a shipment that a specific carrier might have a time-space advantage in lifting reduced the ability of that carrier to extract rents. This flexibility also reduced the ability of shippers to extract rents from carriers. This reduced scope for rent extraction and opportunism in turn reduced the need for contractual protections, and soon after the spot crude market developed, the crude shipping market rapidly transitioned towards short-term chartering arrangements and vertical integration virtually disappeared.

One of the examples of long term contracting in my article was LNG shipping. LNG ships have always been very specialized due to the nature of the cargo: the only thing you can carry on an LNG carrier is LNG, and you can’t use any other kind of ship to carry it. At the time (late-80s/early-90s), most LNG was shipped between a limited set of sources (mainly Algeria) and sinks (mainly in Europe), and sold under long term contracts (20 years or more, for the most part). Consistent with the theory, LNG ships were also under long term contracts or owned by either the seller or buyer of LNG.

An implication of the analysis is that as in the crude market, the development of an LNG spot market should lead to more short term charters for LNG shipping. And lo and behold, this is occurring:

The market for LNG freight trade is relatively new and many companies are reluctant to talk about trading strategies, which are still being developed.


“We see LNG shipping as a commodity on its own,” said Niels Fenzl, Vice President Transportation and Terminals at Uniper, an energy firm which along with Shell, pioneered freight trade within the LNG market.


“We were one of the first companies who started to trade LNG vessels around two or three years ago and we see more companies are considering trading LNG freight now.”
. . . .

In general, traditional shipowners prefer to stick with long-term charters, which help them finance building new vessels, and let the energy firms and trading houses deal in the riskier short-term sublets.
But, given the potential money to be made, there are shipping companies focused almost entirely on servicing the LNG industry’s immediate or near-term requirements.

“The spot market is our priority now given the current rate environment as we don’t want to lock our ships in long-term charters prematurely in the recovery cycle,” said Oystein M. Kalleklev, CEO of Flex LNG, a shipping firm founded in 2006.


“We also do believe spot is becoming a much bigger part of the LNG shipping market as well as the overall LNG trade.”

Theory in action, yet again. The parallels to the experience in crude 40 years ago are striking.

And again as theory (although a different theory than TCE) would predict, the development of a liquid spot market is catalyzing the development of paper derivatives markets for hedging purposes. As one would expect, and has happened historically, this new market is primarily bilateral, opaque, and illiquid. But the potential for a virtuous liquidity cycle is there.

One problem at present is that the liquidity in the spot charter market is insufficient to provide the basis for an index that can be used to settle derivatives:

The difficulty for the index is having enough deals to base a price on, according to Gibson.


Also, many transactions are discussed privately, making it difficult to find out what price was agreed.

“In order for Uniper to consider trading on LNG freight indices we would need to see what mechanisms are offered to make the trade possible. If they could work in principle, we would look into using those,” Fenzl said.

But as the spot LNG market grows, and this leads to more spot ship chartering, indices will become feasible and better, which will spur growth in the derivatives market. And there will be a further positive feedback loop. The ability to manage freight rate risk through derivatives reduces the need to manage them through bilateral term contracts, which will further boost the spot chartering market.

One of the lessons of my old work (done when I was a small child! I swear!) is that there is a substantial coordination game aspect to contracting. If everyone contracts long term, that is self-sustaining: to go against that and try to buy/sell spot makes one vulnerable to opportunism and bargaining problems. Shocks (like the 1970s oil shock that transformed that market, or the variety of developments that led to more spot LNG trading in recent years) that lead to increased spot volumes can undermine that long term contracting equilibrium, especially if those volumes are sufficient to activate the positive feedback loop.

We are seeing that dynamic in LNG, and that dynamic in LNG is creating a similar dynamic in LNG shipping, a la oil in the 1970s. It’s deja vu, all over again.

Print Friendly, PDF & Email

April 8, 2019

CDS: A Parable About How Smart Contracts Can Be Pretty Dumb

Filed under: Blockchain,Derivatives,Economics,Exchanges,Regulation,Russia — cpirrong @ 7:04 pm

In my derivatives classes, here and abroad, I always start out by saying that another phrase for “derivative” is contingent claim. Derivatives have payoffs that are contingent on something. For most contracts–a garden variety futures or option, for example–the contingency is a price. The payoff on WTI futures is contingent on the price of WTI at contract expiration. Other contracts have contingencies related to events. A weather derivative, for instance, which pays off based on heating or cooling degree days, or snowfall, or some other weather variable. Or a contract that has a payoff contingent on an official government statistic, like natural gas or crude inventories.

Credit default swaps–CDS–are a hybrid. They have payoffs that are contingent on both an event (e.g., bankruptcy) and a price (the price of defaulted debt). Both contingencies have proved very problematic in practice, which is one reason why CDS have long been in such disrepute.

The price contingency has proved problematic in part for the same reason that CDS exist. If there were liquid, transparent markets for corporate debt, who would need CDS?: just short the debt if you want to short the credit (and hedge out the non-credit related interest rate risk). CDS were a way to trade credit without trading the (illiquid) underlying debt. But that means that determining the price of defaulted debt, and hence the payoff to a CDS, is not trivial.

To determine a price, market participants resorted to auctions. But the auctions were potentially prone to manipulation, a problem exacerbated by the illiquidity of bonds and the fact that many of them were locked up in portfolios: deliverable supply is therefore likely to be limited, exacerbating the manipulation problem.

ISDA, the industry organization that largely governs OTC derivatives, introduced some reforms to the auction process to mitigate these problems. But I emphasize “mitigate” is not the same as “solve.”

The event issue has been a bane of the CDS markets since their birth. For instance, the collapse of Russian bond prices and the devaluation of the Ruble in 1998 didn’t trigger CDS payments, because the technical default terms weren’t met. More recently, the big issue has been engineering technical defaults (e.g., “failure to pay events”) to trigger payoffs on CDS, even though the name is not in financial distress and is able to service its debt.

ISDA has again stepped in, and implemented some changes:

Specifically, International Swaps and Derivatives Association is proposing that failing to make a bond payment wouldn’t trigger a CDS payout if the reason for default wasn’t tied to some kind of financial stress. The plan earned initial backing from titans including Goldman Sachs Group Inc.JPMorgan Chase & Co.Apollo Global Management and Ares Management Corp.

“There must be a causal link between the non-payment and the deterioration in the creditworthiness or financial condition of the reference entity,” ISDA said in its document.

Well that sure clears things up, doesn’t it?

ISDA has been criticized because it has addressed just one problem, and left other potential ways of manipulating events unaddressed. But this just points out an inherent challenge in CDS. In the case Cargill v. Hardin, the 7th Circuit stated that “the techniques of manipulation are limited only by the ingenuity of man.” And that goes triple for CDS. Ingenious traders with ingenious lawyers will find new techniques to manipulate CDS, because of the inherently imprecise and varied nature of “credit events.”

CDS should be a cautionary tale for something else that has been the subject of much fascination–so called “smart contracts.” The CDS experience shows that many contracts are inherently incomplete. That is, it is impossible in advance to specify all the relevant contingencies, or do so with sufficient specificity and precision to make the contracts self-executing and free from ambiguity and interpretation.

Take the “must be a causal link between the non-payment and the deterioration in the creditworthiness or financial condition of the reference entity” language. Every one of those words is subject to interpretation, and most of the interpretations will be highly contingent on the specific factual circumstances, which are likely unique to every reference entity and every potential default.

This is not a process that can be automated, on a blockchain, or anywhere else. Such contracts require a governance structure and governance mechanisms that can interpret the contractual terms in light of the factual circumstances. Sometimes those can be provided by private parties, such as ISDA. But as ISDA shows with CDS, and as financial exchanges (e.g., the Chicago Board of Trade) have shown over the years in simpler contracts such as futures, those private governance systems can be fragile, and themselves subject to manipulation, pressure, and rent seeking. (Re exchanges, see my 1994 JLE paper on exchange self-regulation of manipulation, and my 1993 JLS paper on the successes and failures of commodity exchanges.)

Sometimes the courts govern how contracts are interpreted and implemented. But that’s an expensive process, and itself subject to Type I and Type II errors.

Meaning that it can be desirable to create contracts that have payoffs that are contingent on rather complex events–as a way of allocating the risk of such events more efficiently–but such contracts inherently involve higher transactions costs.

This is not to say that this is a justification for banning them, or sharply circumscribing their use. The parties to the contracts internalize many of the transactions costs (though arguably not all, given that there are collective action issues that I discussed 10 years ago). To the extent that they internalize the costs, the higher costs limit utility and constrain adoption.

But the basic point remains. Specifying precisely and interpreting accurately the contingencies in some contingent claims contracts is more expensive than in others. There are many types of contracts that offer potential benefits in terms of improved allocation of risk, but which cannot be automated. Trying to make such contracts smart is actually pretty dumb.


Print Friendly, PDF & Email

April 7, 2019

The LNG Market’s Transformation Continues Apace–and Right On Schedule

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — cpirrong @ 7:14 pm

In 2014, I wrote a whitepaper (sponsored by Trafigura) on impending changes to the liquefied natural gas (LNG) market. The subtitle (“racing towards an inflection point”) captured the main thesis: the LNG market was on the verge of a transformation. The piece made several points.

First, the traditional linkage in long term LNG contracts to the price of oil (Brent in particular) was an atavism–a “barbarous relic” (echoing Keynes’ characterization of the gold standard) as I phrased it more provocatively in some talks I gave on the subject. The connection between oil values and gas values had become attenuated, and often broken altogether, due in large part to the virtual disappearance of oil as a fuel for electricity generation, and the rise in natural gas in generation. Oil linked contracts were sending the wrong price signals. Bad price signals lead to inefficient allocations of resources.

Second, the increasing diversity in LNG production and consumption was mitigating the temporal specificities that impeded the development of spot markets. The sector was evolving to the stage in which participants could rely on markets to provide security of demand and supply. Buyers were not locked into a small number of sellers, and vice versa.

Third, a virtuous liquidity cycle would provide a further impetus to development of shorter term trading. Liquidity begets liquidity, and reinforces the willingness of market participants to rely on markets for security of demand and supply, which in turn frees up more volumes for shorter term trading, which enhances liquidity, and so forth.

Fourth, development of more liquid spot markets will make market participants willing to enter into contracts indexed to prices from those markets, in lieu of oil-linkages.

Fifth, the development of spot markets and gas-on-gas pricing will encourage the development of paper hedging markets, and vice versa.

Sixth, the emergence of the US as a supplier would also accelerate these trends. There was already a well-developed and transparent market for natural gas in the US, and a broad and deep hedging market. With US gas able to swing between Asia and Europe and South America depending on supply and demand conditions in these various regions, it was likely to be the marginal source of supply around the world and would hence set price around the world. Moreover, the potential for geographic arbitrages creates short term trading opportunities.

When pressed about timing, I was reluctant to make a firm forecast because it is always hard to predict when positive feedback mechanisms will take off. But my best guess was in the five year range.

Those predictions, including the time horizon, are turning out pretty well. There have been a spate of articles recently about the evolution of LNG as a traded commodity, with trading firms like Vitol, Trafigura, and Gunvor, and majors with a trading emphasis like Shell and Total, taking the lead. Here’s a recent example from the FT, and here’s one from Bloomberg. Industry group GIIGNL reports that spot volumes rose from 27 percent of total volumes in 2017 to 32 percent in 2018.

There are also developments on the contractual front. Last year Trafigura signed a 15 year offtake deal with US exporter Cheniere linked to Henry Hub. In December, Vitol signed a deal with newcomer Tellurian linked to Henry Hub, and last week Tellurian inked heads of agreement with Total for volumes linked to the Platts JKM (Japan-Korea-Marker).* Shell even entered into a deal linked with coal. There was one oil-linked deal signed recently (between NextDecade and Shell), but to give an idea of how things have changed, this met with puzzlement in the industry:

The pricing mechanism that raised eyebrows this week in Shanghai was NextDecade’s Brent-linked deal with Shell. NextDecade CEO Matt Schatzman said he wanted to sell against Brent because his Rio Grande LNG venture will rely on gas that’s a byproduct of oil drilling in the Permian Basin, where output will likely increase along with oil prices.


Total CEO Patrick Pouyanne said he didn’t understand that logic.
“Continuing to price gas linked to oil is somewhat the old world,” Pouyanne said on Wednesday. “I was most surprised to see new contracts linked to Brent, especially from the U.S. Someone will have to explain this to me.”

I agree! In fact, the NextDecade logic is daft. High oil prices that stimulate oil production will lead to lower gas prices due to the linkage that Schatzman outlines. If you have doubts about that, look at the price of natural gas in the Permian right now–it has been negative, often by $6.00/mmbtu or more. This joint-production aspect will tend to make oil and gas prices less correlated, or even negatively correlated.

But it’s hard to believe how much the conventional wisdom has changed in 5 years. The whitepaper was released in time for the LNG Asia Summit in Singapore, and I gave a keynote speech at the event to coincide with its release. The speech was in front of the shark tank at the Singapore Aquarium, and from the reception I got I was worried that I might get the same treatment from the audience as Hans Blix did from Kim Jung Il in Team America.

To say the least, the overwhelming sentiment was that oil links were here to stay, and that any major changes to the industry were decades, rather than a handful of years, away. Fortunately, the sharks went hungry and I’m around to say I told you so 😉

I surmise that the main reason that the conventional wisdom was that the old contracting and pricing mechanisms would be sticky was an insufficient appreciation for the nature of liquidity, and how this could induce tipping to a new market organization and new contract and trading norms. These were ideas that I brought from my work in the industrial organization of financial trading markets (“market macrostructure” as I called it), and they were no doubt alien to most people in the LNG industry. Just as ideas about spot trading of oil were alien to most people in the oil industry when Marc Rich and others introduced it in the 1970s.

Given the self-reinforcing nature of these developments, I believe that the trend will continue, and likely accelerate. Other factors will feed this process. I’ve written in the past about how some traditional contract terms, notably destination clauses, are falling by the wayside due to regulatory pressure in Japan and elsewhere. The number of sources and sinks is increasing, which makes the market thicker and mitigates further temporal specificities. The achievement of scale and greater trading opportunities will encourage investment in infrastructure, notably storage, that facilitates trading. Right now most LNG trading involves only one of the transformations I’ve written about (transformation in space): investment in storage infrastructure will facilitate another (transformation in time).

It’s been kind of cool (no pun intended, given that LNG is supercooled) to watch this happen in real time. It is particularly interesting to me, as an industrial organization economist, given that many issues that I’ve studied over the years (transactions cost economics, the economics of commodity trading, the nature and dynamics of market liquidity) are all present. I’m sure that the next several years will provide more material for what has already proved to be a fascinating case study in the evolution of contracting and markets.

*Full disclosure: My elder daughter works for Tellurian, and formerly worked for Cheniere. I have profited from many conversations with her over the last several years. One of my former PhD students is now at Cheniere.

Print Friendly, PDF & Email

March 25, 2019

Oliver Wyman Misdiagnoses the Causes of the Commodity Traders’ Malaise, and Prescribes Nostrums to Treat It

Filed under: Blockchain,Commodities,Derivatives,Economics,Energy — cpirrong @ 6:15 pm

There are many silly things written about commodity traders, and alas many of the purveyors of this silliness get paid large amounts of money for it. Case in point, this just-released Oliver Wyman study, “Commodity Trading Goes Back to the Future.”

The piece begins with a well-recognized fact (that I’ve written about frequently in the past): commodity trading firm margins are down, relative to 2014-15, and especially 2008-9. It goes off the rails in totally misdiagnosing the cause:

Signs of the coming dramatic shakeout that will result from the commodity trading margin squeeze are already at hand. Trading margins have fallen by more than 20 percent from their recent peak in 2015.

This trading margin meltdown will continue as commodity markets become more mature, stable, and liquid. Over the past decade, the volume of commodity contracts traded nearly tripled and the value of contracts traded on standard electronic platforms doubled. Commodity market data is also increasingly readily available and widely socialized, as a greater number of players sell information and provide services to commodity traders. These new sources of data allow commodity traders to estimate much more precisely events that impact their trading strategies, such as when commodities will arrive at a specific destination and when local stockpiles will be high or low.

The combination of increased transparency and gluts in almost every commodity should keep volatility in the relatively tight band it has been confined to since 2012.

Where to begin? For starters, the electronic trading volumes of futures and futures option contracts has jack-you-know-what to do with the margins on physical commodity trading. Ditto the market data from these transactions. To throw these topics into a discussion of physical commodity trading profitability is to shoot your credibility in the head on page 2.

Further, as I’ve written extensively, particularly with regards to the ABCDs, “gluts in almost every commodity” do not necessarily imply compressed physical trading margins–in fact, they usually do the reverse. What has happened is that commodity transformation capacity has outstripped commodity transformation demand.

So that’s a self-inflicted double tap. Quite a trick!

Relatedly, low flat price volatility is a complete red herring. What matters to physical traders–who transform commodities in space, time, and form–is the volatility of relative prices, specifically the spreads between transformed and untransformed commodity prices.

Triple tap. Even more impressive!

Indeed, the irrelevance of gluts is readily evident from Exhibit 1, a graph of margins by year. When were the biggest margins in oil and oil products? Glut years–2009, and 2014-2015. The traders made easy money on simple storage plays. As Trafigura illustrated in its half-year report last September, it is the disappearance of the contango (i.e., the disappearance of the oil glut) that crushed margins.

Amazingly, the word “contango” does not appear in the OW report. That just screams credibility, I tells ya.

The report also discusses increased price transparency as a source of pressure on margins, but I am unpersuaded that there has been any meaningful increase in cash market transparency, at least not enough to make a difference. Take the grain markets. Yes, you can go online and see what local elevators are bidding in the US. But bids and transactions are very different things, and in these markets there can be huge differences between offers and bids. Having studied the US grain markets for almost 30 years, I don’t see a material increase in cash price transparency in that time. And I can say pretty much the same about cotton and oil.

This is moderately intelligent, at least as a forecast rather than as a diagnosis:

Major commodity producers and consumers like national oil companies and miners will charge higher premiums and claim more margin as they expand their global reach and become more sophisticated market participants. Simultaneously, physical infrastructure service providers and new online platforms will impinge on traders’ traditional roles. These players are making traders less essential by removing bottlenecks in order to correct supply imbalances and connecting more commodity producers and consumers directly

But that has everything to do with increased transformation capacity chasing a limited supply of transformation opportunities, and nothing to do with gluts or increased price transparency.

But every moderately sensible statement is undone by silly ones, like this:

As commodity markets become more liquid and accessible, commodity traders are relying more and more on algorithmic trading, coupling predictive analytics with robotic trade execution. Traders are improving their ability to hedge and speculate by developing codes that more nimbly identify trades and execute them across a broader set of
tradable instruments

Yeah. Robotic execution of physical trades. Right. These statements have some applicability to paper spec/prop trading. Virtually none to trading of physical barrels and bushels.

After completely misdiagnosing the disease, Dr. Wyman has a cure–BIG DATA!

Well, I guess that’s something: they could have prescribed blockchain.

Yes, improved data analytics may permit those who employ them to pick up a few more pennies in front of the steamrollers, but its beyond a stretch to claim that this will affect industry profitability overall.

The report in fact hedges its bets, acknowledging that there is no proof that BD is not just more BS:

It is often unclear if anticipated relationships between data feeds and commodity prices actually exist, and even if they do it is not certain the volume of data is sufficient to make meaningful predictions. For example, it is incredibly difficult to analyze global satellite imagery
to identify precisely the daily flow of commodities given the frequency at which images are being taken. Depending on the specific market, these signals are often also relatively limited compared to just market sentiment when forecasting in the horizon of interest

Who knew?

Nonetheless, OW boldy recommends that traders “completely revamp” their operating models, and closes with:

Traders need to make maximizing the potential of information
advantages their top priority. Previously unthinkable digital
capabilities will determine who will be the industry’s leaders
in the long term.

And no doubt, big fat consulting contracts with Oliver Wyman are ESSENTIAL!!!! to make this leap.

Yes, data analytics will no doubt prove of use, and they will become a necessary tool in traders’ kits. But they are unlikely to be transformative–because the big determinants of trader margins are the demand for transformations in space, time, and form, and the capacity available to perform them. Further, the industry is a very competitive one, with relatively free entry and exit, meaning that any persistent increases in margins will be eroded by new entry, and persistent decreases by exit.

The pool of entrants has plausibly increased, as the one sensible part of the OW piece says. That will tend to lead the traditional players to contract (or at least lose share). Some of the entrants are not mentioned by Wyman, such as the farmers in North and South American who are integrating into traditional merchant niches.

These are the first order drivers of past, current and future commodity trading profitability. Big data is an attention grabbing subject, but at the end of the day, it will be a second order (if that) driver of physical commodity trading profits.

But I guess consultants gotta eat too, right? But that’s no excuse for anyone to pay them, especially for drivel like this report.

Print Friendly, PDF & Email

January 29, 2019

Bo Knows Hedging. Not!

Filed under: China,Commodities,Derivatives,Economics,Energy — cpirrong @ 7:42 pm

Chinese oil major Sinopec released disappointing earnings, driven primarily by a $688 million loss at its trading arm, Unipec. The explanation was as clear as mud:

“Sinopec discovered in its regular supervision that there were unusual financial data in the hedging business of Unipec,” it said in a statement. “Further investigations have indicated that the misjudgment about the global crude oil price trend and inappropriate hedging techniques applied for certain parts of hedging positions” resulted in the losses.

Er, the whole idea behind hedging is to make one indifferent to “global . . . price trend[s].” A hedger exchanges flat price risk–which, basically, is exposure to global trends–for basis risk–which is driven by variations in the difference between prices of related instruments that follow the same broad trends. Now it’s possible that someone running a big book could lose $688 million on a big move in the basis, but highly unlikely. Indeed, there have been no reports of extreme basis moves in crude lately that could explain such a loss. (There were some basis moves in some markets last year that were sufficiently pronounced to attract press attention but (a) even these did not result in any reports of high nine figure losses, and (b) nothing similar has been reported lately.)

The loss did correspond, however, with a large downward move in oil prices. Meaning that Unipec probably was long crude. Some back of the envelope scribbling suggests it was long to the tune of about 17 million barrels ($688 million loss at a time of an oil price decline of about $40/bbl.) Given that Unipec/Sinopec is almost certainly a structural short (since Sinopec is primarily a refiner), to lose that much it had to acquire a big enough long futures/swaps position to offset its natural short, and then buy a lot more.

One should always be careful in interpreting reports about losses on hedge positions, because they may be offset by gains elsewhere that are not explicitly recognized in the accounting statements. That said, as the Metalgesellschaft example cited in the article shows, for a badly constructed hedge, or a speculative position masquerading as a hedge, the derivatives losses may swamp the gains on the offsetting position. In the MG case, Merton Miller famously argued that the company’s losses on its futures were misleading because daily margining of futures crystalized those losses but the gains on the gasoline and heating oil sales contracts the futures were allegedly hedging were not marked-to-market and recognized and did not give rise to a cash inflow. I less famously–but more correctly ;-)–did the math and showed that the gains on the sales contracts were far smaller than the losses on the futures, and what’s more, that the “hedged” position was actually riskier than the unhedged exposure because it was actually a huge calendar spread play: the “hedge” was stacked on nearby futures, and the fixed price sales contracts had obligations extending out years. This position lost money when the market flipped from a backwardation to a contango.

Mert did not appreciate this when I pointed it out to him, and indeed, he threw me out of his office and pointedly ignored me from that point forward. This led to some amusing lunches at the Quandrangle Club at UC.

So perhaps the losses are overstated due to accounting treatment, but I think it’s likely that the loss is still likely a large one.

The Unipec president–Chen Bo–has been suspended. I guess Bo didn’t know hedging.

Bo wasn’t the only guy to get whacked. The company’s “Communist Party Secretary” did too. So Marxists don’t understand hedging either. Who knew?

Print Friendly, PDF & Email

December 5, 2018

Judge Sullivan Channels SWP, and Vindicates Don Wilson and DRW

Filed under: Derivatives,Economics,Exchanges,Regulation — cpirrong @ 10:52 am
After two years of waiting after a trial, and five years since the filing of a complaint accusing them of manipulation, Don Wilson and his firm DRW have been smashingly vindicated by the decision of Judge Richard J. Sullivan (now on the 2nd Circuit Court of Appeals).

Since it’s been so long, and you have probably forgotten, the CFTC accused DRW and Wilson of manipulating IDEX swap futures by entering large numbers (well over 1000) of orders to buy the contract during the 15 minute window used to determine the daily settlement price.  These bids were an input into the settlement price determination, and the CFTC claimed that they were manipulative, and intended to “bang the close.”  The bids were above the contemporaneous prices in the OTC swap market.

The Defendants claimed that the bids were completely legitimate, and that they hoped that they would be executed because the contract was mispriced because of a fundamental difference between a cleared, marked-to-market, daily-margined futures contract and an uncleared swap.  The former has a “convexity bias” and the latter doesn’t.  DRW did some IDEX deals with MF Global and Jefferies at rates close to the OTC swap rate, which it thought were an arbitrage opportunity, and they wanted to do more.  And, of course, they  received margin inflows to the extent that the contract settlement price reflected the convexity effect: thus, to the extent that the bids moved the settlement price in that direction, they expedited the realization of the arbitrage profit.

Here was my take in September, 2013:

Basically, there’s an advantage to being short the futures compared to being short the swap.  If interest rates go up, the short futures position profits, and the short can invest the resulting variation margin inflow at the higher interest rate.  If interest rates go down, the short futures position loses, but the short can borrow to cover the margin call at a low interest rate.  The  swap short can’t play this game because the OTC swap is not marked-to-market.  This advantage of being short the future should lead to a difference between the futures yield and the swap yield.

DRW recognized this difference between the swap and the futures.  Hence, it did not enter quotes into the futures market that were equal to swap yields.  It entered quotes at a differential to the swap rate, to reflect the convexity adjustment.  IDC used these bids to determine the settlement price, and hence daily variation margin payments.  Thus, the settlement prices reflected the convexity adjustment.  Not 100 percent, because DRW was trying to make money arbing the market.  But the settlement prices were closer to fair value as a result of DRW’s quotes than they would have been otherwise.

CFTC apparently believes that the swap futures and the swaps are equivalent, and hence DRW should have been entering quotes equal to swap yields.  By entering quotes that differed from swap rates, DRW was distorting the settlement price, in the CFTC’s mind anyways.

Put prosaically, in a way that Gary Gensler (the lover of apple analogies) can understand, CFTC is alleging that apples and oranges are the same, and that if you bid or offer apples at a price different than the market price for oranges, you are manipulating.

Seriously.

The reality, of course, is that apples and oranges are different, and that it would be stupid, and perhaps manipulative, to quote apples at the market price for oranges.

Here’s Judge Sullivan’s analysis:

[t]here can be no dispute that a cleared interest rate swap contract is economically distinguishable from, and therefore not equivalent to, an uncleared interest rate swap, even when the two contracts otherwise have the same price point, duration, and notional amount.  Put another way, because there is some additional value to the long party . . . in a cleared swap that does not exist in an uncleared swap, the economic value of the two contracts are distinct.

Pretty much the same, but without the snark.

But Judge Sullivan’s ruling was not snark-free!  To the contrary:

It is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented that product.

I also wrote:

In other words, DRW contributed to convergence of the settlement price to fair value relative to swaps.  Manipulative acts cause a divergence between the settlement price and fair value.

. . . .

In a sane world-or at least, in a world with a sane CFTC (an alternative universe, I know)-what DRW did would be called “arbitrage” and “contributing to price discovery and price efficiency.”

Judge Sullivan agreed: “Put simply, Defendants’ explanation of their bidding practices as contributing to price discovery in an illiquid market makes sense.”

Judge Sullivan also excoriated the CFTC and lambasted its case.  He blasted it for trying to read the artificial price element out of manipulation law (“artificial price” being one of four elements established in several cases, including inter alia Cargill v. Hardin, and more recently in the 2nd Circuit, in Amaranth–a case that was an expert in).  Relatedly, he slammed it for conflating intent and artificiality.  All of these criticisms were justified.

It is something of a mystery as to why the CFTC chose this case to make its stand on manipulation.  As I noted even before it was formally filed (my post was in response to DRW’s motion to enjoin the CFTC from filing a complaint) the case was fundamentally flawed–and that’s putting it kindly.  It was doomed to fail, but the CFTC pursued it with Ahab-like zeal, and pretty much suffered the same ignominious fate.

What will be the follow-on effects of this?  Well, for one thing, I wonder whether this will get the CFTC to re-think its taking manipulation cases to Federal court, rather than adjudicating them internally in front of agency ALJs.  For another, I wonder if this will make the CFTC more gun-shy at bringing major manipulation actions–even solid ones.  Losing a bad case should not be a deterrent in bringing good ones, but the spanking that Judge Sullivan delivered is likely to lead CFTC Enforcement–and the Commission–quite chary of running the risk of another one any time soon.  And since enforcement officials are strongly incentivized to, well, enforce, they will direct their energies elsewhere.  I would therefore not be surprised to see yet a further uptick in spoofing actions, an area where the Commission has been more successful.

In sum, the wheels of justice indeed ground slowly in this case, but in the end justice was done.  Don Wilson and DRW did nothing wrong, and the person who matters–Judge Sullivan–saw that and his decision demonstrates it clearly.

Print Friendly, PDF & Email

November 24, 2018

This Is What Happens When You Slip Picking Up Nickels In Front of a Steamroller

Filed under: Commodities,Derivatives,Energy,Exchanges — cpirrong @ 7:14 pm
There are times when going viral is good.  There are times it ain’t.  This is one of those ain’t times.  Being the hedgie equivalent of Jimmy Swaggert, delivering a tearful apology, is not a good look.

James Cordier ran a hedge fund that blowed up real good.   The fund’s strategy was to sell options, collect the premium, and keep fingers crossed that the markets would not move bigly.  Well, OptionSellers.com sold NG and crude options in front of major price moves, and poof! Customer money went up the spout.

Cordier refers to these price moves as “rogue waves.”  Well, as I said in my widowmaker post from last week, the natural gas market was primed for a violent move: low inventories going into the heating season made the market vulnerable to a cold snap, which duly materialized, and sent the market hurtling upwards.   The low pressure system was clearly visible on the map, and the risk of big waves was clear: a rogue wave out of the blue this wasn’t.

As for crude, the geopolitical, demand, and output (particularly Permian) risks have also been crystalizing all autumn.  Again, this was not a rogue wave.

I’m guessing that Cordier was short natural gas calls, and short crude oil puts, or straddles/strangles on these commodities.  Oopsie.

Selling options as an investment strategy is like picking up nickels in front of a steamroller.  You can make some money if you don’t slip.  If you slip, you get crushed.  Cordier slipped.

Selling options as a strategy can be appealing.  It’s not unusual to pick up quite a few nickels, and think: “Hey.  This is easy money!” Then you get complacent.  Then you get crushed.

Selling options is effectively selling insurance against large price moves.  You are rewarded with a risk premium, but that isn’t free money.  It is the reward for suffering large losses periodically.

It’s not just neophytes that get taken in.  In the months before Black Monday, floor traders on CBOE and CME thought shorting out-of-the-money, short-dated options on the S&Ps was like an annuity.  Collect the premium, watch them expire out-of-the-money, and do it again.   Then the Crash of ’87 happened, and all of the modest gains that had accumulated disappeared in a day.

Ask Mr. Cordier–and his “family”–about that.

 

Print Friendly, PDF & Email

Next Page »

Powered by WordPress