Streetwise Professor

September 18, 2018

He Blowed Up Real Good. And Inflicted Some Collateral Damage to Boot

I’m on my way back from my annual teaching sojourn in Geneva, plus a day in the Netherlands for a speaking engagement.  While I was taking that European non-quite-vacation, a Norwegian power trader, Einar Aas, suffered a massive loss in cleared spread trades between Nordic and German electricity.  The loss was so large that it blew through Aas’ initial margin and default fund contribution to the clearinghouse (Nasdaq), consumed Nasdaq’s €7 million capital contribution to the default fund, and €107 million of the rest of the default fund–a mere 66 percent of the fund.  The members have been ordered to contribute €100 million to top up the fund.

This was bound to happen. In a way, it was good that it happened in a relatively small market.  But it provides a sobering demonstration of what I’ve said for years: clearing doesn’t eliminate losses, but affects the distribution of losses.  Further, financial institutions that back CCPs–the members–are the ultimate backstops.  Thus, clearing does not eliminate contagion or interconnections in the financial network: it just changes the topology of the network, and the channels by which losses can hit the balance sheets of big players.

Happening in the Nordic/European power markets, this is an interesting curiosity.  If it happens in the interest rate or equity markets, it could be a disaster.

We actually know very little about what happened, beyond the broad details.  We know Aas was long Nordic power and short German power, and that the spread widened due to wet weather in Norway (which depresses the price of hydro and reduces demand) and an increase in European prices due to increases in CO2 prices.  But Nasdaq trades daily, weekly, monthly, quarterly, and annual power products: we don’t know which blew up Aas.  Daily spreads are more volatile, and exhibit more extremes (kurtosis), but since margins are scaled to risk (at least theoretically–more on this below) what matters is the market move relative to the estimated risk.  Reports indicate that the spread moved 17x the typical move, but we don’t know what measure of “typical” is used here.  Standard deviation?  Not a very good measure when there is a lot of kurtosis (or skewness).

I also haven’t seen how big Aas’ initial margins were.  The total loss he suffered was bigger than the hit taken by the default fund, because under the loser-pays model, the initial margins would have been in the first loss position.

The big question in my mind relates to Nasdaq’s margin model.  Power price distributions deviate substantially from the Gaussian, and estimating those distributions is challenging in part because they are also conditional on day of the year and hour of the day, and on fundamental supply-demand conditions: one model doesn’t fit every day, every hour, every season, or every weather enviornment.  Moreover, a spread trade has correlation risk–dependence risk would be a better word, given that correlation is a linear measure of dependence and dependencies in power prices are not linear.  How did Nasdaq model this dependence and how did that impact margins?

One possibility is that Nasdaq’s risk/margin model was good, but this was just one of those things.  Margins are set on the basis of the tails, and tail events occur with some probability.

Given the nature of the tails in power prices (and spreads) reliance on a VaR-type model would be especially dangerous here.  Setting margin based on something like expected shortfall would likely be superior here.  Which model does Nasdaq use?

I can also see the possibility that Nasdaq’s margin model was faulty, and that Aas had figured this out.  He then put on trades that he knew were undermargined because Nasdaq’s model was defective, which allowed him to take on more risk than Nasdaq intended.

In my early work on clearing I indicted that this adverse selection problem was a concern in clearing, and would lead CCPs–and those who believe that CCPs make the financial system safer–to underestimate risk and be falsely complacent.  Indeed, I argued that one reason clearing could be a bad idea is that it was more vulnerable to adverse selection problems because the need to model the distribution of gains/losses on cleared positions requires detailed knowledge, especially for more exotic products.  Traders who specialize in these products are likely to have MUCH better understanding about risks than a non-specialist CCP.

Aas cleared for himself, and this has caused some to get the vapors and conclude that Nasdaq was negligent in allowing him to do so.  Self-clearing is just an FCM with a house account, but with no client business: in some respects that’s less risky than a traditional FCM with client business as well as its own trading book.

Nasdaq required Aas to have €70 million in capital to self-clear.  Presumably Nasdaq will get some of that capital in an insolvency proceeding, and use it to repay default fund members–meaning that the €114 million loss is likely an overestimate of the ultimate cost borne by Nasdaq and the clearing members.

Further, that’s probably similar to the amount of capital that an FCM would have had to have to carry a client position as big as Aas’.   That’s not inherently more risky (to the clearinghouse and its default fund) than if Aas had cleared through another firm (or firms).  Again, the issue is whether Nasdaq is assessing risks accurately so as to allow it to set clearing member capital appropriately.

But the point is that Aas had to have skin in the game to self-clear, just as an FCM would have had to clear for him.

Holding Aas’ positions constant, whether he cleared himself or through an FCM really only affected the distribution of losses, but not the magnitude.  If Aas had cleared through someone else, that someone else’s capital would have taken the hit, and the default fund would have been at risk only if that FCM had defaulted.  But the total loss suffered by FCMs would have been exactly the same, just distributed more unevenly.

Indeed, the more even distribution that occurred due to mutualization which spread the default loss among multiple FCMs might actually be preferable to having one FCM bear the brunt.

The real issue here is incentives.  My statement was that holding Aas’ positions constant, who he cleared through or whether he cleared at all affected only the distribution of losses.  Perhaps under different structures Aas might not have been able to take on this much risk.  But that’s an open question.

If he had cleared through another FCM, that FCM would have had an incentive to limit its positions because its capital was at risk.  But Aas’ capital was at risk–he had skin in the game too, and this was necessary for him to self-clear.  It’s by no means obvious that an FCM would have arrived at a different conclusion than Aas, and decided that his position represented a reasonable risk to its capital.

Here again a key issue is information asymmetry: would the FCM know more about the risk of Aas’ position, or less?  Given Aas’ allegedly obsessive behavior, and his long-time success as a trader, I’m pretty sure that Aas knew more about the risk than any FCM would have, and that requiring him to clear through another firm would not have necessarily constrained his position.  He would have also had an incentive to put his business at the dumbest FCM.

Another incentive issue is Nasdaq’s skin in the game–an issue that has exercised FCMs generally, not just on Nasdaq.  The exchange’s/CCP’s relatively thin contribution to the default fund arguably reduces its incentive to get its margin model right.  Evaluating whether Nasdaq’s relatively minor exposure to default risk led it to undermargin requires a more thorough analysis of its margin model, which is a very complex exercise which is impossible to do given what we know about the model.

But this all brings me back to themes I flogged to the collective shrug of many–indeed almost all–of the regulatory and legislative community back in the aftermath of the Crisis, when clearing was the silver bullet for future crises.   Clearing is all about the allocation and pricing of counterparty credit risk.  Evaluation of counterparty credit risk in a derivatives context requires a detailed understanding of the price risks of the cleared products, and dependencies between these price risks and the balance sheet risks of participants in cleared markets.  Classic information problems–adverse selection and moral hazard (too little skin in the game)–make risk sharing costly, and can lead to the mispricing of risk.

The forensics about Aas blowing up real good, and the lessons learned from that experience, should focus on those issues.  Alas, I see little recognition of that in the media coverage of the episode, and betting on form, I would wager that the same is true of regulators as well.

The Aas blow up should be a salutary lesson in how clearing really works, what it can do, and what it can’t.   Cynic that I am, I’m guessing that it won’t be.  And if I’m right, the next time could be far, far worse.

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August 16, 2018

Why ABCD Sing the Blues, Part II: Increased Farm Scale Leads to Greater Competition in Capacity and Less Monopsony Power

Filed under: Commodities,Derivatives,Economics,Politics,Regulation — cpirrong @ 6:34 pm

In “Why Are ABCD Singing the Blues?” I called bull on the claim that ag trading firms were suffering through a rough period because of big crops and low prices.  I instead surmised that gains in capacity, in storage and throughput facilities, had outstripped growth in the amount of grain handled, and that this was pressuring margins.  In yesterday’s WSJ, Jacob Bunge (no relation, apparently, to the grain trading family) had a long and dense article that presents a lot of anecdotal support for that view.  The piece also provides other information that allows me to supplement and expand on it.

In a nutshell, due to increased economies of scale in farming, farms have grown larger.  Many farms have grown to the point that they can achieve efficient scale in storage and logistics to warrant investment in storage facilities and trucks, and thus can vertically integrate into the functions traditionally performed by Cargill and the others.  This has led to an expansion in storage capacity and logistical capacity overall, which has reduced the derived demand for the storage and logistics assets owned and operated by the ABCDs.  Jacob’s article presents a striking example of an Illinois farmer that bought a storage facility from Cargill.

In brief, more integrated farms have invested in capacity that competes with the facilities owned by Cargill, ADM, Bunge, and smaller firms in the industry.  No wonder their profits have fallen.

The other thing that the article illustrates is that scale plus cheaper communication costs have reduced the monopsony power of the grain merchants.  The operation of the farmer profiled in the piece is so large that many merchants, including some from a distance away, are competing for his business.  Furthermore, the ability to store his own production gives the farmer the luxury of time to sell: he doesn’t have to sell at harvest time to the local elevator at whatever price the latter offers–which was historically low-balled due to the cost of hauling to a more distant elevator.  Choosing the time to sell gives the farmer the value of the optionality inherent in storage–and the traditional merchant loses that option.  Further, more time allows the farmer to seek out and negotiate better deals from a wider variety of players.

The traditional country market for grain can be modeled well as a simple spatial economy with fixed costs (the costs of building/operating an elevator).  Fixed costs limit the number of elevators, and transportation costs between spatially separated elevators gave each elevator some market power in its vicinity: more technically, transportation costs meant that the supply of grain to a country elevator was upward sloping, with the nearby farms willing to sell at lower prices than more distant ones closer to competing elevators.  This gave the elevators monopsony power.  (And no doubt, competition was limited even in multi-elevator towns, because the conditions for tacit collusion were ripe.)

Once upon a time, the monopsony power of elevator operators was a hot-button political issue.  One impetus for the farm cooperative movement was to counteract the monopsony power of the line elevator operators.  The middlemen didn’t like this one bit, and that was the reason that they excluded cooperatives from membership of futures exchanges, like the Chicago Board of Trade: this exclusion raised cooperatives’ costs, and was effectively a raising-rivals-cost strategy.  Brokers also supported excluding cooperatives because as members cooperatives could have circumvented broker commission cartels (i.e., the official, exchange-approved and enforced minimum commission rates).  This is why the Commodity Exchange Act contains this language:

No board of trade which has been designated or registered as a contract market or a derivatives transaction execution facility exclude  from membership in, and all privileges on, such board of trade, any association or corporation engaged in cash commodity business having adequate financial responsibility which is organized under the cooperative laws of any State, or which has been recognized as a cooperative association of producers by the United States Government or by any agency thereof, if such association or corporation complies and agrees to comply with such terms and conditions as are or may be imposed lawfully upon other members of such board, and as are or may be imposed lawfully upon a cooperative association of producers engaged in cash commodity business, unless such board of trade is authorized by the commission to exclude such association or corporation from membership and privileges after hearing held upon at least three days’ notice subsequent to the filing of complaint by the board of trade.

Put differently, in the old days the efficient scale of farms was small relative to the efficient scale of midstream assets, so farmers had to cooperate in order to circumvent merchant monopsony power.  Cooperation was hampered by incentive problems and the political nature of cooperative governance.  (See Henry Hansmann’s Ownership of Enterprise for a nice discussion.) The dramatic increase in the efficient scale of farms now means (as the WSJ article shows) that many farmers have operations as large as the efficient scale of some midstream assets, so can circumvent monopsony power through integration.  This pressures merchants; margins.

Jacob Bunge is to be congratulated for not imitating the laziness of most of those who have “reported” on the grain merchant blues, where by “reporting” I mean regurgitating the conventional wisdom that they picked up from some other lazy journalist.  He went out into the field–literally–and shed a good deal of light on what’s really going on.  And what’s going on is competition and entry, driven in large part by economic and technological forces that have increased the efficient scale of grain and oilseed production.  Thus, the grain handlers are in large part indirect victims of technological change, even though the technology of their business has remained static by comparison.

 

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July 8, 2018

The CFTC Intervenes to Prevent Moral Hazard in the CDS Market–But Why the CFTC?

Filed under: Derivatives,Economics,Politics,Regulation — cpirrong @ 8:36 pm

The WSJ reports that the CFTC engaged in extraordinary efforts to prevent manipulation of the CDS market by Blackstone Group.  Blackstone had bought about $333 million in protection on homebuilder Hovnanian, and then extended a low-interest loan to the company to induce it to make a technical default on debt the company itself owned (having bought it back).  The CFTC caught wind of this, and put on the full court press and eventually, uhm, persuaded (by intimating that it considered such behavior manipulative) Blackstone to negotiate an exit from the CDS with its counterparties.

In the Allen-Gale taxonomy, this would be best characterized as an “action-based” manipulation, as opposed to trading-based, or information-based.  It is clearly not a market power manipulation.

The conduct at issue is clearly a form of rent seeking–a set of transactions engineered for the purpose of obtaining a wealth transfer.  Unlike a market power manipulation, the direct welfare costs of this activity were probably small, and limited to the costs of negotiating with Hovnanian, and executing the CDS transactions.  However, as in most manipulations, the big costs here were indirect.  Blackstone’s scheme undermines the CDS market as a risk transfer mechanism.  In effect, Blackstone’s stratagem was a form of moral hazard, in that the insured could affect the probability of loss.  Moral hazard raises the cost of insurance, and leads to suboptimal risk transfer.  (Yes, I know that CDS market participants shudder at the use of the word “insurance” to describe CDS, in part because they want to avoid insurance regulation.  I am not using the word in its legal sense, but in an informal way to describe a risk transfer mechanism.)

CDS are particularly prone to moral hazard because individuals (notably, the managers of corporations) can do things to trigger defaults, and CDS can provide them directly or indirectly with an economic incentive to do so.  Further, CDS contracts are incomplete (i.e., not all possible contingencies can be specified) and often as a result contain ambiguities that clever rent seekers can exploit to win a payoff.

The CFTC’s actions are therefore laudable.  What’s particularly curious about this, however, is precisely the fact that it was the CFTC that intervened here.  Under Title VII of Frankendodd, the SEC has jurisdiction “over ‘security-based swaps,’ which are defined as swaps based on a single security or loan or a narrow-based group or index of securities (including any interest therein or the value thereof), or events relating to a single issuer or issuers of securities in a narrow-based security index”–the CFTC has jurisdiction over everything else.

The Hovnanian CDS are clearly in the SEC’s ambit, and not in the CFTC’s.  But in the case of the Hovnanian CDS, the SEC has been conspicuously absent. IIt is not mentioned at all in the WSJ piece.)  Curious, that.  Even more curious given the jealousy with which the SEC (like most government agencies) defends its turf against perceived incursions–especially the CFTC.   Why did the SEC let the CFTC take the lead on this, without a peep of protest?  And why did the CFTC apparently overstep its authority?

Things could have become interesting had Blackstone persisted with its scheme, and the CFTC filed an action against it.  In the event, an obvious legal response by Blackstone would have been to claim that the CFTC had no legal authority to take enforcement action.

Given this legal issue, the CFTC’s intervention may have less of a deterrent effect on future manipulations than an SEC intervention would have.

The SEC does not have the reputation of being a shrinking violet by any means, but it has been noticeably shy in some high profile events, the Hovnanian CDS story being one, and Tesla being another.  Makes me wonder . . .

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July 6, 2018

Chinese Oil Futures: Performing As Predicted

Filed under: China,Commodities,Derivatives,Economics,Energy — cpirrong @ 6:27 pm

The recent introduction of Shanghai oil futures has resulted in a lot of churn in the front month, and very little activity in even the 1st and 2nd nearby:

China’s new oil futures are a hit with investors but they’re facing commitment issues.

While daily volume in the yuan-denominated contract has increased five-fold since its debut in late-March amid steady growth in open interest, almost all trading is focused in front-month, September futures.

. . . .

It suggests that, for now, traders are using the futures principally to speculate on short-term price fluctuations, as opposed to hedge long-term consumption or production, according to Jia Zheng, a portfolio manager at Shanghai Minghong Investment Co.

Which is pretty much what I predicted on the day of the launch:

Will it succeed?  Well, that depends on how you measure success.  No doubt it will generate heavy volume.  Speculative enthusiasm runs deep in China, and retail traders trade a lot.  They would probably make a guano futures contract a success, if it were launched: they will no doubt be attracted to crude.

. . . .

If you are looking for a metric of success as a commercial tool (rather than of its success as a money making venture for the exchange) look at open interest, not volume.  And look in particular in open interest in the back months.  This will take some time to build, and in the meantime I imagine that there will be a lot of awed commentary about trading volume.  But that’s not the main indicator of the utility of a contract as a commercial risk management and price discovery tool.

 

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June 28, 2018

A Tarnished GEM: A Casualty of Regulation, Spread Explosions, or Both?

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 6:28 pm

Geneva Energy Markets LLC, a large independent oil market maker, has been shuttered.  Bloomberg and the FT have stories on GEM’s demise.  The Bloomberg piece primarily communicates the firm’s official explanation: the imposition of the Basel III leverage ratio on GEM’s clearer raised the FCM’s capital requirement, and it responded by forcing GEM to reduce its positions sharply.  The FT story contains the same explanation, but adds this: “Geneva Energy Markets, which traded between 50m and 100m barrels a day of oil, has sold its trading book after taking ‘significant losses’ in oil futures and options, a person close to the company said.”

These stories are of course not mutually exclusive, and the timing of the announcement that the firm is shutting down months after it had already been ordered to reduce positions suggests a way of reconciling them. Specifically, the firm had suffered loss that made it impossible to support even its shrunken positions.

The timing is consistent with this.  GEM is primarily a spread trader, and oil spreads have gone crazy lately.  In particular, spread position short nearby WTI has been killed in recent days due to the closure of Canadian oil sands production and the relentless exports of US oil.  The fall in supply and continued strong demand have led to a rapid fall in oil stocks, especially at Cushing.  This has been accompanied (as theory says it should be!) by a spike in the WTI backwardation, and a rise in the WTI-Brent differential (and other quality spreads with a WTI leg).  If GEM was short the calendar spread, or had a position in quality spreads that went pear-shaped with the explosion in WTI, it could have taken a big hit.  Or at least a big enough hit to make it unviable to continue to operate at a profitable scale.

Here’s a cautionary tale.  Stop me if you’ve heard it before:

“The notional value of our book was in excess of $50 billion,” Vonderheide said. “However, the actual risk of the book was always relatively low, with at value-at-risk at around $2 million at any given time.”

If I had a dollar for every time that I’ve heard/read “No worries! Our VaR is really low!” only to have the firm fold (or survive a big loss) I would be livin’ large.  VaR works.  Until it doesn’t.  At best, it tells you the minimum loss you can suffer with a certain probability: it doesn’t tell you how much worse than that it can get.  This is why VaR is being replaced or supplemented with other measures that give a better measure of downside risk (e.g., expected shortfall).

I would agree, however, with GEM managing partner Mark Vonderheide (whom I know slightly):

“The new regulation is seriously damaging the liquidity in the energy market,” Vonderheide said. “If the regulation was intending to create a safer and more efficient market, it has done completely the opposite.”

It makes it costlier to make markets, which erodes market liquidity, thereby making it costlier for firms to hedge, and more difficult to enter and exit positions.  Liquidity reductions resulting from this type of regulation tend to be most acute during periods of high volatility–which can exacerbate the volatility, perversely.  Moreover, like much of Frankendodd and its foreign fellow monsters, it tends to hit small to medium sized firms worse than bigger ones, and thereby contributes to greater concentration in the markets–exactly the opposite of the stated purpose.

As Reagan said: “The most terrifying words in the English language are: I’m from the government and I’m here to help.” Just ask GEM about that.

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May 15, 2018

Contrary to What You Might Have Read, the Oil Market (Flat Prices and Calendar Spreads) Is Not Sending Mixed Signals

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 9:27 pm

In recent weeks, the flat price of crude oil (both WTI and Brent) has moved up smartly, but time spreads have declined pretty sharply.  A common mistake by oil market analysts is to consider this combination of movements anomalous, and an indication of a disconnect between the paper and the physical markets.  This article from Reuters is an example:

Oil futures prices have soared past three-year highs, OPEC’s deal has cut millions of barrels of inventory worldwide and investors are betting in record numbers that prices could rocket past $80 and even hit $90 a barrel this year.

But physical markets for oil shipments tell a different story. Spot crude prices are at their steepest discounts to futures prices in years due to weak demand from refiners in China and a backlog of cargoes in Europe. Sellers are struggling to find buyers for West African, Russian and Kazakh cargoes, while pipeline bottlenecks trap supply in west Texas and Canada.

The divergence is notable because traditionally, physical markets are viewed as a better gauge of short-term fundamentals. Crude traders who peddle cargoes to refineries worldwide say speculators are on shaky ground as they drive futures markets above $70 a barrel, their highest levels for three-and-a-half years, on concerns about tighter supply from Venezuela and the potential impact of U.S. sanctions on supply from Iran.

Investors have piled millions of dollars in record wagers in the options market, betting on a further rally on the back of rising geopolitical tensions, particularly in Iran, Saudi Arabia and Venezuela, and the global decline in supply.

“Guys who are trading futures have a view that draws are coming and big draws are coming,” a U.S.-based crude trader at a global commodity merchant said, adding that demand could ramp up as global refinery maintenance ends.

. . . .

BIG DISCONNECT

Those on the front lines of the physical market are not convinced. Traders say the surge in U.S. exports to more than 2 million bpd has saturated some markets, leaving benchmark prices ripe for a correction.

“There is a huge disconnect between futures and fundamentals,” a trader with a Chinese independent refiner said. “I won’t be surprised if prices correct by $20 a barrel.”

In fact, the alleged “disconnect” is readily explained based on recent developments in the market, notably the prospect for interruption/reduction in Iranian supplies due to the reimposition of sanctions by the US.  The situation in Venezuela is exacerbating this situation.  Two things are particularly important in this regard.

First, the Iranian situation is a threat to future supplies, not current supplies: the potential collapse in Venezuela is also a threat to future supplies (although current supplies are dropping too).  A reduction in expected future supplies increases future scarcity relative to current scarcity.  The economically efficient response to that is to share the pain, that is, to shift some supply from the present to the future by storage.  To reward storage, the futures price rises relative to the spot price–that is, the time spread declines.  However, since the driving shock (the anticipated reduction in future supplies) will result in greater scarcity, the flat price must rise.

A second effect works in the same direction. This is a phenomenon that I worked out in a 2008 paper that later was expanded into a chapter my book on commodity price dynamics.  Both the US actions regarding Iran, and the current tumult in Venezuela increase uncertainty about future supplies.  The efficient way to respond to this increase in fundamental uncertainty is to increase inventories, relative to what they would have been absent the increase.  This requires a decline in current consumption, which requires an increase in flat prices.  But incentivizing greater storage requires a fall in calendar spreads.

An additional complicating factor here is the feedback between inventories or calendar spreads (which are often used as a rough proxy for inventories, given the opacity and relative infrequency of stocks numbers) and OPEC decisions.  To the extent OPEC uses inventories or calendar spreads as a measure of the tightness of the supply-demand balance, and interprets the fall in calendar spreads and the related increase in inventories (or decline in the rate of inventory reductions), it could respond to what is happening now by restricting supplies . . . which would exacerbate the future scarcity. Relatedly, a known unknown is how current spread movements reflect market expectations about how OPEC will respond to spread movements.  The feedback/reflexivity here (that results from a price maker/entity with market power using spreads/inventory as a proxy for supply-demand balance, and market participants forming expectations about how the price maker will behave) greatly complicates things.  Misalignments between OPEC behavior and market expectations (and OPEC expectations about market expectations, and on an on with infinite regress) can lead to big jumps in prices.

Putting to one side this last complication, contrary to what many analysts and market participants claim, the recent movements in flat prices and spreads are not sending mixed signals.  They are a rational response to the evolution in market conditions observed in recent weeks: a decline in expected future supply, and an increase in fundamental risk.  The theory of storable commodities predicts that such conditions will lead to higher flat prices and lower calendar spreads.

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May 8, 2018

Libor Was a Crappy Wrench. Here–Use This Beautiful New Hammer Instead!

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 8:02 pm

When discussing the 1864 election, Lincoln mused that it was unwise to swap horses in midstream.  (Lincoln used a variant of this phrase many times during the campaign.) The New York Fed and the Board of Governors are proposing to do that nonetheless when it comes to interest rates.  They want to transition from reliance on Libor to a new Secured Overnight Financing Rate (SOFR, because you can never have enough acronyms), despite the fact that there are trillions of dollars of notional in outstanding derivatives and more trillions in loans with payments tied to Libor.

There are at least two issues here.  The first is if Libor fades away, dies, or is murdered, what is to be done with the outstanding contracts that it is written into? Renegotiations of contracts (even if possible) would be intense, costly, and protracted, because any adjustment to contracts to replace Libor could result in the transfer of tens of billions of dollars among the parties to these contracts.  This is particularly like because of the stark differences between Libor and SOFR.  How would you value the difference between a stream of cash flows based on a flawed mechanism intended to reflect term rates on unsecured borrowings with a stream of cash flows based on overnight secured borrowings?  Apples to oranges doesn’t come close to describing the difference.

Seriously: how would you determine the value so that you could adjust contracts?  A conventional answer is to hold some sort of auction (such as that used to determine CDS payoffs in a default), and then settle all outstanding contracts based on the clearing price in the auction (again like a CDS auction).  But I can’t see how that would work here.

Let’s say you have a contract entitling you to receive a set of payoffs tied to Libor.  You participate in an auction where you bid an amount that you would be willing to pay/receive to give up that set of payoffs for a set of SOFR payoffs.  What would you bid?  Well, in a conventional auction your bid would be based on the value of holding onto the item you would give up (here, the Libor payments).  But if Libor is going to go away, how would you determine that opportunity cost?

Not to mention that there is an immense variety of payoff formulae based on Libor, meaning that there would have to be an immense variety of (impractical) auctions.

So it will come down to bruising negotiations, which given the amounts at stake, would consume large amounts of real resources.

The second issue is whether the SOFR rate will perform the same function as well as Libor did.  Market participants always had the choice to use some other rate to determine floating rates in swaps–T-bill rates, O/N repo rates, what have you.  They settled on Libor pretty quickly because Libor hedged the risks that swap users faced better than the alternatives.  A creditworthy bank that borrowed unsecured for 1, 3, 6, or 12 month terms could hedge its funding costs pretty well by using a Libor-based swap: a swap based on some alternative (like an O/N secured rate) would have been a dirtier hedge.  Similarly, another way that banks hedged interest rate risk was to lend at rates tied to their funding cost–which varied closely with Libor.  Well, the borrowers (e.g., corporates) could swap those floating rate loans into fixed by using Libor-based swaps.

That is, Libor-based swaps and other derivatives came to dominate because they were better hedges for interest rate risks faced by banks and corporates than alternatives would have been.  There was an element of reflexivity here too: the availability of Libor-based hedging instruments made it desirable to enter into borrowing and lending transactions based on Libor, because you could hedge them. This positive feedback mechanism created the vexing situation faced today, where there are immense sums of contracts that embed Libor in one way or another.

SOFR will not have this desirable feature–unless the Fed wants to drive banks to do all their funding secured overnight! That is, there will be a mismatch between the new rate that is intended replace Libor as a benchmark in derivatives and loan transactions, and the risks that that market participants want to hedge.

In essence, the Fed identified the problem with Libor–its vulnerability to manipulation because it was not based on transactions–and says that it has fixed it by creating a benchmark based on a lot of transactions.  The problem is that the benchmark that is “better” in some respects (less vulnerable to a certain kind of manipulation) is worse in others (matching the risk that market participants want to hedge).  In a near obsessive quest to fix one flaw, the Fed totally overlooked the purpose of the thing that they were trying to fix, and have created something of dubious utility because it does a poorer job of achieving that purpose.  In focusing on the details of the construction of the benchmark, they’ve lost sight of the big picture: what the benchmark is supposed to be used for.

It’s like the Fed has said: “Libor was one crappy wrench, so we’ve gone out and created this beautiful hammer. Use that instead!”

Or, to reprise an old standby, the Fed is like the drunk looking for his car keys under the lamppost, not because he lost them there, but because the light is better.  There is more light (transactions) in the O/N secured market, but that’s not where the market’s hedging keys are.

This is an object lesson in how governments and other large bureaucracies go astray.  The details of a particular problem receive outsized attention, and all efforts are focused on fixing that problem without considering the larger context, and the potential unintended consequences of the “fix.” Government is especially vulnerable to this given the tendency to focus on scandal and controversy and the inevitable narrative simplification and decontextualization that scandal creates.

The current ‘bor administrator–ICE–is striving to keep it alive.  These efforts deserve support.  Secured overnight rate-based benchmarks are ill-suited to serve as the basis for interest rate derivatives that are used to hedge the transactions that Libor-based derivatives do.

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May 1, 2018

Cuckoo for Cocoa Puffs: Round Up the Usual Suspects

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 10:39 am

Journalism on financial markets generally, and commodity markets in particular, often resorts to rounding up the usual suspects to explain anomalous price movements.  Nowadays, the usual suspect in commodity markets is computerized/algorithmic/high frequency trading.  For example, some time back HFT was blamed for higher volatility in the cattle market, even though such trading represents a smaller fraction of cattle trading than it does for other contracts, and especially since there is precious little in the way of a theoretical argument that would support such a connection.

Another case in point: a flipping of the relationship between London and New York cocoa prices is being blamed on computerized traders.

Computers are dominating the trading of cocoa in New York, sparking a dramatic divergence in the longstanding price relationship with the London market.

Speculative funds have driven the price of the commodity in New York up more than 50 per cent since the start of the year to just under $3,000 a tonne. The New York market, traded in dollars, has traditionally been the preferred market for financial players such as hedge funds.

The London market, historically favoured by traders and commercial players buying and selling physical cocoa, has only risen 34 per cent in the same timeframe.

The big shift triggered by the New York buying is that its benchmark, which normally trades at a discount to London, now sits at a record premium.

So, is the NY premium unjustified by physical market price relationships?  If so, that would be like hundred dollar bills lying on the sidewalk–and someone would pick them up, right?

Not according to this article:

The pronounced shift in price relationships comes as hedge fund managers with physical trading capabilities and merchant traders have exited the cocoa market.

In the past, such a large price difference would have encouraged a trader to buy physical cocoa in London and send it to New York, hence narrowing the relationship. However, current price movements reflected the absence of such players, said brokers.

Fewer does not mean zero.  Cargill, or Olam, or Barry Callebaut or Ecom and a handful of other traders certainly have the ability to execute a simple physical arb if one existed.  Indeed, given the recent trying times in physical commodity trading, such firms would be ravenous to exploit such opportunities.

What’s even more bizarre is that pairs/spread/convergence trading is about the most vanilla (not chocolate!) type of algorithmic trade there is, and indeed, has long been a staple of algorithmic firms that trade only paper.  Meaning that if the spread between this pair of closely related contracts was out of line, if physical traders didn’t bring it back into line, it would be the computerized traders who would.  Yes, there are some complexities here–different delivery locations, different currencies, different deliverable growths with different price differentials, different clearinghouses–but those are exactly the kinds of things that are amenable to systematic–and computerized–analysis.

Weirdly, the article recognizes this

Others use algorithms that exploit the shifts in price relationships between different markets or separate contracts of the same commodity. [Emphasis added.  I should mention that cocoa is one of the few examples of a commodity with separate active contracts for the same commodity.]

It then fails to grasp the implications of this.

One “authority” cited in the article is–get this–Anthony Ward of Armajaro infamy:

Anthony Ward, the commodities trader known in the cocoa market for his large bets, has been among the more well-known fund managers to close his hedge fund, exiting the market at the end of last year. Mr Ward, dubbed “Chocfinger” due to his influence over the cocoa price, blamed the rising power of algorithmic and systems-based trading for making position-taking based on “fundamental” supply and demand factors more difficult.

Methinks that the market isn’t treating Anthony well, and like many losing traders, can’t take the blame himself so he’s looking for a scapegoat. (I note that Ward sold out Armajaro’s cocoa trading business to Ecom for the grand sum of $1 in December, 2013.)

I am skeptical enough that computerized trading can distort flat prices, but those arguments are harder to refute because of the knowledge problem: the whole reason markets exist is that no one knows the “right” price, hence disagreements are inevitable.  But when it comes to something as basic as an intracommodity spread, I find allegations of computer-driven distortions completely implausible.  You can’t arb flat price distortions, but you can arb distorted spreads, and that business is the bread and butter for commodity traders.

So: release the suspect!

PS. For my Geneva students looking for a topic for a class paper, this would be ideal. Perform an analysis to explain the flipping of the spread.

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Rusal: Premature Celebration

Filed under: Commodities,Derivatives,Economics,Politics,Regulation,Russia — The Professor @ 9:31 am

Rusal shares rose sharply and aluminum prices fell sharply on the news that the US Treasury had eased sanctions on the company.  The concrete change was an extension in the time granted for those dealing with Deripaska-linked entities to wind down those dealings.  But the market was more encouraged by the Treasury’s statement that the extension was being granted in order to permit it to evaluate Rusal’s petition to be removed from the SDN list.  It is inclusion on that list that sent the company into a downward spiral.

Methinks that the celebration is premature.  Treasury made clear that a stay of execution for Rusal was contingent upon it cutting ties with Deripaska.  Well, just how is that supposed to happen? This is especially the case if any transaction that removes Deripaska from the company not benefit him financially.  Well, then why would he sell?  He would have no incentive to make certain something–the total loss of his investment in Rusal–that is only a possibility now.

Of course, Putin has ways of making this happen, the most pleasant of which would be nationalization without compensation to Deripaska, perhaps followed by a sale to … somebody (more on this below). (Less pleasant ways would involve, say, Chita, or a fall from a great height.)

But if the US were to say that this was sufficient to bring Rusal in from the cold, the entire sanctions regime would be exposed as an incoherent farce.  For the ultimate target of the sanctions is not Deripaska per se, but the government of Russia, for an explicit foreign policy purpose–a “response to the actions and polices of the Government of the Russian Federation, including the purported annexation of the Crimea region of Ukraine.”

Deripaska didn’t personally annex Crimea or support insurrection in the Donbas.  The Russian government did.  The idea behind sanctions was to put pressure on those the Russian government (allegedly) cares about in order to change Putin’s policies.  They are an indirect assault on Putin/the Russian government, but an assault on them nonetheless.

So removing Rusal from the SDN list because it had been seized by the Russian government would make no sense based on the purported purpose of the sanctions.  Indeed, under the logic of the sanctions, the current discomfiture of the Russian government, facing as it does the potential unemployment of tens of thousands of workers, should be a feature not a bug. The sanctions were levied under an act whose title refers to “America’s adversaries,” which would be the Russian state, and were intended to punish said adversaries.

Mission accomplished!  Which is precisely why the Russian government is completely rational to view the Treasury announcement “cautiously,” and to view the US signals as “contradictory.”  The Russians would be fools to believe that nationalization and kicking Deripaska to the curb would free Rusal from the mortal threat that sanctions pose.

Perhaps Treasury has viewed the market carnage, and is trying to find a face-saving way out.  But it cannot do so without losing all credibility, and appearing rash, and quite frankly stupid, for failing to understand the ramifications of imposing SDN on Deripaska.  Also, doing so would feed the political fire that Trump is soft on Russia.

Further, who would be willing to take the risk buying Rusal from Deripaska either directly, or indirectly after nationalization?  They would only do so if they had iron clad guarantees from the US government that no further sanctions would be forthcoming.  But the US government is unlikely to give such guarantees, and I doubt that they would be all that reliable in any event.  Analogous to sovereign debt, just what could anyone do if the US were to say: “Sorry.  We changed our mind.”?

Indeed, the Treasury’s signaling of a change of heart indicates just how capricious it can be.  Any potential buyer would only buy at a substantial discount, given this massive uncertainty.  A discount so big that Deripaska or the Russian government would be unlikely to accept.

And who would the buyers be anyways?  Glencore already has a stake in Rusal, and a long history of dealings.  But it is probably particularly reluctant to get crosswise with the US, especially given its vulnerabilities arising from, say, its various African dealings.

The Chinese?  Well, since China is already on the verge of a trade war in the US, and a trade war involving aluminum in particular, they would have to be especially chary about buying out Deripaska.  Such a deal would present the US with a twofer–an ability to shaft both Russia and China.  And perhaps a three-fer: providing support to the US aluminum industry in the bargain (although of course harming aluminum consuming industries, but that hasn’t deterred Trump so far.)

So short of the US going full Emily Litella (and thus demolishing its credibility), it’s hard to see a viable path to freeing Rusal from SDN sanctions.  Meaning: Put away the party hats.  The celebration is premature.

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Begging the Question on VIX Manipulation

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 9:29 am

Stung by yet another allegation of manipulation of the VIX, Cboe Chairman and CEO Ed Tilly and President and COO Chris Concannon fired off an open letter defending the exchange and VIX.  To say it begs the key questions is an understatement.

Here’s their explanation of the April 18 event:

During the opening auction on April 18th, a single market participant submitted orders to buy approximately 212,000 SPX options across a wide range of strike prices. Five additional market participants submitted buy orders totaling 20,000 options. The size and structure of these buy orders appeared consistent with the weights prescribed by the VIX Index formula. Offsetting this buy interest were sell orders submitted by nine participants for a total of 118,000 contracts. This left a buy order imbalance of 114,000 SPX options. This buy order imbalance contributed to the opening prices of the option series that were used to calculate the final VIX settlement value. Based on the orders that were submitted, we believe the auction process functioned as intended, notwithstanding that the final settlement value was higher than what market participants may have otherwise expected.

Although oddly disconnected from the discussion of the 18 April spike in the VIX, this statement ostensibly directed at the Griffin and Shams paper claiming to find frequent manipulations of the VIX strongly suggests that they are denying there was a manipulation on 18 April as well:

Finally, we would like to again address the claims of possible manipulation of the settlement process. We reiterate that we believe these claims are without merit, and that the academic paper’s analysis and conclusions are based upon a fundamental misunderstanding about how VIX derivatives are traded and settled. The trading behavior the author considered suspicious is
consistent with normal and legitimate trading behavior.

The explanation of what happened a couple of weeks ago begs the question because in no way does it disprove that a manipulation took place.  Indeed, what they describe is exactly how a large trader could and would “bang the auction” to influence the settlement price of VIX derivatives, in order to profit on positions in those derivatives.  What Tilly and Concannon describe involves a single large trader submitting a huge order on one side of a market with liquidity constraints.  That is almost certain to affect the auction price. That’s how that kind of manipulation works.

Note that the order–again, entered by a single participant–represented about 90 percent of the buy side interest, and more than 80 percent of the order imbalance.  Further, Tilly and Concannon’s touting of the Cboe’s efforts to improve liquidity at the auctions (perhaps inadvertently) concedes that the liquidity at the auctions is presently inadequate, which would mean that a huge order imbalance would almost certainly move prices–as occurred on the 18th–and be anticipated to move prices.  “There’s no problem (’the auction process functioned as intended’), but we’re fixing it!” hardly inspires confidence.

Any participant with the heft to enter such a large order would surely be sophisticated enough to know that it would be highly likely to move prices.  Note that non-manipulative traders would typically want to mitigate price impact, not trade in a way that exacerbates it.  So why do this?

Thus, there is evidence to support all of the elements of a manipulation case, but one.  There is evidence for artificial price, causation, and ability to cause.  The missing element is intent.  I’d be open to suggestions as to why this one market participant would enter such a large order but for an intent to distort prices.  Any such explanation would have to show how this was the most economical way of achieving some non-manipulative objective, such as hedging.

Addressing the issue of intent would require knowledge of the large trader’s positions in VIX-related instruments.  Tilly and Concannon are silent on that issue, which makes their confident disavowal of manipulation incomplete and hence unpersuasive.  Discussing the auction alone, disconnected from the VIX derivatives markets tied to the auction, is inadequate to dispel suspicions of manipulation.

Perhaps the exchange execs are right, and this “whale” (as the FT referred to the trader) was not manipulating.  But the information in the public record, including the information in their letter, is not sufficient to demonstrate this claim. The question-begging defense will therefore likely feed suspicions about VIX, rather than lay them to rest, as the letter’s authors intended.

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