Streetwise Professor

Deus ex Machina has a typically succinct and excellent post on CCPs.  He argues that CCPs perform two functions, derivatives receivable insurer and central margin custodian, and there is no reason why these functions must be combined in a single entity.

Absolutely true. I have made this point several times, notably in this Cato policy review piece.

My only quibble with DEM is that CCPs perform more than the two functions.  In addition to those, it serves as a trade data repository, monitor of the creditworthiness of its members (which, admittedly, could be considered part of their derivatives receivable insurer function), and importantly, default manager.

But DEM’s (and my) fundamental point remains the same: what is the economic rationale for combining in all these functions in a single entity for all derivatives?  Maybe this bundle is optimal for some derivatives (e.g., highly liquid, mainly short maturity futures and options), but not for others.  But why is that the right bundle for all derivatives?  Is there a reason to believe that the market will necessarily settle on the wrong bundle, thereby requiring the mandating of the futures bundle for all derivatives trades?

Vital questions, IMO, but ones that have seldom been asked by people who merrily dictate market structure and contracting practices.  Or by academics for that matter.

DEM’s numbering of the functions of CCPs brings to mind a Monty Python sketch (but then again most things do):

The Economist just ran a long piece about the unintended, and largely unforeseen, consequences of collateral and clearing mandates.*  And they aren’t all good.  Anything but.

I say largely unforeseen because I’ve been jumping up and down about these consequences here on SWP, in some academic papers (including one to be published in the next issue of the  Journal of Applied Corporate Finance), and numerous presentations.  I have repeatedly emphasized that it was a fallacy that requiring more collateral would necessarily reduce the amount of leverage in the system, make the leverage in the system less fragile, or reduce interconnectedness among financial institutions. I have consistently argued that market participants would substitute alternative forms of leverage and utilize other financing techniques (e.g., collateral transformation and liquidity swaps) as fragile or more fragile than the leverage embedded in derivatives, and that these new forms of financing would just change the topology of the network of connections among firms in the financial markets, and that the new topology would be as or more complex than the pre-mandate topology.

It was always particularly maddening to see regulators and others present pictures of the OTC derivatives market with a spaghetti bowl of interconnections between market participants, and contrast it to a neat and tidy picture of a cleared market with a few neat lines connecting market participants with the CCP.  There was no consideration of how the necessity of funding collateral and making variation margin payments would lead to the creation of financing arrangements among firms that would resemble the spaghetti bowl picture.  No consideration of how the very complex financial system would adjust on the myriad margins available to it.

In some respects, I can make some allowances for the regulators and legislators who imposed this on the world.   Those allowances are mainly a function of low expectations.  I am less forgiving of the academic community.  Many people smarter than I whom I respect have bought into the neat and tidy picture, and have dismissed concerns that the various Frankendodd mandates (and their European cousins) will create a new set of problems that may be worse than the ones that were supposedly fixed.

I think that in large part, this failure to anticipate the real effects of mandates, and the blithe confidence in the efficacy of collateral in particular, reflects the standard partial equilibrium, ceteris paribus way that economists use to approach problems.  This method is very powerful, and I utilize it regularly, but it has its limits.  In particular, it blinds one to the systemic responses to big changes like Frankendodd, to the fact that market actors will respond to these shocks on many dimensions.  As I’ve said repeatedly, there has been a systematic failure to consider how the financial system as a whole would respond to massive interventions designed to reduce systemic risk.

This is a particularly hard problem to analyze mathematically and formally due to its inherent complexity.  The daunting nature of the task, and the fact that formal mathematical modeling is almost required by top tier journals, has, in my opinion, made it unattractive for academics to pursue these issues.  The constraints of the accepted toolset have led to the slighting of an extremely important and interesting issue.

But this is not to say that the problem is immune to analysis that can generate meaningful insights and falsifiable predictions.  Indeed, largely disdained non-formal (“literary”) approaches can do so-and have done so.  I started from a very simple premise, that there were fundamental economic considerations that had led market participants to choose financing arrangements and contracts with certain amounts of leverage and fragility.  Constraining the ability to use those sorts of financing arrangements would induce actors to substitute towards arrangements with similar properties.  Non-formal analysis also shed light on how these mechanisms would operate during periods of systemic stress.

Based on these non-formal approaches, I made predictions about how the markets would evolve under clearing and collateral mandates.  Those predictions can be tested by empirical observation (though again, more descriptive than formally econometric).  That’s as “scientific” (in the Friedman Methodology of Positive Economics sense) as the densest, or most elegant, mathematical model.

And as it turns out, in this instance, some of those predictions are being borne out.  In ways that make me appreciate Cassandra.

I think it is more important to focus on important problems and find the best tools for the job at hand, rather than let narrow conceptions about the appropriate tools define and the problems you work on.  The latter mindset has limited academic economists’ influence on big things like Frankendodd.

The one-eyed man is king in the land of the blind.  Non-formal methods provide sight-and insight-on issues to which formal methods are often quite blind.  Given the incentive structure in academia, however, I am skeptical that the lesson will be learned.

* Link fixed. H/T Phil R.

For years I have been saying and writing that every spike in energy prices results in a replay of the final scene from Casablanca: “Round up the usual suspects,” with speculators being at the front of the line.   No exception now. With rising gas prices being the main threat to his reelection prospects, Obama and other Democrats are doing their best Captain Renault imitation.  Obama:

Obama sought to deflect growing Republican attacks over rising prices at the pump, blaming recent increases on a mix of factors beyond his control, including tensions with Iran, hot demand from China, India and other emerging economies, and Wall Street speculators taking advantage of the uncertainty.

Noted energy expert, Nancy-natural-gas-is-not-a-fossil-fuel-Pelosi also chimed in:

“Wall Street profiteering, not oil shortages, is the cause of the price spike,” Pelosi said in a statement. “Unfortunately, Republicans have chosen to protect the interests of Wall Street speculators and oil companies instead of the interests of working Americans by obstructing the agencies with the responsibility of enforcing consumer protection laws.”

And, again at the risk of sounding like a broken record (responding to a vast collection of broken records): no theory, no evidence.

With respect to evidence, a heads up: The opponents of the “financialization” of commodity markets have flogged the Singleton paper on oil index trading for all it is worth. I am putting the finishing touches on a far more extensive study, the conclusion of which is quite simple: the Singleton results do not stand up in a broad sample of commodities, or even in oil for a longer sample period.  Watch this space.

In other words: try again, guys.  But that would actually presume, I guess, that evidence matters to these people, anyways.

One thing struck me about the Obama and Pelosi statements: the deliberate inclusion of “Wall Street” in their formulation, as in “Wall Street speculators.”  What, London, Geneva, and Singapore don’t rate?

Which brings another movie image to mind: the scene in Frankenstein in which the villagers storm the castle.  Obama and Pelosi are just following the #OWS-themed, Valerie Jarret-inspired class warfare campaign script. Be prepared to be bombarded with similar rhetoric for the next eight months.  And the shrillness of the attacks will vary directly and exponentially with the price of gasoline.

I don’t have a lot more to say on the subject, primarily because there’s not a lot new to say.  Obama and Pelosi are being good greens, and recycling well-used rhetoric.

I was interviewed on the subject Tuesday for an NPR piece.  It does a pretty good job of summarizing what I said in a 20 minute interview.  A few brief comments:

1. The CFTC claims that it has brought numerous energy enforcement actions and collected large fines.  This is highly disingenuous.  Highly.  These have not been in the oil market (except for the Arcadia case which I criticize in the piece, echoing what I’ve written on SWP).  They have not shown any connection between speculation and manipulation and high oil prices. Virtually all of these cases relate to price reporting fraud and wash trading in the natural gas markets during the merchant energy boom, prior to the demise of Enron and the merchant energy meltdown in 2002.  I was highly involved in efforts designed to prevent these abuses from recurring.  Efforts that did not come to fruition, but which focused on a solution (the creation of transaction data hubs with mandatory reporting) that has now been adopted for the derivatives markets worldwide-not just natural gas in the US.  That is arguably one of the only sensible things in Frankendodd.
2. The piece mentions John Arnold making a billion in speculating.  Yes, he did.  In gas.  The price of natural gas is at near-historic lows, demonstrating that speculative activity does not inevitably cause prices to be high.  Indeed, the disconnect between natural gas prices and oil prices is a huge embarrassment to the anti-speculation mob, especially those who claim that index investing (which results in highly correlated trades in oil and gas) is a dominant force in driving commodity prices.
3. It drives me to distraction that “speculation” and “manipulation” are used interchangeably.  No. No. No.
4. Manipulation definitely occurs in commodity markets, including the energy markets: for instance, manipulations were common in the Brent market in the late-90s and early-00s, and may become more common again as BFOE production continues to diminish.   These manipulations lead to highly temporary and localized price distortions.   Most of the Brent squeezes resulted in elevations in Brent prices for days, or a few weeks, and didn’t push up prices of other types of oil: indeed, the main symptom of these squeezes was the rise in Brent relative to other grades and locations.  As another example, the BP propane squeeze (a case I was involved in) resulted in a spike in TET propane prices for about two weeks.  They don’t explain persistent, global prices spikes.

Hopefully I will have the results on the expanded Singleton analysis available within a few weeks.  Until then, get prepared for a continued onslaught against “Wall Street profiteers and speculators.”  La plus ca change . . .

Last March I noted that in my two previous trips to teach in Geneva, there had been squeezes in the coffee market, and I said I was going to buy coffee spreads before my next trip.  Well, that trip is coming up in about 3 weeks, but somebody in the market (perhaps the Noble Group, according to the FT) beat me to the punch: there is a good squeeze underway in the robusta market, with spreads going from contango to a $182/ton backwardation.  That ain’t a hill of beans.

Note to self: put on the trade earlier next year.

When I was in Geneva last year the Li(e)bor story came to life after having faded from view for several years.  That story has now exploded into prominence, with numerous disclosures over the past several weeks.

Indeed, the story has taken a major turn.  Whereas suspicions as to motive originally focused on the idea that banks were attempting to make themselves look sounder than they were by exaggerating their ability to borrow unsecured, the new stories claim that there is evidence that some traders were manipulating rates specifically to influence the value of derivatives positions tied to Libor.  This is a major development because specific intent to manipulate the price of a derivative is a necessary element of a manipulation case under the Commodity Exchange Act.  If confirmed, these allegations regarding motive dramatically increase the legal stakes for the banks.

Eric Posner and E. Glen Weyl have attracted a lot of attention for their proposal to create an agency that would approve trading of new financial products, in the same way the FDA must approve new drug entities before they can be sold to the public.  Their initiative is fundamentally flawed, both in its diagnosis and its prescription.

There are a variety of problems.  The most basic is their false dichotomy between contracts that are used for speculative purposes, and those that are used for hedging.  In fact, speculation and hedging are highly complementary functions.  The most important function of derivatives markets is to facilitate risk transfer.  This risk transfer often involves a hedger on one side of a transaction, and a speculator on the other.  The speculator may be, as Posner and Weyl claim, trading on the basis of incorrect beliefs.  So be it.  His existence allows the hedger to reduce risk, and makes both parties subjectively better off, although Posner and Weyl seem to suggest that it would be possible to determine objectively that the speculator is acting irrationally.

In other words, much speculation in financial markets facilitates hedging.  To suggest that these activities are antithetical, or unrelated, as Posner-Weyl do, is highly misleading.

Posner and Weyl use mutual funds as an example of a salutary financial innovation.  No disagreement here.  But these can be used for activities that are commonly and properly considered “speculative.”  Moreover, equity and bond futures are widely used to speculate on broad movements in stock and interest rate changes.  But they are also used by pension funds and institutional investors to achieve the same type of objectives as mutual fund investments. So what, really, is the difference between mutual funds and derivatives?

There are indeed well-known problems with speculation.  Much of it (including excessive acquisition of costly information, the development of faster ways to trade) is properly understood as rent seeking.  But these problems are not uniquely associated with particular kinds of instruments, as Posner-Weyl insinuate.  There can be inefficient acquisition of information for speculative purposes in derivatives that are widely used for hedging–including the agricultural futures that Posner-Weyl consider to be salutary. (Although it does not speak highly of their understanding of these markets that they use farmer hedging as their justification of ag futures, though that is hardly the primary hedging use of these instruments.)

Other possible problems highlighted by Posner-Weyl include the use of derivatives for tax avoidance or regulatory arbitrage.  I say “possible problems” because the real problem can be with inefficient regulations or taxes, not the means that are used to mitigate these inefficiencies.  But even abstracting from this difficulty, there is also a fundamental problem distinguishing “bad” derivatives that are used for tax or regulatory avoidance, and “good” derivatives that are used to hedge.

Back in the 1970s and 1980s, simple plain vanilla futures contracts were widely used in a tax reduction strategy called “tax straddles” involving a spread trade (buying one future, selling another with a different delivery day).  The trader would liquidate the losing leg of the trade to generate losses to offset against other gains, or to convert ordinary income into capital gains.  This strategy was eventually disallowed in 1981: the instruments themselves were not banned because they could be used to avoid taxes.

In sum, hedging and speculation are complementary; speculation is not always inefficient;  and inefficient forms of speculation are not confined to specific instruments.  Therefore, regulations designed to impede speculation by requiring the approval of specific products are misguided because impeding speculation interferes with efficient transfer of risk, and because the inefficient uses of derivatives cannot be reduced reliably by preventing the marketing of particular instruments.

This means that charging some financial FDA with the responsibility of choosing which innovations to permit and which to proscribe, based on the goal of eliminating speculation, is basically hopeless.  Such an agency’s choices will be plagued by Type I and Type II errors.

Not to mention that whereas the effects of a drug can be determined with some (though incomplete) precision in clinical trials, there is no comparable way of determining how financial innovations will be used, the volume of their use, or their economic effects (in part because these effects depend on the scale of adoption, and the interaction of these products with other products in the market).  All of these things depend on the choices of myriad individuals, and these choices can change over time: who would have envisioned, in the 19th century when wheat and corn futures were first traded in Chicago, that they would one day be used by index funds to offer diversification opportunities to pension funds?

Drugs are taken by individuals and their effects can be understood by studying individuals who take them: the systemic effects are just the sum of individual effects. Things are very different in financial markets.  The introduction of financial products can lead to very complex responses in the entire system that cannot be understood or quantified in any clinical trial.

When I originally heard of the Posner-Weyl paper, I thought they would focus on how particular instruments can be systemically risky.  They in fact pay very little attention to this issue.  In this regard, it should be noted that the FDA/clinical trial model is completely inapposite.  You cannot study the systemic effect of a financial innovation in an isolated trial: you have to see how it interacts with, and affects, the entire system.

And to try to understand these effects a priori is certainly futile.  The system is too complex, and there is no way to understand how a particular innovation will fare in the market, and how it will affect the entire system.  As a concrete example, no one truly understood the consequences of CDOs on subprime ex ante, just based on the characteristics of the instrument themselves.  The risks embedded in the instruments were not well understood when they were first created, and these risks depended on the scale of their use, which was impossible to predict at the time they were first created.  In the end, there were risks that were not widely understood at the time of introduction, and these risks had systemic import only because these instruments proved very popular and grew to massive proportions completely unanticipated when they were first introduced.

We actually have historical experience with ex ante entry regulations on financial innovation.  Until the 1990s, no exchange could introduce a futures contract unless the CFTC approved it.  The approval was contingent on a CFTC finding that the proposed contract passed an “economic purpose” test, and was designed in a way that would permit it to achieve this purpose.  In some ways, the economic purpose test was analogous to what Posner and Weyl propose today.

This system was costly and reduced competition.  Like many entry barriers, it was exploited by incumbents to hamstring competitors. I am not familiar with any dangerous product that was kept off the market through this procedure, and the introduction of good products was delayed.  All pain, no gain.  Why would we want to repeat that experience.

Maybe Posner and Weyl would disagree with my appraisal of the CFTC precedent.  They don’t seem to be aware of it, in fact.  Before making such sweeping proposals perhaps they should have performed an analysis of a similar system that operated for decades.

Being a Sam Peltzman student, I was never all that impressed with the FDA model in the first place, even in pharmaceuticals.  I am even less impressed with the FDA as a model for the regulation of products that are fundamentally different from drugs.  Especially when those advocating this model make basic errors about the instruments that they believe should be regulated, and the uses to which they are put.

Walter Russell Mead’s excellent blog recently discussed the conflicts over massive natural gas deposits in the eastern Mediterranean:

Naturally, the race to get the gas has reinvigorated old arguments (Cyprus-Turkey) and added fuel to newer disagreements (Israel-Turkey). Israel and Cyprus have been fastest off the blocks, agreeing their common maritime border in 2010 and contracting exploration work to Noble Energy. Turkey, on the other hand, has been slow to react and increasingly confrontational, holding naval exercises and trying to prevent Cyprus from accessing gas that Turkey says belong to Northern Cyprus, which only Ankara recognizes as a country. The confrontation also threatens to further destabilize Israeli relations with Turkey, which appeared to be on the uptick this week when an Israeli delegation arrived in Turkey’s quake-hit Van Province with aid supplies; “You are our true friends” said Van’s vice governor.

The gas reserves in the Levant Basin may be large enough to make Cyprus self-sufficient in energy and turn Israel into a major gas exporter for the next several decades. That, and Israel’s new tilt toward Greece as a way of countering the cold wind in its relations with Turkey, is opening a new era in Israel-Cyprus relations. Netanyahu is on his way to Nicosia this week (the first ever visit of an Israeli PM to the island), and Israel is expected to formally ask to station fighter jets at a southern Cypriot airbase.

Oh joy. Another reason for conflict in a region of the world that counts conflict and strife as its most important export.

Unmentioned in Mead’s post is Russia, the country which has a huge economic stake in the development of a major gas resource right next to its major western European customers.  Eastern Med supplies would far closer to Europe–especially big consumers like Italy–than Russia, and these supplies wouldn’t be subject to the Russian-Ukrainian Punch and Judy routine every winter, or the vicissitudes of Russian domestic considerations.  Meaning that if these resources were developed to their full potential, Gazprom (and Russia) would suffer substantially.  Very substantially.

Which gives Russia a tremendous incentive to foment instability in the region.  Not like that is very hard, either.

It has two major levers in this endeavor.  The first is Cyprus, which is deeply enmeshed with Russia financially and politically.  Russia has been Greek Cyprus’s financial savior, extending it substantial amounts of credit to keep the country from plunging into Greece-like catastrophe.  Even more importantly, Cyprus is the destination or conduit of dirty Russian money, and the location of choice for Russians setting up dodgy shell companies.  (Oh, how entertaining it would be if Cyprus were the target of an invasion by an army of forensic accountants!) (Also recall that the SVR agent who was the money man for the Anna Chapman spy ring miraculously disappeared in Cyprus after being arrested there.)

The second is . . . Syria.  I do not suggest that this is the only for Russian intransigence in that country: that behavior is overdetermined.  But stoking conflict–or standing in the way of resolution of conflict–in Syria does promote Russian interests in the gas business.  Indeed, the economic stakes here are far greater than the oft-cited Russian commercial interests in Syria: some rather shambolic business and infrastructure projects, and arms sales (which appear never to be paid for, at least fully).

Just saying.

I have long been nauseated by the hagiography surrounding Warren Buffett.  The veneration of St. Warren has reached a peak of late, as he is Obama’s go to guru, providing protection against accusations that the president is anti-business, and giving cover to Obama’s plans to jack up taxes on the wealthy.  After all, if a man richer than God is on your side, how can you possibly be a class warrior?

My cynicism about the saintly Buffett dates from almost exactly 14 years ago. There is substantial evidence that in February, 1998, Buffett cornered the silver market.

I repeat: there is substantial evidence that Warren Buffett cornered the silver market.  Cornered, as in manipulated.

Yes, Saint Warren was almost certainly a manipulator.

The story in a broad outline. Beginning on 25 July, 1997, Buffett began to accumulate large quantities of silver via Phibro, a subsidiary of Salomon Brothers, an investment bank in which Buffett had a big stake, and which he had saved from extinction when Salomon traders cornered the Two Year Treasury note market in 1991.  He eventually acquired nearly 130 million ounces of silver.

He stood for big deliveries in February, 1998.  The market went nuts.  All of the inidicia of a corner were present.  Nearby prices skyrocketed relative to prices for delivery in the spring.  The following chart depicts the spread between the March, 1998 COMEX silver price, and the prices for May and July. 

Note that the spread blows out when Buffett stood for delivery, during the first week of February, with the March-July spread going from -.2 cents/oz on 1/29/98 to 20 cents/oz on 2/5/98.  The March 98 price went up a dizzying $1.25/oz (about 20 percent) during that week.

The loco London lease market for silver also showed acute signs of a squeeze.  (The lease rate is the cost of borrowing metal.  If you need silver in a hurry to make delivery, you are willing to pay a big premium for nearby delivery, that is, you are willing to pay a lot to borrow/lease silver.  Formally, the forward price of silver is the spot price times one plus the interest rate minus the lease rate.  If the lease rate is very high, the forward price will be below the spot price: that is, the market is in backwardation.)

This depicts the one month lease rate for silver.  Note it skyrocketing right around the time of the deliveries.  In early February, the lease rate was quoted as much as 75 percent annualized (some press reports say 80 percent).

There were physical distortions characteristic of a squeeze.  People around the world scrambled to get silver and transport it to London–often by plane.  The silver market in India, a major consumer, almost shut down:

But in the past two months, work at the refinery has slowed–because of one man half a world away. Until a few days ago, most Indians had never heard of Warren Buffett. They even say his name wrong, confusing it with buffet. No matter. Since last October, when Buffett began buying silver, imports into India have nearly stalled as Indians decided that the metal costs too much. Today, more and more Indians are selling their dishes and jewelry made of silver, which now fetches $7.25 an ounce, 20% above the normal $6. That makes for an interesting match-up: 960 million Indian sellers vs. one billionaire buyer from Omaha. “Tell [Buffett] he can’t last,” thunders dealer and refiner Mukul Sonawala. “Indians say the price is too high. They’re saying: `Mr. Buffett, have your buffet, we’ll wait till the price drops. Good-bye.”‘

There were backlogs processing the silver flooding into London: the official weighers couldn’t keep up.  The London Bullion Market Association responded to the bottleneck by extending the normal 5 day delivery period to 15 days.

There was plenty of silver in New York, but Buffett didn’t buy it there, even though it was cheaper there (more on this below).  Instead, silver was shipped from NY to London, by airfreight(!) mainly, where it had to be re-assayed because the assay marks were from a firm no longer in existence.  This created yet another bottleneck.

As soon as the deliveries were completed, prices, spreads and lease rates collapsed: by 27 February, the London price had fallen 22.5 percent off its peak, and lease rates were down to where they’d been before the frenzy began in the immediate aftermath of a Buffett press release (see below).  These price and price relation changes are also symptomatic of a corner.  They are the manifestations of what is often referred to as “burying the corpse”–a phrase I’ve been accused of coining.*

What did Buffett have to say?  This (on February 3, 1998):

During 1998, Berkshire has accepted delivery of 87,510,000 ounces in accordance with the terms of the purchase contracts and the remaining contracts for 42,200,000 ounces call for delivery at varied dates until March 6, 1998. To date, all deliveries have been made on schedule. If any seller should have trouble making timely delivery, Berkshire is willing to defer delivery for a reasonable period upon payment of a modest fee.

Over 30 years ago, Warren Buffett, CEO of Berkshire Hathaway, made his first purchase of silver in anticipation of the metal’s demonetization by the U.S. Government. Since that time he has followed silver’s fundamentals but no entity he manages has owned it. In recent years, widely-published reports have shown that bullion inventories have fallen very materially, because of an excess of user-demand over mine production and reclamation. Therefore, last summer Mr. Buffett and Mr. Munger, Vice Chairman of Berkshire, concluded that equilibrium between supply and demand was only likely to be established by a somewhat higher price.

On which I call Bull!

If it was a long term investment, why did Buffett take delivery at a huge premium over deferred prices? If he was betting on the long term fundamentals, why not sell nearby silver at its huge premium, and buy silver at a much lower price for delivery in July, say?  If he was right about the fundamentals, the July price would rise as the “equilibrium [was] established.”

Taking delivery at a premium price was actually foolish, if long term investment was the actual goal.  Buffett paid a premium of about 45 cents/oz to get silver in early-February.  He was buying high and selling low. If he wasn’t manipulating, and his trading wasn’t causing the price distortions, he could have sold spot silver, bought silver for delivery in a month, and picked up 45 cents/oz by doing so (instead of standing for delivery).  Warren Buffett did not get that rich by being that stupid.  No, the evidence clearly shows he had another, very short-term objective in mind.

Put differently, if Buffett had been acting purely as a long term investor, why would he have needed people around the world–as far away as India–to scrape up all the silver they could find, put it on planes, fly it to London to get in the customs queue to be delivered in a five day window (later extended to 15 days)?  Why did Mr. Long Term need silver on those 5 (15) days? What was the big hurry, if he was taking the long view?

And why did he need it in London? This chart depicts the difference between the London silver fix and the COMEX March futures price.  Note the spike when Buffet was taking deliveries in early February.  At the margin, he paid a premium of 56 cents/oz–representing almost 8 percent of the NY price–to get silver in London in early February rather than getting it in NY.  Note too that the premium crashed after the bottleneck cleared.

The answer to these questions: demanding delivery in a short time window in a single location had nothing to do with a long term view on silver.  It was a corner, pure and simple, exploiting the frictions involved in bringing large quantities of silver to London on short notice. That made it very costly to deliver, allowing Buffett to loan out silver very profitably at the inflated lease rate.  He created an artificial shortage, and likely profited accordingly.  An investor acquiring silver based on a long-term view would attempt to minimize cost by purchasing in the cheapest locations and dates.  Buffett bought a lot of silver at the most expensive location and the most expensive date.

And note well the little insult that Buffett added to economic injury:

If any seller should have trouble making timely delivery, Berkshire is willing to defer delivery for a reasonable period upon payment of a modest fee.

A reasonable period.  A modest fee.  How saintly.  Note well again: the market rate for deferring delivery by as little a month was as high as 75 percent on an annualized basis.  In dollar terms, about 45 cents/oz (6 percent of the price) to defer delivery by one month.  Does that sound “modest” to you? Not to me.  Does it sound like the actions of a purely long term investor, who shouldn’t need to get the silver RIGHT NOW? Couldn’t a long term investor wait a month? Wouldn’t a long term investor want to buy at the cheapest location, not the most expensive?

The lease rate tells you exactly what that “modest fee” was.  Deferring delivery for one month cost 75 percent annualized–over 6 percent per month.  That’s not even that modest for loan sharks.

No, the market showed acute signs of shortage, and that shortage had one cause: Buffett standing for huge deliveries.

So keep this in mind when you hear Buffett praised to the heavens.  He is more than willing to play smash mouth to add to his fortune.  He is also very willing to lie about it, and to claim sanctimoniously that he is doing those he is smashing a favor.

That doesn’t sound too saintly to me.

* I wish.  Actually, the phrase originates with P. D. Armour, a famous Chicago grain and meat magnate in the 19th and early-20th centuries.  (You might have had Armour chili–same company.)  He was asked whether it was easy to corner the market.  He responded that it was like a murder: ” to commit murder is very simple, the trouble is to bury the corpse”, the corpse being the excessive quantities of the commodity delivered to the market, that the cornerer had to unload later at a loss.

I’m sure you’ve noticed that I haven’t written much about clearing lately. (And yes, I can hear the Hallelujah Chorus.)  Simple reason, really.  Most of the clearing related news warrants schadenfreud, and an “I told you so” response.  I enjoy a good Lulz as much as the next guy, but I know it gets old.

But this article hits on so many things at once I have to impose on you all.  It basically gives the lie to all the justifications for the clearing mandates in Frankendodd.

1. The advocates of mandates, notably GiGi and Timmy! asserted repeatedly that clearing would reduce the connectedness of the financial system, and in particular, would reduce the importance of big banks in those connections.  I argued in response that clearing mandates would just change the topology of the network; that it would remain densely connected; big banks would still be tightly connected; and that the new topology was not obviously less systemically risky than the old one.

From the article:

Where do you find the spare $2 trillion needed as collateral for cleared swap trades?

With new regulation in the US and Europe set to move the bulk of the over-the-counter derivatives market towards central clearing from next year, swap buyers and dealers will soon be faced with that very question. Many custody banks believe they could provide the answer.

Already heavily involved in the plumbing of the clearing market, custodians act for almost every major financial services firm without a custody arm – including most dealers and every clearing house.

Most also offer collateral management services, including securities lending and collateral improvement – the process of turning less-liquid securities into eligible collateral to post as surety in transactions.

This experience could prove invaluable with the advent of new swap clearing rules, which come in with the expected implementation of the Dodd-Frank Act in the US from early next year, increasing the demand for collateral transformation services.

David Field, managing director with banking consultancy Rule Financial, said: “The buyside simply doesn’t have enough quality collateral available to lodge for clearing.

Executing brokers are expecting to generate strong post-trade revenues from collateral transformation – but the custody banks are the ones holding the collateral.

This is a huge opportunity for custodians, and several are already investing anywhere between $50m and $100m to position themselves.”

In other words, big custodial banks will be even more tightly connected with all major participants in the derivatives trade because of their comparative advantage in providing collateral transformation, and the strong economies of scope between providing this service and providing other custodial services.

2. The advocates of mandates argued that it would reduce leverage in the system.  I responded repeatedly that this was not at all obvious, and that the most likely effect would be to transform the nature of leverage.  The big move to collateral transformation makes it abundantly clear that this is in fact happening.  I go into this in much more detail in my forthcoming Journal of Applied Corporate Finance article titled “Clearing and Collateral Mandates: The New Liquidity Trap?”

Credit means credit risk.  So the clearing mandate has not eliminated credit risk from the derivatives market, or even reduced it sharply.  It has just transformed it, relocated it.  And it has definitely not eliminated derivatives-related credit risk from big banks.   Indeed, it is moving more risk to some big banks.  BNY-Mellon and JP Morgan are also the most important settlement banks, and play a vital role in the repo market.  This is already a source of systemic risk.  These banks are arguably the most important pieces of the financial infrastructure, and these developments will make them even more important, and also concentrate more risks from disparate markets (e.g., repo and derivatives) in them.

3. The advocates of mandates asserted that it would make the derivatives market less concentrated and more competitive (although nb these are NOT equivalent).  From the article:

Tech-heavy effort

Among the most ambitious to gain business in the swaps market is BNY Mellon, the world’s largest custodian with $25.8 trillion of assets under custody. The bank sees its existing footprint as a springboard towards dominance in the collateral services market for OTC derivatives.

[A director] for collateral management and clearing at BNY Mellon in London, believes it will be a tech-heavy effort. He said: “According to recent Isda Margin Survey figures, roughly 80% of collateral used in the OTC swaps market is cash, with about 15%-20% being fixed-income securities.

If even 20% of the estimated extra $2 trillion of collateral required to clear OTC swaps via central counterparties is in the form of securities, that puts a big onus on the collateral managers to offer smart, quick systems capable of handling huge draws on client collateral daily.”

Rival US custodian State Street has also been boosting its presence in the cleared derivatives markets, launching a swaps clearing operation in September. In a signal of intent, the bank has quietly begun hiring senior futures brokers from established rivals.

Charley Cooper, senior managing director at State Street Global Markets, said: “State Street’s unconflicted approach combined with the operational efficiencies gained from clearing with a custodian, gives us a significant edge in the emerging clearing marketplace.”

A senior derivatives banker said that clients are already looking at custodians as a viable counterparty.
He said: “In the past six months, we’ve seen growing migrations to the custodial clearing business.

Some have a better credit rating than almost every investment bank, and it’s unlikely they will be subject to capital ring-fencing regulations.”

He said that if a major custodian is able to convert even half of its existing custody clients into clearing clients, it could be looking at a share of anywhere between 10% and 20% of the OTC clearing market.”

The incumbents

But existing derivatives flow dealers – especially ones with large custody and treasury businesses – are unlikely to shy away from a revenue-generating opportunity.

Citibank, in particular, is hoping to combine a swaps clearing operation with its custody and treasury services in the US.

Jerome Kemp, global head of exchange-traded derivatives and OTC clearing at Citi, is in no doubt which direction the market is heading.

He said: “We’re looking at a re-dealing of the cards in the derivatives clearing space. Post-Dodd-Frank implementation, clearing will be led by the larger, well-capitalised banks.”

Citi hired aggressively to expand its futures commission merchant business last year, including the hire of Kemp, previously co-head of listed derivatives and clearing at JP Morgan, who arrived with a raft of colleagues.

Kemp thinks the next battleground for the bigger futures commission merchants, which will act as clearers for many firms on the buyside, could hinge on the bundling of services across clearing and asset servicing.

JP Morgan, meanwhile, is also looking to leverage its existing prime services footprint for its hedge fund clients for whom swaps clearing will be a new experience.

The bank has merged its listed and OTC clearing teams, and invested heavily in client roadshows and clearing masterclasses since the Dodd-Frank Act was passed in 2010.

Dale Braithwait, a member of JP Morgan’s OTC clearing team, said: “It’s to our advantage that we’re a big collateral manager too.

For a lot of asset managers, who do not feel they are able to use prime brokerage services, it’s a big benefit to have someone who can act as a custodian and a clearer.”

So there is a big fixed cost to play in this game.  The resulting scale economies tend to increase concentration.  Moreover, there is a strong scope economy across collateral management and transformation services, and other custodial services.  Meaning that the big custodian banks have a strong competitive advantage in providing the new collateral management and transformation services that will become a crucial component of the OTC derivatives markets.

It is particularly ironic that BNY-Mellon will be a major beneficiary of this.  You might recall the execrable NYT piece (written by Louise Story) about the evil derivatives dealer cabal.  One of the most memorable parts of the article was BNY’s whinging about its inability to break into the dealer space.  Read this new piece and you can just imagine BNY execs rubbing their hands together in glee, throwing their heads back, and laughing an evil laugh.  All your cabal belong to us.

So let’s summarize, shall we? Clearing mandates (and requirements to collateralize uncleared swaps) will result in the formation of new links between buyers and sellers of swaps (including dealer banks who do not offer custodial services) and a handful of major custodian banks.  These links will involve the extension of credit, and hence the existence of derivatives-related counterparty risk in which big banks still have substantial exposure.  If anything, the mandates will increase concentration in an important part of the derivatives market.  Moreover, it will arguably increase the concentration of credit risk exposure in a handful of systemically important banks.

Well played!  The actual results of Frankendodd will be the exact opposite of what was claimed by its tireless advocates (And yeah, I’m looking at you, Timmy! and GiGi.  I’m trying not to look at Barney, but that’s a whole other story.)

Unintended consequences, indeed.  Unintended, but predictable–and predicted.

An adviser to German Finance Minister Wolfgang Schaeuble has told a Greek paper that the 50 percent haircut deal (PSI) is no longer operative:

The planned 50 percent writedown of Greek government bonds held by private creditors as part of a debt swap won’t be enough to make the country’s debt sustainable, an adviser to German Finance Minister Wolfgang Schaeuble told To Vima in an interview.

The write down, which aims to lower Greece’s debt to 120 percent of gross domestic product in 2020, will have to be greater and shouldn’t be voluntary, Oxford University professor Clemens Fuest told the Athens-based newspaper.

I’ve just seen on Twitter a 60 percent number being batted around–no link as of yet.

In addition to the scuppering of the 50 percent “deal” agreed to in October, the significant part of this statement is that the haircut shouldn’t be voluntary.  This suggests that governments are tiring of the negotiations, and believe that immediate action is necessary.  Indeed, given the horror with which Euro officialdom had previously contemplated the possibility of an involuntary haircut of this magnitude–which would trigger CDS, if ISDA wants to maintain a shred of credibility–this drip-drip-drip of leaks indicates that said officialdom recognizes that the can has arrived at the end of the road.

Reports suggest that some of the MF Global customer funds may have made their way to MF’s UK subsidiary.  In which case, I found it, and right around the block no less!