Streetwise Professor

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Think about that for a minute.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Some practical implications.

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

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

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

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

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

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

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

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

I’ve often written that every big move in commodity prices leads to a reprise of Casablanca: “Round up the usual suspects!”

The usual suspects, of course, being speculators.

And here we have a case of the usual suspects calling for a roundup of the usual suspects. People like Michael Greenberger and Tyler Slocum. I would be more than glad to move on. Them apparently not so much.

Now they feel especially energized because they can blame speculators not just for a rise in the price of this or the price of that, but the price of everything. Yes, boys and girls, speculators cause INFLATION!!!!! THEY ARE DRIVING UP THE PRICE OF EVERYTHING!!!!

A handful of congressional Democrats are turning their attention to an arcane loophole that, as TYT previously reported, is driving high prices for gas and food. Rep. Ro Khanna, D-Calif., told TYT that he wants the Biden administration to close the loophole, which lets Wall Street speculators gamble on commodity prices, driving inflation.

I’ll get back to “Ruh Ro” Khanna in a moment.

What Greenberger and others are serving up is the same-old, same-old that was discredited long ago. It’s too tedious to reprise the arguments: go back and look at my posts from 2006-2009 or so. The BS hasn’t changed, so the response to the BS hasn’t changed.

The quickest counterpoint: If–and even Paul Krugman and I agree on this, people, so the apocalypse must be nigh–speculators are driving prices above the competitive level determined by supply and demand fundamentals, (a) inventories increase, and (b) speculators hold the inventories.

Well, inventories are dropping to rock bottom levels in everything from oil, to diesel, to industrial metals. So (a) isn’t happening. And if (a) isn’t happening, (b) can’t happen.

QED.

But this would require Greenberger et al to have a modicum of understanding of economics. In fact, I once forced him to admit he has no such understanding.

We were witnesses at a House Ag Committee hearing on speculation and oil prices in July, 2008. Right about the time WTI hit its all time high. (I published a WSJ oped about the same time.). Greenberger and I were on a panel. He tried to make an argument that prices were irrational because they hadn’t gone down when the Saudis announced an increase in output. I pointed out that the real shortage was in low-sulfur crude (like WTI), driven in large part by Europe’s new low sulfur diesel rules. The Saudi oil was high in sulfur and didn’t address this issue at all, so it didn’t impact the prices of WTI and Brent (which are low sulfur).

In reply, Greenberger stuttered: “Well, I’m not an economist . . .” I interrupted: “That’s the first thing you’ve ever said that I agree with.” (Yeah. I know I’m bad. I can never pass up an easy shot.)

That still holds true. He ain’t an economist. He knows no economics. And anybody who listens to him bloviate about economics is wasting time and killing brain cells. (Though looking at his audience–Salon AKA Daily Dipshit readers, congressional Democrats–that latter is pretty much impossible.)

These geniuses think they’ve uncovered some damning new evidence. In footnotes:

But thanks to an obscure CFTC passage — Footnote 563, in regulatory guidance — buyers and sellers of oil and other commodities are outnumbered something like 10 to one by Wall Street traders, none of whom have a genuine buyer’s incentive to keep prices low, because few of them ever actually buy it; they mostly bet on it.

Uhm, that factoid, or a variant thereon, has been tossed around every time this tiresome debate has occurred. It was irrelevant every one of those times. It’s irrelevant now. It means nothing.

But some geniuses in Congress are going to flog this dead horse yet again. FFS.

But this is not the only idiocy that is being resurrected. Ron Wyden D-But you knew that-OR is proposing a revival of the windfall profit tax.

Another ’70s acid flashback. I’m trippin’, man!

pic.twitter.com/Wxw4EMk27e

— streetwiseprof (@streetwiseprof) June 14, 2022

Yeah that worked so well under Carter. Hey! Here’s an idea! Let’s reduce the incentive to invest by reducing payoffs when the investments are most valuable! What could go wrong?

Another hardy perennial: Our ranting senile narcissist in chief is demanding refiners cut prices and increase output. Er, look at the EIA capacity utilization numbers, dude. Refineries are operating flat out.

Apparently they did that, because today they mooted restricting exports instead. Another dumb idea.

And then there’s Ruh Ro Khanna:

Thanks for the heads up on "Ruh Roh" Khanna's insanity. I'll do a little more research and then bring the lumber to him. pic.twitter.com/WOn6Ls9l8X

— streetwiseprof (@streetwiseprof) June 3, 2022

h/t @CantillonCH

Khanna’s brainstorm is–get this–to have the government “buy the dips” and then sell commodities to consumers at low prices.

WHY HASN’T ANYBODY THOUGHT OF THIS BEFORE????

Well, because it’s so stupid only a California Democrat could come up with it.

Of the top of my head, Family Feud fashion, the top 4 reasons why this is stupid:

1. The best traders can’t time the market consistently. Why would anyone possibly believe government GS-13s or whatever could?
2. The government wouldn’t be a price taker–it would be driving prices.
3. Every trader in the world would be trying to front run the government. Talk about creating speculative opportunities! Speculate on what the government is going to do!
4. A California Democrat came up with it.

Bad economic times bring out bad economic ideas. Stupid never goes out of style in politics, and bad ideas never die. And that’s our reality today.

Gary Gensler is back, as clueless as ever. Perhaps in a future post I will discuss his malign proposal on corporate climate disclosure, but today I will focus on his latest brainwave: the restructuring of US equity markets.

In a speech, Gensler outlined his incisive critique of market structure:

“Right now, there isn’t a level playing field among different parts of the market: wholesalers, dark pools, and lit exchanges,” Gensler said in remarks delivered virtually for an event hosted by Piper Sandler in New York. “It’s not clear, given the current market segmentation, concentration, and lack of a level playing field, that our current national market system is as fair and competitive as possible for investors,” adding that there was a cost being borne by retail investors.  

“Level playing field” is a favorite trope of his, and of regulators generally. But what does it even mean in this context? Seriously–I have no idea. It’s just something that sounds good to the gullible that has no analytical content whatsoever. Yes, there are a variety of different types of market participants in competition and cooperation with one another. How does the existing setup disadvantage or advantage one group of participants in an inefficient way? How do we know that the current distribution of winners and losers does not reflect fundamental economic conditions? Gensler doesn’t say–he doesn’t even define what a level playing field is. He just makes the conclusory statement that the playing field isn’t level.

Furthermore, note the mealy mouthed statement “It’s not clear . . . that our current national market system is as fair and competitive as possible.” Well, then it’s not clear that it isn’t as fair and competitive as possible. And if Gensler isn’t clear about the fairness and competitiveness of the current system, how can he justify a regulator-mandated change in that system?

For God’s sake man, at least make a case that the current system is inefficient or unfair. If your case is bullshit, I’ll let you know. But to call for a massive change in policy just because you aren’t certain the current system is perfect is completely inadequate.

The Nirvana Fallacy looks good by comparison. At least the Nirvana Fallacy is rooted in some argument that the status quo is imperfect.

Foremost in GiGi’s crosshairs is payment for order flow (“PFOF”). This practice exercises a lot of people, but as Matt Levine notes, and as I’ve noted for years, it exists for a reason. Different types of order flow have different costs to service. Retail order flow is cheaper to trade against because retail traders are unlikely to be informed, which reduces adverse selection costs. PFOF is a way of segmenting order flow and charging retail traders lower prices which reflect their lower costs, in the current environment through zero (or very low commissions). This passes some (and arguably all) of the value of retail order flow to the retail traders.

The main concern over PFOF is that retail investors won’t see the benefit. Their brokers will pocket the payments they get from the wholesalers they sell the order flow to, and won’t pass it on to investors. Well, overlooking the fact that’s a distributive and not an efficiency issue, that’s where you rely on competition in the brokerage sector. Competition will drive the prices brokers charge customers down to the cost of serving them net of any payments they receive from wholesalers. In a highly competitive market for brokerage services, retail traders will capture the lion’s share of the value in their order flow.

So if you think retail customers are not reaping 100 pct of the benefits of PFOF (which begs the question of whether that’s the appropriate standard), then the focus should be on documenting some inadequacy of competition (which has NOT been done, and which Gensler does not even discuss); and if (and only if) that analysis does demonstrate that competition is inadequate, devising policies to enhance competition in the brokerage sector.

Only if (a) it is somehow efficient (or “fair”) for retail investors to reap 100 pct (or a large fraction) of PFOF revenues, (b) brokerage competition is inadequate to achieve objective (a), and (c) policies to enhance brokerage competition are inferior to banning or restricting PFOF is such a restriction/ban sufficient.

Does Gensler do any of that? Surely you jest. He says “unlevel playing field blah blah blah crack down on PFOF QED.” It is fundamentally unserious intellectual mush.

Gensler’s approach to equity market structure is disturbingly similar–and disturbingly similarly idiotic–to his approach to swap market structure in the Frankendodd days. As I (tediously after a while) wrote repeatedly while the CFTC was working on Swap Execution Facility regulations, Gensler favored a one-size-fits-all approach that failed to recognize that market structures develop to accommodate the disparate needs and preferences of heterogeneous traders. OTC and exchange markets served different clienteles and trading protocols and market structures were adapted to serving those clienteles efficiently. He did not analyze competition in any serious way at all. He did not address the Chesterton’s Fence question–why are things they way they are–before charging full speed to change them.

History is repeating itself with equity market structure. PFOF is an institution that has evolved in response to the characteristics of a particular class of market participants, (relatively) uninformed retail investors.

Crucially, it is an institution that has evolved in a competitive environment. There is value in retail order flows. There will be competition to capture that value. Considerable competition will ensure that retail investors will capture most of the value.

Gensler has proposed requiring routing all retail order flow through an auction mechanism where wholesalers will compete to offer the best price. The idea is that the auction prices will be inside the NMS spread, giving retail customers a better execution price.

But it’s a leap of faith to assert that this improvement in execution price will exceed the loss of PFOF that is passed back to investors through lower commissions. Will the auction be more competitive than the current market for retail order flow (including both the broker-wholesale and broker-customer segments)? Who knows? Gensler hasn’t even raised the issue–which demonstrates that he really doesn’t understand the real economic issues here. (Big shock, eh?)

And again, this means that the appropriate analysis is a comparative one focusing on competition under alternative institutional arrangements/market structures.

And insofar as competition is concerned, if auctions are such a great idea, why didn’t an exchange or an ECN or some other entity create one? Barriers to entry are low, especially in the modern electronic world.

I further note the following. One potential reason to eliminate or reduce PFOF that would actually be grounded in good economics is that segmentation of order flow exacerbates adverse selection problems on lit markets (exchanges) causing wider spreads there. However, the auction proposal would not mitigate that problem at all. The exacerbation of adverse selection is due to segmentation of order flow. The auction is just another way of segmenting order flow, and executing that order flow outside the lit exchange markets.

And here’s an irony. Assume arguendo that the auction does benefit retail investors–they capture more of the value inherent in their order flow. That would tend to lead to more order flow being directed to the auction market, and less to the lit markets. This would increase adverse selection costs in lit markets, exacerbating the inefficiencies of segmentation.

Nah. GiGi hasn’t thought that through either.

Talleyrand said of the Bourbons: they have learned nothing, and they have forgotten nothing. That’s Gary Gensler in a nutshell. He hasn’t learned any real economics, especially the economics of market structure and competition. But he hasn’t forgotten that he knows best, and he hasn’t forgotten the things that he knew that just aren’t true. That is a poisonous combination that damaged the derivatives markets when he was CFTC chair. But Gensler figures his work isn’t done. He has to damage the equity markets too based on his capricious understanding of how markets work–which is really no understanding at all.

FTAlphaville had a fascinating piece this week in which it described a discussion at a CFTC roundtable debating the FTX proposal that is generating so much tumult in DerivativesWorld. In a nutshell, Chris Edmonds of ICE revealed that due to a “technical issue” during the market chaos of March 2020 (which I wrote about in a Journal of Applied Corporate Finance piece) a large market participant was arguably in default to the ICE clearinghouse, but ICE (after consulting with the CEO, i.e., Jeff Sprecher) did not pull the trigger and call a default. Instead, it gave some time for the incipient defaulter to resolve the issue.

This raises an issue that I have written about for going on 15 years–the “tight coupling” of the clearing mechanism, and the acute destabilizing potential thereof. Tightly coupled systems are subject to”normal accidents” (also known as systemic collapses–shitshows): in a tightly coupled system, everything must operate in a tight sequence, and the failure of one piece of the system can cause the collapse of the entire system.

If ICE had acted in a mechanical fashion, and declared a default, the default of a large member could have caused the failure of ICE clearing, which would have had serious consequences for the entire financial system, especially in its COVID-induced febrile state. But ICE had people in the loop, which loosened the coupling and prevented a “normal accident” (i.e., the failure of ICE clearing and perhaps the financial system).

I have a sneaking suspicion that the exact same thing happened with LME during the nickel cluster almost exactly two years after the ICE situation. It is evident that LME uncoupled the entire system–by shutting down trading altogether, apparently suspending some margin calls, and even tearing up trades.

Put differently, it’s a good thing that important elements of the financial system have ways of loosening the coupling when by-the-book (or by-the algorithm) operation would lead to its destruction.

The ICE event was apparently a “technical issue.” Well that’s exactly the point–failures of technology can lead to the collapse of tightly coupled systems. And these failures are ubiquitous: remember the failures of FedWire on 19 October, 1987, which caused huge problems. (Well, you’re probably not old enough to remember. That’s why you need me.)

This issue came up during the FTX roundtable precisely because FTX (and its fanboyz) tout its algorithmic, no-man-in-the-loop operation as its innovation, and its virtue. But that gets it exactly backwards: it is its greatest vulnerability, and its greatest threat to the financial markets more generally. We should be thankful ICE had adults, not algos, in charge.

As I pointed out in my post on FTX in March:

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.

It’s particularly remarkable that FTX still is the subject of widespread adulation in light of Terra’s spiraling into the terra firma. As I said in my Luna post, it is lunatic to algorithmize positive feedback (i.e., doom) loops. (You might guess I don’t have a Luna tattoo. Not getting an FTX tattoo either!*)

FTX’s Sam Bankman-Fried is backtracking somewhat:

In the face of the agricultural industry complaints, Bankman-Fried gave ground. While maintaining his position that automated liquidations could prevent bad situations from growing worse, he said the FTX approach was better suited to “digitally settled” contracts — such as those for crypto — than to trades where physical collateral such as wheat or corn is used

Sorry, Sam, but digital settlement vs. physical settlement matters fuck all. (And “physical collateral”? Wut?) And you are deluded if you believe that “automated liquidations” generally prevent bad situations from growing worse. If you think that, you don’t get it, and are a positive threat to the financial markets.

*FTX bought the naming rights for a stadium in Miami. I say only slightly in jest that this is another indication of the dangers posed by FTX and its messianic founder. FFS, you’d think after the 2000 tech meltdown people would recognize that buying naming rights is often a great short selling signal, and a harbinger of future collapse. To say that those who forget the past are condemned to repeat it is too strong, but those who follow in the footsteps of failures that took place before their time betray an an arrogance (or an ignorance) that greatly raises the odds of repeating failure.

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.

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.

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.