Streetwise Professor

John Kemp pixeled a rather lame response to my criticism of his earlier piece on “Broken Brent.”  I say lame because he did not even attempt to address any of the analysis I laid out.  Specifically, Kemp originally pointed to the dramatic drop in correlations between spot and forward prices and the different behavior of the curve in 2008 vs. 2012-2013 as evidence that fundamentals were somehow no longer driving oil prices.  I pointed out that that a fundamentals-based model would predict exactly such a pattern due to the pronounced backwardation in Brent and the substantial decline in macro volatility; I further pointed out that I had presented theoretical models that made this prediction and empirical evidence supporting it going back to the early-to-mid-1990s.  That’s what we call science.

Kemp’s response?  <Crickets.>

The most plausible explanation for his failure to rebut my analysis is that he can’t.  So instead he doubles down on “the hedge funds done it.”  Although he does it in a much more circumspect, passive way the second time around:

In a recent column, I suggested most of the short-term movements in Brent (and WTI) prices since mid-2010 could be traced to changes in money managers’ positions rather than fundamentals.

Read his original piece, and you’ll see that he did more than “suggest.” Accuse is more like it.

Kemp’s evidence consists of a few graphs depicting managed money futures positions and prices.  Point 1: eyeballs are not reliable evidence. Point 2: reliable evidence would involve some rigorous statistical analysis, which Kemp does not provide.  Point 3: said statistical analysis should attempt to control for other relevant factors, notably fundamentals.

But Kemp breezily dismisses the possibility that fundamentals could explain price movements in recent months.  After all, his original post is titled “static fundamentals”, and in that article and his response to me he asserts-and merely asserts-that fundamentals cannot explain price movements.  Since he does not even attempt to control for any fundamentals-related variable, Kemp’s analysis is plagued by omitted variables bias.  And that’s being charitable, because that phrase is usually employed to criticize statistical/econometric analyses, rather than gazes at graphs.

Sorry, John, but that doesn’t cut it.  In a commodity characterized by extremely inelastic supply and demand, such as oil, small fluctuations in supply and demand fundamentals can cause appreciable price movements.  Indeed, in a low macro volatility environment, fundamentals-based models imply that price movements are driven by highly technical, transient supply and demand shocks, and that moreover, these shocks cause substantial volatility in the shape of the forward curve.  That is, they cause low correlations between spot and futures prices.

In such an environment, seemingly minor factors such as the shut down of a refinery or regulatory perversities (such as the impact of RIN credits) drive movements in prices and the slope of the curve.  People who understand the fine structure of energy markets-people like Phil Verleger-realize this. Phil’s 18 February “Notes at the Margin” (which he kindly sent to me) provides a very detailed analysis of how low gasoline stocks and the closure of a Hess refinery are combining to increase gasoline cracks, which in turn are causing European refineries to buy and process Brent crude for sale to the US gasoline markets, which is in turn supporting Brent prices and backs.  As Phil characterizes it, the tight US East Coast gasoline market tail is wagging the Brent crude dog.  Fundamentals 101.

Phil analyzes these things carefully.  John couldn’t be bothered.  Instead, he squints at a few charts of COT data and prices, and declares fundamentals don’t matter.  If he could show that after correcting for the kinds of factors Phil Verleger analyzes carefully week after week that managed money position movements were associated with price changes, he would have established that a necessary condition for speculative price impact would hold: merely a necessary condition, but not a sufficient condition, because it could well be the case that the fundamentals were driving the managed money trades.  (To his credit, Kemp recognizes this possibility in his original article, though he dismisses it too readily.)

In brief, John Kemp’s attempt to show that hedge fund trading is causing movements in Brent crude prices and that fundamentals do not is plagued by numerous flaws.  Methodologically, graph gazing is the start of an analysis, not the culmination.  Furthermore, fundamentals-based models explain many of the phenomena Kemp finds anomalous.  What’s more, a micro-level analysis of supply and demand factors in the oil and product markets can account for many of the price movements that mystify Kemp.  When he confronts these issues head on, I’ll take him more seriously.

Climateer Investing weighs in on Kemp-Pirrong, and wonders why I felt obliged to go into smack down mode.  The answer is simple.  There are too many regulators and legislators and rabble-rousers (e.g., Oxfam)  who are more than willing to seize upon any claim that evil speculators are distorting markets in order to justify interference, in the form of position limits or transaction taxes or just general harassment of those engaged in legitimate and beneficial activities: yes, speculation is a legitimate and beneficial activity.  I have written and lectured extensively on the subject, and understand that speculation can, in exceptional circumstances, distort markets, but that such distortions leave distinctive tracks in quantities (e.g., inventories).  If you believe speculation has distorted markets, provide evidence that those tracks indeed exist.  Superficial examinations not grounded in well-established theoretical and empirical work don’t cut it, but feed prejudices that in turn too often lead to wrongheaded and destructive interventions into markets that cause real distortions (e.g., the rather cowardly decision of some European banks to exit the ag markets because of the propaganda campaigns waged by Oxfam and others).  When people writing for reputable sources like Reuters lazily encourage these prejudices, I will respond.  And being a Chicago guy, from a school where econ seminars are the academic equivalent of the MMA or UFC, my responses tend to be rather blunt and uncompromising.  If you can’t take it, don’t get in the ring.

And as to Climateer’s claim that the fall in oil prices from the $140s in July 08 to the $30s in early ’09 is some sort of “gotcha!” QED of the impact of speculation.  Please.  If you want me to take you seriously, you have to do a lot better than that.  A major adverse macro shock that causes the most severe, protracted economic contraction in decades following a period of robust demand (and again I commend Phil Verleger’s analysis of the summer of 2008 as the go-to source to understand what drove prices in that period) will cause a precipitous drop in the price of an inelastically supplied commodity.  Every time.  It would be anomalous if they didn’t.

There has been considerable hue-and-cry over reports that the CFTC’s SEF rule will require market participants to solicit only two quotes instead of five when using a Request for Quote (RFQ) in a swaps trade.  This is being portrayed as a concession to the dealer banks that will permit them to perpetuate their alleged oligopoly.

I have always been harshly critical of the SEF mandate, and of regulations dictating how market participants execute transactions.  Indeed, I named the SEF mandate the Worst of Frankendodd.  And believe me, the competition is so intense, so hell to the victor.

There are diverse market participants trading diverse instruments, and there is no one-size-fits-all best execution mechanism: diverse execution mechanisms have evolved to accommodate diversity in products and transactors.

This is true of RFQ mandates too.  Indeed, it is passing strange that anyone believes that requiring end users to get more quotes is in their benefit.  If the goal of the execution mandates is to help end users by breaking the dealers’ alleged stranglehold on the market, why should you impose constraints/requirements on the end users?  Why can’t they determine what the right number of quotes to solicit is?  Don’t they know their own interests?  Can’t they trade off the alleged benefits of soliciting more quotes-namely, greater competition to take the other side of the trade-against potential costs-such as information leakage?  The regulation seems to be extremely paternalistic.  Like end users are children who need to be made to eat their Brussels Sprouts, because they don’t know what’s good for them.

But, in fact, end users-including extremely sophisticated buy side firms like Blackrock and Pimco and FMC-know quite well what works for them.  Indeed, ISDA and SIFMA just released the results of a poll showing that buy side firms-non-dealers, in other words-heartily oppose the 5 quote rule.  Actually, “heartily oppose” is a putting it mildly.  They hate it.  By wide margins they think it will reduce liquidity and raise their execution costs.  More than 80 percent of poll respondents expressed concerns about information leakage.

Ironically, 68 percent of the respondents said that they would try to trade instruments not subject to the SEF requirement.  In other words, a regulation intended to ensure that swaps were traded on open, transparent, exchange-like platforms will instead cause traders to attempt to avoid them.

Another example of “we’re from the government and here to help you” in action.

The histrionics over the “weakening” of execution mandates also betrays the intellectual incoherence of Frankendodd and it’s advocates.  The putative purpose of the law is to reduce systemic risk.  Its focus on derivatives is predicated on the belief that these instruments are inherently systemically risky, and that derivatives markets are too big and need to be cut down to size.

If that’s what you believe, then you should favor of the exercise of market power by dealers.  You should love-love!-a dealer oligopoly that raises the price of execution, because that reduces the size of derivative markets.  You believe that derivatives markets are too big, and should be taxed: and practically speaking, a dealer oligopoly that inflates execution costs serves as a tax.  It is equivalent in many ways to a transaction tax.  What’s more, the rents created by such supercompetitive prices are like a boost to the capital of dealer banks which reduces the likelihood that they will need a bailout.  That is, a dealer oligopoly reduces systemic risk, and increasing competition increases systemic risk.

In other words, if you believe derivatives markets are too big, you should *NOT* want to make execution more efficient.  You should love love love dealer market power, and strive to do anything to enhance it, rather than reduce it.  This is the theory of the second best in action.

But, sadly, intellectual coherence has never been the strong point of Frankendodd advocates. Which goes a long way to explaining what a mess it is, and what havoc it will wreak.

John Kemp of Reuters-accompanied by cheerleading by Izabella Kaminska at FT Alphaville–is going on about the “disconnect” between nearby and deferred Brent.  He blames-wait for it-hedge funds.  Natch.

The Brent market is currently in a steep backwardation.  I demonstrated empirically almost 20 years ago that backwardation is associated with low correlations between spot and futures prices for oil and a variety of other commodities.  Indeed, my 1994 criticism of the Metallgesellschaft 1992-1993 “hedging” strategy-which led to several confrontations with Merton Miller-was based on the fact that MG’s “hedge” of long the nearby against distant deferred short positions was in fact risk increasing due to the fact that MG implemented this strategy during a backwardation, and this reduced substantially correlations thereby making the MG position very risky.  My 2011 book provides a robust model that predicts exactly this result.

The intuition is quite straightforward-as I’ve been teaching for about 20 years too.  Inventory is what connects spot and futures prices.  When inventories are large, the market is in contango, and spot and futures prices move together: cash-and-carry arbitrage connects these prices.  In contrast, when inventories are low, the market is in backwardation, cash-and-carry arbitrage doesn’t link the spot and the futures, and the correlation between these prices can go very low.  Hence the association between contango and high correlations.

Note: hedge funds, speculation, yadda yadda yadda have nothing to do with this.

Kemp does note that there is physical tightness that does explain the backwardation:

Overlaying all these broader factors are continuing problems with production of the four North Sea crude streams (Brent, Forties, Oseberg and Ekofisk) that physically underpin the Brent futures prices. BFOE crudes remain in short supply, keeping the market in a steep backwardation, with futures prices tending to rise sharply in the run up to contract expiry.

But then he discards this fundamental fact, and mounts his favorite hobby horse of bashing hedge funds and speculation.

Note even in this paragraph there is a telling piece of information that contradicts his view: “with futures prices tending to rise sharply in the run up to contract expiry.”  Uhm, that’s exactly when hedgies and other speculators are liquidating-selling-their nearby contracts and rolling them into the deferred months.  This should put downward pressure on nearby prices, if the speculators were really  in command. Completely inconsistent with his assertion that hedge funds are driving the disconnect between spot and futures.

Kemp also makes a comparison to spot price and curve movements in 2008 to more recent movements.  But as I also show in my book, to explain commodity price dynamics you need multiple shocks of differing persistence.  Curve shape is driven mainly by transitory shocks: that’s what inventory is used to smooth out.  The level of the curve is largely driven by persistent, business-cycle type shocks.  This means that conditioning on price levels alone is insufficient to make an apples-to-apples comparison.  The 2007-2008 boom was driven more by long run, secular factors-namely the Asian/Chinese growth boom.  This resulted in a rise in the price level and only a modest increase in backwardation.  That is completely different from current conditions-hence the different behavior.

Similarly, the differences between high correlations pre-2010 and low correlations now are readily explicable.  The market was much more abundantly supplied in 2009-2010 due to the severe economic contraction following the financial crisis, and as a result, the market was in contango most of that time-at times in a “supercontango”.  Again, one would expect this to be associated with high spot-futures correlations.

Moreover, there is a big difference in the composition of shocks, and the magnitude of these shocks that also explains the observed declines in correlations.  The 2009-2011 period was dominated by macro uncertainty driven by the financial crisis and then the Eurozone crisis.  These shocks tend to be persistent, affecting both current and expected future economic conditions in the same way, thereby contributing to high correlations between points on the curve; moreover, they tend to affect all commodities and asset classes similarly, leading to high correlations across commodities and asset classes.

At that time, macro volatility-as measured by the VIX-was high.   In early ’09, VIX was in the 30-50 percent range, and remained above 20 percent for most of 2010-2011, with spikes up to 35-40 percent.  Now VIX is tame, with levels in the low-teens, just like during the period of the “Great Moderation.”  High macro volatility tends to lead to high correlations along the curve and across commodities and between commodities and equities: common shocks dominate, especially when they are big.  The decline in macro volatility means that commodity-specific, relatively transient shocks tend to dominate: this tends to depress correlations along curves and across commodities, and between commodities and equities.  These are exactly the patterns observed in the past months.

That said, there are reasons to suspect the backwardation and the decline in correlations might be overdone, but not because of the malign influence of hedge funds.  Specifically, given the declining Brent supply base, it is reasonable to ask whether the backwardation is excessive.  At present, Forties is cheapest-t0-deliver, and this represents only about 350kbd of production.  Overall BFOE production is only about 1mmbpd.  Given the immense open interest in Brent futures and OTC derivatives, it is more that possible that large players are exercising market power by taking delivery of too much physical oil, thereby exacerbating the backwardation (i.e., creating an artificial scarcity).

If you want to identify who might be doing that, look at who is taking the physical cargoes.  Those parties would be the squeezers.  If hedge funds are the culprits, they should be taking a lot of physical supply.  Kemp certainly doesn’t provide any evidence of this, and his piece suggests these players are just playing with paper barrels, not wet ones: that’s my understanding too.  Historically, the Brent market has been the scene of many squeezes, but the squeezers have tended to be trading companies (e.g., Arcadia) or perhaps supermajors.

Brent was a squeezers paradise in the 1990s due to declining physical volumes and growing paper volumes.  Platts’s addition of Forties, Ekofisk and Oseberg to the delivery slate increased supply sufficiently to mitigate the manipulation problems.  But the decline in production has continued inexorably, and Brent is increasingly vulnerable to squeezes.  Which is why Platts and Shell have competing plans to tweak the pricing mechanism, namely by providing premiums for OE (Platts) or BOE (Shell), thereby reducing the delivery pressure on the cheapest-to-deliver Forties.

Squeeze-driven backwardation also tends to reduce spot-forward correlations.  The spot price is driven by squeeze-related technicals, the forward price by longer run fundamentals.  Squeezes also distort the inventory holding decision, and cause a breakdown in the cash-and-carry arb mechanism.  As I show in another book (and many articles).

So Brent may indeed be broken, but hedge funds haven’t broken it.  It is a classic problem in derivatives markets: a burgeoning derivatives market balancing on top of a declining deliverable supply.  I often analogize this to an inverted pyramid: and in Brent, the base of the pyramid (the paper market) is growing while its point (the physical market) is getting sharper.

Fixing Brent requires enhancing deliverable supply.  Not an easy thing to do.

Again contrast Brent and WTI.  Brent boosters have constantly bashed the WTI disconnect.  But this can be fixed by investments in infrastructure, which are being made, though not as fast as expected or as needed.  But building infrastructure is a helluva lot easier than building  a new Buzzard. Trust me on this.

So in the medium term, I expect Brent will get broker, and WTI will get better, leading to a shift of much futures and index trading activity (including hedge fund trades) back to WTI, which will no doubt lead John Kemp to saddle up his hobby horse and ride west into the Oklahoma sunset.

I laughed out loud when I read this paragraph from a Risk Magazine article about futurisation in the energy markets:

Top CFTC officials [GiGi? Is that you?] as well as members of Congress who supported Dodd-Frank [that’s Frankendodd around here, buddy] have repeatedly said the law was not aimed at physical end users of derivatives.  But if the the flight towards futures causes liquidity elsewhere in the market to dry up, end-users might have no choice but to fall in line.

Look: Elvis Costello’s “My aim is true” is definitely not the theme song of regulators and legislators in the US, or anywhere for that matter.  A 16 year old, hopped up, Afghan jihadi sprayin’ and prayin’ with his AK on full auto is more discriminating in his targeting than most regulators, and regulations.  Unintended consequences-AKA collateral damage-are the rule, rather than the exception with regulations.  This goes N-fold for monstrosities like Frankendodd.

Frankendodd is just starting its rampage.  The energy derivatives markets-and end-users in them-are only the first victims.

So when a regulator or legislator says that a particular reg or law isn’t aimed at you, don’t take comfort: take cover; there will be incoming.   We’re not talking Sergeant York or Annie Oakley behind the trigger here. More like Blind Lemon Jefferson.

Gazprom has announced that it is entering into exclusive negotiations with Levant LNG to secure the rights to market 100 percent of the gas produced by the Tamar floating LNG plant:

OAO Gazprom (GAZP), the world’s biggest natural gas producer, is seeking exclusive rights to export liquefied natural gas produced from fields off Israel’s Mediterranean coast.

Gazprom Marketing & Trading signed a heads of agreement with Levant LNG Marketing Corp., outlining the terms of a 20- year sales deal from the Tamar floating LNG plant, the unit said today in an e-mailed statement.

Levant and Gazprom’s marketing unit will hold exclusive talks on LNG sales for six months, according to a separate statement to the Tel Aviv bourse today. Sales may amount to 3 million tons of LNG a year, linked to Brent crude prices, according to the statement. That equals the plant’s total planned output volume.

My first reaction is that I cannot believe the Israelis will be so stupid as to lock themselves into Gazprom on an LNG project.  Why not?

Most importantly, Gazprom has little interest in seeing gas from the Mediterranean come onto market, and hence has an incentive to throw roadblocks in way of the project.  Interestingly, the announcement indicates that Gazprom plans to sell the gas in Asia, even though eastern Med gas is perfectly positioned to sell into Europe-which is probably precisely the reason that Gazprom wants to send the gas east rather than north and west.  But even if those tons of Israeli LNG don’t go to Europe, they would displace other gas that would otherwise go to Asia, and which could show up on European shores.  Thus, Gazprom still has an incentive to delay the gas coming on line any way that it can.  Yes, as a marketer, Gazprom would have less ability to do that than would the project developer, but it could still throw up obstacles.  If the Israelis do deal with Gazprom, they should be damned sure that the  contract is written very tightly.  And it would not be wise to give Gazprom the exclusive marketing rights, because that would maximize the Russian’s leverage.

But my second reaction is that the Russians may be signaling that they will overpay.  I base this on one detail in the announcement:  the price in the deal will be tied to the Brent crude oil price.  It is ironic that this announcement came out on the same day that the FT ran an article detailing how Japan-which is a major LNG buyer and which will purchase substantially more in the future as it moves away from nuclear power-is seriously considering ditching oil linked contracts for contracts tied to Henry Hub gas prices.

A flurry of projects has now emerged to harness the plentiful supplies of cheap shale gas by selling it on to international markets as LNG. And the exporters are pricing their gas off Henry Hub, the US natural gas benchmark, rather than off Brent or WTI. Henry Hub gas is now selling for about $3 to $4 per million British thermal units, less than a quarter of the price LNG cargoes are sold for in Asia. Japanese, Korean and Chinese buyers have, understandably, been flocking to the US in search of deals.

As a consequence, says Professor Jonathan Stern, head of gas research at the Oxford Institute for Energy Studies, Japanese utilities are increasingly reluctant to commit to oil-indexed LNG.

“They recognise how dangerous it is to sign up to any contracts on the old formula,” he says. “They can see the degree of commercial exposure, which is huge.”

What has spurred the Japanese into action is the way that rising LNG prices have stoked the country’s mounting trade deficit and exposed power utilities to big financial losses. Not only is LNG becoming more expensive, Japan has also been importing more of it: with most of the country’s nuclear reactors shut down in the wake of the 2011 Fukushima disaster, gas is filling the gap.

. . . .

Other Japanese gas importers, including Tokyo Gas and Osaka Gas, are also trying to move away from oil-linked prices, even for gas not produced in the US. Kansai Electric Power, for example, signed an innovative long-term agreement where the LNG it buys from BP, sourced from various parts of the world, is linked to daily Henry Hub settlements. Kepco is hoping for a 30 per cent reduction in LNG import costs.

So if it did an oil-linked deal with Levant LNG anticipating selling to Asia on the same terms, Gazprom will face increasing difficulty in doing so.  It therefore runs the risk of being effectively short oil (i.e., being hurt by rising oil prices) and long North American gas (hurt by falling gas prices).

But maybe this is the attraction of the deal to the Israelis.  If they anticipate a widening spread between oil and gas prices, and the Russians are willing to pay them the oil price when other marketers, anticipating that the market will soon transition to being priced off of gas (especially North American gas) will only be willing to do deals based on the gas curve.

So although the potential exposure to Gazprom opportunism would suggest that the Israelis would be suckers to enter into an exclusive deal with the Russian firm, Gazprom’s increasingly frantic attempts to defend the oil link may be leading the firm to overpay.  So maybe the Israelis are thinking that Gazprom is the sucker.

The pricing mechanism in gas is in a state of transition.  Moreover, these transitions tend to be very abrupt and “tippy.”  Once the market starts to shift from one benchmark to another, the move is self-reinforcing: there is a positive feedback effect as the liquidity in the new benchmark increases, attracting more trade, which increases liquidity, and so on.  The tipping process is well underway in Europe, and if Japan truly does move to gas based pricing and away from its historic commitment to oil linkage, that would likely start the snowball rolling downhill in Asia too.

Just look at what has happened in iron ore.  In a period of about two years, the industry has moved from annual negotiated contracts to spot price indexed deals between miners and steelmakers.

The economic case for gas linkage is compelling.  Gas prices reflect, well, gas market supply and demand fundamentals.  Oil prices, not so much.  The potential for misalignment of prices and values, which is so evident in European gas markets in particular, is much greater with oil indexing than gas indexing.  It is this misalignment that leads to misallocation of resources, and to disputes between buyers and sellers.   This provides a natural impetus towards the move to gas indexing.

But Gazprom is wedded to oil linkages.  Its commitment is likely what makes it willing to offer such a deal to the Israelis, and it is at least plausible that the Israelis see the writing on the wall that oil linkage is dying, and are calculating if Gazprom wants to be the sucker and lock itself into this obsolete mechanism, why should they say no?

Gensler and Chilton are taking up the cudgels again for position limits-this in spite of the spanking from Judge Wilkens last year.

Chilton, as usual, is most outspoken on this issue:

Today, energy costs for most families have risen more than 20 percent since 2001. This hurts not only American households, but also American business—like many of your businesses—that rely on energy. According to the Energy Information Administration (EIA), nearly nine percent of our economy or $1.4 trillion is spent on energy annually. Imagine if that figure dropped by just ten percent—$140 billion freed up for investment and economic growth.

So that’s why I continue to lead the charge for position limits—to help keep the markets working for you. The efforts to stop position limits will ultimately fail. Congress told us in no uncertain terms to get it done, and I intend to see that we do that, before more families and businesses go into the “red” column on their balance sheets.

First of all, 20 percent in 13 years is less than 2 percent per year-that is, less than the rate of inflation: the CPI is up almost 30 percent over those 20 years, meaning that the real price of energy has fallen.   I say again: the real price of energy-per Chilton’s own numbers-have fallen.

I also note Chilton’s continued focus on the rise in oil prices, and his complete refusal to acknowledge the collapse of natural gas prices precisely during the period in which his Massive Passive bogeymen have allegedly driven commodity prices generally, and energy prices particularly, far above what they “should” be.   If “speculation” by “massive passives” (or whoever) can cause prices to become completely unhinged from fundamentals, why has natural gas moved in the exact opposite direction from oil?

Chilton’s egregious errors of omission and commission must be caused either by a lack of intellectual capacity, or a lack of intellectual honesty.  I really see no other alternative.

Frankendodd runs hundreds of pages.  The regulations written to bring it to life run to thousands more.  Every word on every page has the potential to wreak havoc: hell, apropos the position limit case, even the commas matter.

Case in point, the CFTC’s proposed rule on protection of customer funds, most particularly Section 1.22.  Some of the relevant language:

The Commission proposes to amend § 1.22 by clarifying that the prohibition on the FCM’s use of one futures customer’s funds to margin or secure the positions of another futures customer, or to extend credit to another person, applies at all times.

. . . .

Further, the Commission is proposing language providing a clear mechanism to ensure compliance with this prohibition, which is to require an FCM to maintain residual interest in segregated accounts in an amount which exceeds the sum of all margin deficits for futures customers.

This is very inside baseball, but has seismic implications.

The basic thing is that some customers are late in meeting margin calls.  This gives rise to margin deficits.  Under the traditional omnibus model used in futures markets for donkey years, futures commission merchants (brokers-“FCMs”) can cover customers’ margin deficits with the margins of other customers.  Effectively, customers lend one another money to address the timing issues that the rigorous mark-to-market and variation margin processes inevitably create.  Moreover, the FCM is ultimately on the hook to cover the losses of a defaulted customer.  The FCM’s customers can lose only if there is a default by a customer that the FCM can’t cover (resulting in an FCM default).

That is, customers effectively lend to one another, and thus there is “fellow customer risk”-a solvent customer can lose as a result of the default of another customer. The CFTC rule is intended to eliminate this risk.

Problem: the risk can’t really be eliminated, merely shifted around.  Related problem: the likely reaction to this attempt to shift risk.

The CFTC seems to want to shift the risk to the FCMs: the “residual interest” language means that the FCM has to have enough of its own money on hand to cover any margin deficits.  This will require the FCM to hold substantial precautionary balances, because (a) the magnitude of margin deficits is likely to be quite variable, and particularly will be large in the aftermath of a big price move (that can’t be predicted in advance), and (b) there are serious penalties to being undersegregated.  Alternatively, FCMs are likely to require customers to post margins far in excess of exchange margin levels, thereby reducing the likelihood that any customer’s account will have a margin deficit, and the amount of residual interest the FCM must hold to cover any such deficits.

Either way, there will be a substantial increase in the amount of cash tied up, and the needs for customers and FCMs to have access to contingent liquidity.  The omnibus model was an effective way for customers to supply liquidity to, and obtain liquidity from, other customers.  Yes, there are risks, but there are corresponding benefits: the near universality of the omnibus model in futures markets, and its survival for decades, provides compelling evidence that the benefits far exceed the costs.

But apparently that’s not good enough for GiGi and the Gang.

The clearing and collateral mandates-combined with Basel III and other regulatory measures-are already requiring substantial increases in the amount of collateral-liquid assets-that will be tied up to support derivatives trades.  This will just add to that.  And insofar as being a customer protection mechanism: uhm, customers will pay for it.  Don’t act as if your are doing them a big favor. (Raising the question if its so valued by customers, why hasn’t some FCM adopted voluntarily what the CFTC wants to impose by fiat?  If it’s so great, customers would flock to firms offering that model.)

It also comes at a terrible time for the FCM industry.  The economics of the business are terrible.  ZIRP has blown a hole in a major source of revenue, volume is down sharply, and competition is intense.  A recent Celent study details the carnage:

“The leading FCMs in the US are struggling with falling revenues and profits,” saysAnshuman Jaswal, PhD, Senior Analyst with Celent’s Securities & Investments Group and author of the report. “This puts them in an unenviable position, especially when we consider the overall impact and related costs of various regulatory implementations taking place in the next couple of years.”

Another data point: SocGen just wrote down its investment in big FCM Newedge.  This is not a thriving industry, and ladling more costs onto it won’t help it one bit.

The ostensible purpose of this new regulation is to prevent another MF Global or Peregrine situation.

Seriously?

MF Global broke every rule in the book about segregation and the treatment of customer money.  Peregrine’s owner ran a huge fraud for 20 years. So creating more rules for troubled or criminal FCMs to break will help?  If the CFTC or SROs couldn’t enforce the old rules and thereby prevent losses of customer funds, why should we expect they’ll do any better with the new ones?

It’s also hard to see how these rules, if they had been in place, would have prevented either the Peregrine or MFG situations.  Furthermore, there are other ways of attacking the exceptional-and MFG and Peregrine were exceptional-without imposing crushing burdens on the ordinary day-to-day operation of the markets, FCMs and their customers.  For instance, the Peregrine fraud could not have continued if Peregrines regulator (the NFA) had direct electronic access to the firm’s accounts, thereby preventing Wasendorf from altering the paper statements he sent on to regulators to cover up his fraud.  Hell, in the MFG case, having more excess margin in customer accounts would have just increased the money that Corzine could have tapped to cover the company’s losses and own margin calls: it is just that excess margin that disappeared somewhere, somehow.  I would further note that since an FCM is most likely to be tempted to get at customer funds when it is in financial jeopardy (which is what happened with MF), adding to its financial burdens could create more problems than it solves.

The cost-benefit analysis the CFTC advanced in support of the rule is just the kind of joke I’ve come to expect.  This is actually a problem that is amenable to calculation.  Collect data on the distribution of customer margin deficits under current rules.  Figure out the 99.9th percentile of this distribution.  (Importantly, condition this distribution on market conditions-find out what that percentile is during very volatile periods.)    Given the rigor of the rule, it is plausible to assume that additional funds equal to this 99.9th percentile will have to be held by customers, FCMs, or both will be held to ensure compliance.  Calculate the return on this sum lost because customers and FCMs are required to hold low-yielding assets in order to comply with the rule.  That’s one component of the cost.

Another cost is the additional operational cost required to ensure compliance.  This will not be trivial: indeed, one reason FCMs might require substantial increases in customer margins is to reduce the operational burdens required to maintain compliance.

One cost that is important is hard to quantify.  As I’ve written repeatedly, spikes in liquidity needs during periods of market stress can be systemically destabilizing.  This rule will: (a) restrict one vital source of liquidity, namely, intracustomer loans; (b) result in far more liquid assets being tied up in brokerage accounts; (c) lead to increases in liquidity demand during periods of high volatility, as FCMs will either have to hold more liquid assets, or will force customers to hold more excess margin, during high volatility periods in order to maintain compliance (i.e., the 99.9 percentile is much bigger during high volatility periods, requiring more margin to meet this threshold-the distribution of liquidity demand spikes caused by this could be calculated); and (d) result in position unwinds by those unwilling to incur the cost of the elevated margins.  All of these effects are pro-cyclical, and tend to exacerbate market instability/volatility.  Liquidity problems are what create or exacerbate crises.  Derivatives market “reforms” have already imposed substantial liquidity burdens: this will only add another.  That is systemically risky.

Benefits?  Uhm, hard to ascertain.  As noted above, the rule is ill-suited to address either a Peregrine or MFG problem, even though those are the examples the CFTC repeatedly invokes in their support.  Moreover, it must be noted that reducing the amount of loss arising from the default of fellow customers is not necessarily a benefit.  This is primarily a transfer of wealth from one party to another.  The relevant issue is whether one risk sharing rule is better than another.

This is another example of the pernicious effects of attempts to “fix” high profile problems such as MF Global and Peregrine.  In response to truly extraordinary episodes, we get “fixes” that (a) don’t really do anything to address the problems they are supposed to be fixing, and (b) impose substantial burdens on the ordinary operations of the markets, operations that have gone on swimmingly for decades under the old way of doing business, thank you very much.

As a rule of thumb, I think it wise to be very suspicious of rules designed to prevent recurrence of an extreme event or events.  That is especially true in this case.   Another example of all pain, no gain.

Is that the CFTC’s motto now?

While I’m on the subject of commodity spreads and transformations, I’ll turn my attention to another spread story in the commodity news: cash premiums in aluminum.  This is a matter of great interest to people in the aluminum business, but even though I highly doubt such people make up a big fraction of my readers, it’s worth some analysis here because the broader and politically charged topic of the “financialization” of commodities has come to the fore in this debate.

In brief, there is a big differential between the price of aluminum “in store” in LME warehouses, and the price of newly produced aluminum at the factory gate.  Metal outside LME warehouses trades at a big premium to ingots inside them: the premium is about $300 on a price of around $2000.  The premium has become so wide and volatile that banks are offering swaps to hedge this risk.

So we have a spread.  Spreads price transformations.  What is the transformation at issue here?  Turning metal inside warehouses into metal outside of warehouses.  So if the spread is wide, that tells us that there must be a bottleneck in getting Al out of warehouses.  And indeed there is.  It can take more than a year (!) to get some metal out of LME warehouses.  Warehouse operators (including Goldman, JP Morgan, and Glencore) are the subject of bitter criticism from aluminum consumers (e.g,. Coca Cola) for what consumers claim are unnecessarily glacial load-out rates.  File this under There is Nothing New Under the Sun.  Warehousemen and consumers have fought over load-out rates forever in every commodity.  (Look at a history of the warehouse wars in Chicago stretching back to the mid-19th century.)

As a result of the load-out bottleneck, large quantities of aluminum inventory that built up during the financial crisis and period of extended economic weakness in the US and Europe, are trapped in warehouses.  The storage facilities have become the metallic equivalent of Roach Motels: aluminum checks in, but it can’t check out.  Or maybe the metallic Hotel California: aluminum can check in, but it can never leave.

The fact that large quantities of metal are trapped in warehouses means that there are large quantities of metal that have to be carried-and financed, primarily in cash-and-carry trades hedged by forward sales.  What other alternative is there?  It ain’t going anywhere, so it has to be held and financed by somebody.  Moreover, well-capitalized banks (Morgan, Goldman, etc.) can finance the inventory cheaper than anybody else.  So just surely as day follows night, given the fundamentals in the market, and crucially the load-out bottleneck, the well-capitalized banks end up holding, financing, and hedging a big chunk of the inventory.

Here’s where the financialization meme comes in.  Many people-including some who should know better-see the co-existence of financed inventory and premiums, and conclude that it is the participation of financial institutions that is causing the wide premiums.  See! they exclaim.  Look at how the participation of financial institutions in commodity markets is distorting things! Something must be done!

This is totally back-asswards, and confuses cause and effect.  The underlying problem here is the load-out constraint.  The cash premiums clearly signal that is the problem.  Banks are not holding back metal to create profitable financing deals: time spreads adjust so that financing deals break even.  The problem is that insufficient quantities of metal can get out of warehouses.  That’s what inquiries should focus on.  Is the rate too low?  Why?  Are warehousemen exercising market power by unduly constraining load-out?  If so, why isn’t there sufficient competition between them?  (It would also seem that this would have to be an ex post holdup problem: if those storing metal anticipated the exercise of market power via slow load-out, it would reduce their derived demand for storage, thereby reducing the amount of metal stored and the rate the warehouse could charge.  This would tend to attenuate and perhaps eliminate the ability and incentive to exercise market power.  An opportunistic response to an exceptional circumstance not anticipated when metal was put into store could be what is going on.  That is, this could be a time inconsistency problem combined with an unprecedented shock.)

In other words, large financing deals are a symptom of the load-out bottleneck, and the overhang of metal in store resulting from the financial crisis.  It is not the financing deals that are holding back metal.  It is the load-out bottleneck that is holding back the metal, and driving the need to finance the metal.

One last note.  One of the biggest complainers about the situation and the involvement of banks in the aluminum market is the living proof that Neanderthals still walk the earth: Oleg Deripaska.  Yes, Putin’s favorite pen catcher.  Word to the wise: Deripaska’s whines about the causes of the aluminum cash premiums should be heavily discounted, as should always be the case when a highly financially stressed individual loudly talks his book.  Especially when the book talker has, shall we say, a rather testy relationship with banks.

Hint: collateral crunches are not an ab exercise.  Instead, regulators and legislators around the world are waking up to the reality of what they have wrought: that the regulations that they blithely decided to impose on the derivatives markets are likely to have severe adverse consequences.  Specifically, Europeans have awakened to the fact that clearing and collateral mandates will be extremely burdensome on firms that use derivatives to manage risk, but who pose no real systemic threat.  Thus, a committee of the European Parliament has voted to send clearing regulations back to the European Commission for reconsideration.  There is a realization that a “collateral crunch” is impending as a result of these various regulations:

This has led to talk of a “collateral crunch”, with most central counterparties accepting only government bonds or cash as collateral, assets that may not be readily available. This is more restrictive than at present, with corporate bonds and even equities often accepted as collateral in uncleared bilateral deals, if lodged in sufficient quantity.

The problem may be particularly acute for mutual funds, as an equity or corporate bond fund will simply not possess anything it can use as collateral. Instead it may have to use the securities lending or repo markets to secure suitable assets.

But many pension funds will also be hit. As Mr Haines points out, even the index-linked government bonds that pension funds do tend to hold in abundance are not generally accepted as collateral by central counterparties, even if conventional bonds issued by the same governments are.

Estimates of the cost of using the repo market to access the necessary collateral range from 50 basis points of a pension fund’s assets to several hundred basis points, Mr Haines adds. Alternatively, pension funds may feel pressured to alter their asset allocation so they do have sufficient in-house collateral.

Totally unpredictable, right?  Uhm, not really.

I find it particularly amusing that virtually every article on the effects of Frankendodd and Emir bewail the “unintended consequences.”  A million pardons, but that was a theme here on SWP, and in various presentations I made, before Frankendodd and Emir were actually adopted.  Unintended, but eminently foreseeable-and totally ignored.

The recent angst focuses on initial margin: the amount of capital that has to be tied up to support derivatives positions from the moment they are initiated.  Given that collateral is costly, the large increases in initial margin will require derivatives users to choose between continuing to use them to manage risk, but obtain lower returns, or to eschew derivatives and live with greater risk.

The benefit received in exchange for this very real cost?  Given that many entities so affected pose no systemic risk, it’s quite difficult to identify any gain.

Not that initial margin is unimportant, but the focus on it distracts attention from what I believe to be the true systemic risk inherent in clearing and collateral mandates: the contingent needs for liquidity to make variation margin payments.  Big price moves lead to big variation margin flows.  These will tend to occur when markets are stressed and liquidity becomes scarce.  Thus, the need to make variation margin payments will exacerbate stresses on the market, especially will stress liquidity supply mechanisms.  Given that financial crises are, typically, liquidity crises, this is a major systemic problem.

So by all means pay attention to the drag that the dramatic increase in initial margin requirements will impose.  This is a drag that will be experienced day after weary day.  But do not overlook the truly dangerous unintended consequence of the clearing and collateral mandates in Frankendodd and Emir.  The stress that these mandates will put on liquidity supply mechanisms at the precise instant that these mechanisms are at risk of failure.

What could go wrong?

I say again: regulate/legislate in haste, repent at leisure. The seeds for the next crisis are being sown in the alleged attempts to prevent a recurrence of the last one.  Legislative and regulatory generals fighting the last war.

A tag-team of my favorite blogs-the wonderfully sardonic (and insightful) Rhymes With Cars and Girls and the less sardonic (but equally insightful) Deus ex Macchiato-discuss the fact that model-based risk-weighted capital calculations on the same assets differ substantially between models/banks.

From this, DEM concludes the need to centralize capital calculations:

he answer is clear. Centralize and standardise capital calculation. Throw all those internal models away, and use one common, regulator developed approach. Now that a lot of progress has been made on trade reporting, the data infrastructure exists to do this — or least it wouldn’t be too hard to extend what does exist to do it. Developing the models would be a huge undertaking, but compared to having each large bank do it individually, a central infrastructure would be cheaper and more reliable, and anyway you could pick the best of individual banks’ methodologies. You could even spin out the var teams from four or five leading banks into the new central body — just don’t pick the bank whose IRC is less than 10% of the average answer…

Crimson Reach at Rhymes is more cautious, repeating his theme that All Large Calculations are Wrong.  He concludes:

In other words, it’s a Large Calculation. But as RWCG readers know, all large calculations are wrong. So, I’m skeptical that the answer to this is to ‘centralise’ the calculation – i.e., make it even larger.

I’m on Crimson’s side on this one.  (Sorry, David.)

Centralize capital calculations?  No. No. No. No. No fucking no.

Crimson is right: all Large Calculations Are Wrong.  Including those-and I would suggest, especially those-undertaken by some Centralized Authority, e.g., The Wizard of Financial Oz.

What would you rather have?  Randomly distributed mistakes, or perfectly correlated ones?

The answer, it seems to me, is gob-smackingly obvious.  Randomly distributed.  Perfectly correlated errors are a recipe for systemic risk.  All banks will crowd the risks that the model underprices and avoid the risks that it overprices.  If an adverse shock hits the crowded investment, every bank is screwed simultaneously.  All will need to liquidate their positions in that asset, or in other assets.  Every bank will have fire sales at the same time.

That’s what we want to avoid.  That’s what creates a systemic risk.

We want to diversify model risk, not concentrate it.  Centralized calculation concentrates it.  I actually see an evolutionary benefit in the wide range of model risk weights that DEM bewails.  That represents a diverse ecosystem of entities with divergent views that is less vulnerable to a single shock.  Yeah, that shock will crater some banks, but not all of them. When I think of any-ANY-centralized calculation, I think of the Socialist Calculation Debate.  I also think of monocultures that are dangerously vulnerable-systemically vulnerable-to a single shock.  Think of the devastation that smallpox wreaked on native American populations.  A single shock can crater everybody all at once.

If that happens, who is the buyer in the fire sale?  If there are no buyers in the fire sale, how low can prices go? Pretty damn low.

Crimson is right.  All Large Calculations Are Wrong.  The answer to this problem is exactly the opposite that DEM suggests.  Diversify this risk.  Don’t concentrate it.  Don’t sort on it.

We need less centralized control-freakishness.  Not more.  A lot less.  Mistakes are inevitable.  Create a system that induces them to make uncorrelated mistakes (or at least, mistakes with low correlation).  Don’t induce perfect correlation in errors.  I say again: don’t induce perfect correlation in errors.  Create a diverse ecosystem, not a monoculture.   Imposing uniformity because disagreement is unseemly and reveals the fundamental uncertainty with assessing risk is exactly-exactly-the wrong answer.  It makes errors systematic.  Systematic errors create systematic risk.

Diversified, diverse populations are far more robust than uniform, monocultural ones.  Disagreement is a feature, not a bug.  Enforced agreement is the worst bug of all.  Sort of like smallpox.