Streetwise Professor

I have a relatively simple way to filter out serious research on commodity prices from the not-so-serious. If you rely on “convenience yield” I will not take you seriously. Alas, based on this filter, the bulk of commodities research is unserious.

For the uninitiated (consider yourself lucky!), convenience yield is an attempt to explain that commodity futures prices are typically at less than “full carry”, i.e., that futures prices are below the spot price plus the cost of carrying inventory (financing plus physical storage costs). Furthermore, convenience yield is invoked to explain the fact that departures from full carry vary systematically with (some measure of) inventories, with big departures associated with small inventories.

These are empirical regularities, and convenience yield is invoked to explain them. The idea dates from Kaldor (1939), who was attempting to explain Working’s earlier (1934) empirical findings from the CBOT wheat market.

The intuition is simple. With true assets (e.g., bonds, stock, currencies), the futures price is depressed by the income (“yield”) on the asset (e.g, the dividend on a stock). So, to explain the depression in commodity futures prices below full-carry values, Kaldor said: stocks “have a yield, qua stocks, by enabling the producer to lay hands on them the moment they are wanted and thus saving the cost and trouble of ordering frequent deliveries, of waiting for deliveries.”

Problem solved!

The problem is not solved, because there are no real microfoundations here. Kaldor merely waved his hands, and analogized a departure from full carry in commodity markets to the depression in the prices of futures on assets caused by the income on these assets.

The problem is that, as Stephen Ross pointed out around 30 years ago in a paper on the Metallgesellschaft episode, commodities are not true assets. True assets are always in positive net supply. Commodities–and in particular commodities at the delivery point of a futures contract–are not always in positive net supply: sometimes there are “stockouts” when all inventories at a particular location are consumed. As Bob Lucas taught me years ago, commodity inventories in positive supply at all times is inefficient, as this would imply that a commodity is produced but never consumed. So stockouts are inevitable in competitive commodity markets.

Thus, the real cause of below-full-carry futures prices is that the zero inventory constraint is periodically binding.

So how to explain positive inventories and less-than-full-carry futures prices? There are two basic explanations: aggregation in space, and aggregation in time.

The best exposition of the former is Brennan, Wright, and Williams, (1997). Working off of earlier theoretical research by Wright and Williams, this article shows that including inventories held outside a delivery point (where spreads are used to measure carry) is misleading. When a delivery point is at an inverse/backwardation/less than full carry while inventories are positive at other locations, it is because the inverse (which measures the benefit of immediate delivery and consumption in the market where the inverse is measured) is smaller than the cost of moving inventories from where they are held to the delivery point.

With respect to the latter, the rigorous theory of storage based on optimal intertemporal allocation subject to a non-negative inventory constraint implies that if inventories at the delivery point are positive, the futures price for delivery on the next day will be at full carry. However, most departures from full carry are typically measured using futures prices for many delivery days if not months into the future. (For example, Working analyzed the May-July and July-September spreads.) These deferred delivery contracts can be below full carry when the one-day price is at full carry if there is a positive probability of a stockout prior to the expiration of the futures contract used to measure the spread.

This explains the Working Supply of Storage relationship even when one uses stocks in the delivery market as the independent variable. The smaller the inventory, the more likely a stockout prior to expiration of the futures contract used to calculate the spread, and hence the bigger the inverse.

This was all discussed thoroughly in my book.

In sum, convenience yield is a fudge factor, justified with hand waving. The attempts to provide microfoundations, such as invoking inventories as a factor of production, as in Ramey (1989), have farcical implications (which I ridicule in my book).

The Working supply of storage curve is an empirical regularity. Convenience yield is not the explanation for this regularity. The real theory of storage, which is based on the non-negative inventory constraint, is.

I plead guilty to using convenience yield in some of my earlier research, in particular my fairly widely cited paper with Victor Ng on industrial metals. By way of justification, I would say that (a) I was a young academic that needed to present our research in a way that conformed with the conventional wisdom (which alas did, as it still does, rely on convenience yield, as illustrated by a slightly earlier paper by Fama and French) (ah the price of publish or perish) , and (b) we also invoked the more rigorous theory of storage.

But I have seen the light: indeed, I saw the light years ago. Academics working in commodities now should also have a Come to Jesus moment, and swear off the concept of convenience yield. At least if you want to be a serious researcher committed to analysis grounded in firm microfoundations–which “convenience yield” is decidedly not.

I can always use a good laugh, and noted nitwit Nikole Hannah-Jones has provided one:

Other than being Black, what exactly is Sowell's expertise in slavery or history?

— Ida Bae Wells (@nhannahjones) February 10, 2023

Oh Nikki, where to possibly begin? I suggest you start with Race and Culture: one whole column of the index lists the mentions of the subject of slavery in the book. Then maybe Black Rednecks, White Liberals. (Though that may result in a messy explosion of your magenta-maned head.) And for a bit of self-knowledge, Intellectuals and Race. But in point of fact, analyses of slavery are found throughout Sowell’s massive literary output. (When thinking of him, I am reminded about a quip someone made about Paul Johnson: it’s not the amount he’s written that astonishes, it’s the amount he’s read.)

And not just North American slavery, but slavery around the world. And that’s precisely why he can speak with far more authority and insight on whether slavery in British North American colonies, and later the United States, was somehow unique and makes the U.S. the most fallen of nations, than can Hannah-Jones and her ilk.

And history generally. Again. Look at at his incredible record of scholarship, which includes detailed expositions and analyses of a wide variety of historical issues, such as immigration.

Moreover, Sowell’s approach to history stands in stark contrast to 1619 Project-style leftist “history”: In Sowell, history is a reservoir of facts and data against which theories are tested, whereas in Hannah-Jones’ “work” it is something to be twisted and distorted in order to make political and ideological points.

Thomas Sowell has had a major impact on my life and thinking since I was in college: his Knowledge and Decisions profoundly affected, and continues to affect, how I think about economics, law, and policy. Although somewhat dated because many of its examples were current at the time it was published 43 years ago, the underlying conceptual framework and analyses are timeless: it is astounding at how the intellectual errors that Sowell analyzed back then curse us today–most notably, his theme that there are no solutions, only trade-offs, something that politicians ignore daily, with COVID policy being one of the most egregious examples.

To my mind, Thomas Sowell is the most impressive public intellectual (and intellectual, period) of the past 50 years. The breadth and depth of his scholarship is unsurpassed, and his steadfastness and courage in the face of vicious criticism from lilliputians like Hannah-Jones is truly remarkable. He is a true intellectual: Hannah-Jones and her ilk are intellectualoids, at best. People with intellectual pretensions that far outstrip their abilities, and who pass off agitprop as scholarship. Only idiots think them geniuses.

One of the highlights of my academic career occurred when Sowell wrote an oped defending me against the New York Times’ slanders. No doubt his unfortunately extensive experience with slanders directed at him motivated and informed what he wrote. And the slanders continue, as Hannah-Jones’ ignorant tweet reveals. But sometimes, as in this instance, the slanders are so ridiculous that they elicit only laughter.

Nina Khan’s FTC has indicated that it will outlaw non-compete clauses in labor contracts. Be skeptical. Be very skeptical.

My priors are that such restrictions are unwarranted, especially when originating in the Khan FTC.

For one thing, this brings to mind Coase’s dictum that the knee jerk response to any non-standard contracting practice is that it is the result of monopoly (or in this instance monopsony) power. Coase argued that instead most such practices economize on transactions costs. Research dating back more than a half century reveals that many practices frequently branded as monopolistic, such as resale price maintenance, exclusive dealing, and exclusive territories, reduce transaction costs associated with free riding on information. Non-compete clauses can obviously serve this function by preventing an employee who obtains proprietary information at company X from supplying that information to company Y. Eliminating this protection on property rights to information will result in less investment in this information.

Furthermore, although the monopoly/monopsony explanations that Coase belittled at least involve the application of economics, the Khan FTC has basically thrown economics out the window. (It has definitely thrown Chicago School economics–which provided efficiency rationales for RPM, etc.–out the window.) Instead, her FTC has embraced Brandeisian big-is-bad, unconventional-is-bad antitrust. The Khan Theory of Antitrust Enforcement is akin to Potter Stewart’s theory of pornography: she knows an antitrust violation when she sees it. It is a very subjective approach completely contingent on her non-economics-based subjectivity.

Moreover, the process at the Khan FTC is highly dubious. The Chairwoman is alleged to run roughshod over staff and other commissioners–as epitomized by the resignation of the FTC’s Republican Custer, Christine Wilson. This furthers suspicions that this proposed rule is purely the product of Khan’s uneconomic, idiosyncratic mind and prejudices, rather than on sober analysis.

So my priors are that anything that comes out of the Khan FTC is likely bilge.

But priors can be modified by evidence! So let’s look at the economics of a ban.

So as not to keep you in suspense: this analysis provides no reason for me to change my priors. To the contrary.

Evidently the rationale for this ban is that non-competes are a means of exercising monopsony power. Where to begin?

First, given the plethora of participants on both sides of labor markets–including markets for fairly specialized labor–there is considerable room to be skeptical that monopsony power is severe. This is particularly true for information workers for whom non-competes are most likely used.

This is especially the case today, when the reduced cost of remote work sharply mitigates one of the factors that could conceivably create a quasi rent that an employer could extract, the cost of moving.

Not that this would be a major issue for a lot of information workers anyways. Due to well-understood agglomeration effects (that have been operating since, say, the heyday of New England cotton milling in the antebellum US!) firms of a particular type, and hence employees of this type of firm, tend to be geographically concentrated. So an employee with valuable information can find work at another firm that can use that information without having to move, or move far.

Indeed, this can explain why non-competes exist in the first place. Employers in industries with a high degree of spatial agglomeration cannot rely on the costs of relocation to prevent competitors from poaching employees. Thus, I would predict that non-competes are more likely in industries where agglomeration effects operate, whereas the monopsony power theory would predict the opposite.

To make it more specific: I predict non-competes would be more prevalent in places like Silicon Valley, whereas the monopsony theory would predict that they would be less prevalent there (because employers would have less market power when relocation costs and hence quasi rents are low).

Second, although non-competes can potentially create quasi rents ex post, ex ante potential employees can negotiate contract terms (or at least reject terms offered by a potential employer). Employers can attract employees only if the other terms of the contract (including pay, but also other terms) compensate for the restriction on the employees ex post options. As long as the ex ante employment market is largely competitive, contractual terms will compensate (or more than compensate) for the employee’s ex post loss of freedom. If (due, for instance, to information disclosure problem) non-competes are wealth enhancing, the Coase Theorem comes into play. Employers and employees will negotiate other terms that make both better off.

Third, even granting arguendo that non-competes are a way of exercising market power ex ante (a dubious proposition), eliminating non-competes does not eliminate the market power, so it is by no means clear that eliminating non-competes will make employees better off. Rapacious, monopsonistic employers will just find some other way to exploit their market power. And that could make employees worse off. Eliminating an efficient way of exercising market power makes the pie smaller, and it is likely that both employers and employees would both suffer as a result.

This raises the issue of why monopsonists would prefer to use non-competes to exercise (ex ante) market power, rather than just paying lower wages/salaries, or offering fewer benefits. Perhaps you could view it as a form of price discrimination where employers exploit differences among employees by offering a menu of contracts with different pay and non-pay terms (including non-competes, or not) to extract rents. Even if that’s what’s going on, it is well known that the welfare effects of price discrimination–and hence of its restriction–are highly ambiguous.

That is, even if non-competes are a way of exercising market power, eliminating this particular way of doing so does not necessarily mean that market power will decrease: firms may instead utilize less efficient ways of exercising it.

One Chicago School staple is that a monopolist has no incentive to engage in things like exclusive dealing in order to extend market power: it can extract the maximum profit by just charging the monopoly price. Hence, there is likely some non-monopoly leveraging explanation for such contracting practices. Similar logic applies to exercise of monopsony power.

The pushback against Chicago resulted in the creation of a lot of highly stylized, not to say contrived, models in which such monopoly leveraging can occur. Nice models! Never seen one that applies to a real world situation.

I therefore surmise that even if employers have ex ante market power, it is unlikely that non-competes enhance that market power, and that eliminating them will make employees better off–because the elimination does not reduce the ex ante market power.

The empirical evidence that supposedly supports the ban is that elimination of non-competes is associated with higher wages. Even putting aside my skepticism that wages are a sufficient statistic for employee welfare (since so many other terms of employment can be varied), it must be recognized that there are reasons why elimination of non-competes in competitive labor markets could boost wages for some.

Elimination of non-competes essentially gives employees property rights in valuable information. Absent non-competes they can effectively sell this information, whereas they cannot do so (or are limited in their ability to do so) when non-competes are in place. Since the information cannot be sold separately, it is bundled with the other services supplied by the employee. All else equal, employers (including an individuals current employer and potential employers) are willing to pay more for the information-service bundle than the service alone. That means higher compensation.

As Coase and subsequent scholars (including prominently my thesis advisor Lester Telser) noted, contractual restrictions can be ways of creating or protecting property rights in information. It is highly likely that’s the role that non-competes play, especially given their widespread use in tech and other information industries. Therefore, be skeptical indeed about the FTC proposal. Indeed, even if you believe that instead non-competes are in part a means of exercising market power, you should not conclude that their elimination will make employees better off because the market power remains even after one means of exercising it is constrained.

We should all fear the Wrath of Khan generally, given her economic ignorance, and indeed her hostility to economic reasoning. We should especially fear it in her latest attempt to reshape private contracting in what is arguably the largest market in the United States–the market for labor, and for information intensive labor in particular.

A coda to my previous post. The EU natural gas price regulation avoids many of the faults of price controls, largely as a result of its narrow focus on a single market: TTF natural gas futures. That said, the fact that it potentially applies to one market means that there are still potentially negative consequences.

These negative consequences are not so much to the allocation of natural gas per se, but to the allocation of natural gas price risk. Futures markets are first and foremost markets for risk, and the price regulation has the potential to interfere with their operation.

In particular, the prospect of being locked into a futures position when the price cap binds will make market participants less likely to establish positions in the first place: traders dread being stuck in a Roach Motel, or Hotel California (you can check out but you can never leave). Thus, less risk will be hedged/transferred, and the market will become less liquid. Relatedly, price caps can lead to perverse dynamics when the price approaches the cap as market participants look to exit positions to avoid being locked in. This can lead to enhanced volatility which can perversely cause the triggering of the cap.

Caps also interfere with clearing. There is a potential for large price movements when the cap no longer binds. Thus, in the EU gas situation, ICE Clear Europe has said that it will have to charge substantially higher initial margins (an estimated $33-47 billion more), and indeed, may choose to exit the EU.

These negative effects are greater, the closer prices are to the cap. Europe’s good luck with weather this winter has provided a relatively large gap between the market price and the cap, so the negative impacts are relatively unlikely to be realized. But that’s a matter of luck rather than a matter of economic principle.

Risk transfer is a vital economic function that generates substantial economic value. The cost of interfering with this mechanism is material, and should not be ignored when evaluating the EU policy. That policy avoids many of the standard problems with price caps, but its narrow focus to the futures market means that it has the potential to create economic costs not typically considered in evaluations of price controls. Meaning that not even Saul Goodman would come to its defense.

At the very end of last year the European Union finally agreed on a rule capping natural gas prices. And what a strange duck it is–unlike any price cap I’ve seen before, which is probably for the best for reasons I discuss below.

Rather than a simple ceiling on the price of natural gas–which is what many EU nations were clamoring for–the rule limits trading in front month, three month, and one year TTF futures if (a) the front-month TTF derivative settlement price exceeds EUR 275 for two week(s) and (b) the TTF European Gas Spot Index as published by the European Energy Exchange (EEX) is EUR 58 higher than the reference price during the last 10 trading days before the end of the period referred to in (a).  The “reference price” is: “the daily average price of the price of the LNG assessments “Daily Spot Mediterranean Marker (MED)”, the “Daily Spot Northwest Europe Marker (NWE)”, published by S&P Global Inc., New York and of the price of the daily price assessment carried out by ACER pursuant to Article 18 to 22 of Council Regulation .”

So in other words: (a) the TTF price has to be really high for two weeks straight, and (b) the TTF price has to be really high relative to the European LNG price over that period.

In the event the cap is triggered, “Orders for front-month TTF derivatives with prices above EUR 275 may not be accepted as from the day after the publication of a market correction notice.” So basically this is a limit up mechanism applied to front month futures alone that basically caps the front month price alone. Moreover, it will not go into effect until mid-February, meaning that the last two weeks of February would have to be really cold in order to trigger it. (The chart below shows how far below prices currently are below the flat price cap trigger.)

These conditions are so unlikely to be met that one might get the idea that the cap is intended never to be triggered, and if it is, its impact is meant to be limited to front month futures. And you’d probably be right. Some nations definitely wanted a traditional cap on the price of gas inside the EU, but the Germans and Dutch especially realized this would be a potential disaster as it would cause of of the usual baleful effects of price controls, notably shortages.

The rule as passed does not constrain the physical/cash market for natural gas anywhere in the EU. This is the market that allocates actual molecules of gas, and it will continue to operate even if the front month futures market is frozen. The freezing of futures may well interfere with price discovery in the physical/cash market, but regardless, prices there can rise to whatever level necessary to match supply and demand. As a result, the cap will not achieve the objectives of those pressing for a traditional price ceiling, and won’t result in the consequences feared by the Germans and Dutch.

So the cap is unlikely ever to be triggered, and if it does, won’t interfere with the operation of the physical market or have much of an impact on the prices that clear that market. So what’s the point?

One point is political: the Euros can say they have imposed a cap, thereby appeasing the suckers who don’t understand how meaningless it is.

Another point is distributive–which is also political. The document setting out and justifying the rule spends a tremendous amount of effort discussing a very interesting fact: namely, that when prices spiked last year, basis levels got way out of line with historical precedents. Notably, TTF traded at a big premium relative to LNG prices, and to prices at other hubs in the EU. Sensibly, the document attributes these extreme basis levels to infrastructure constraints within the EU, namely constraints on gasification capacity, and pipeline constraints for moving gas within the EU. (Although I note that squeezing the TTF could have exacerbated these basis moves.)

Again, the rule won’t have any impact on the basis levels in the physical market. So again–what’s the point? Well almost in passing the document notes that many natural gas contracts throughout the EU are priced at the TTF front month futures price plus/minus a differential. What the rule does is prevent prices on these contracts from being driven by the TTF front month price when those infrastructure constraints cause TTF to trade at a big premium to LNG or to prices at other hubs. So for example, a buyer in Italy won’t pay the market clearing TTF price when that would have traded at a big premium and high flat price level: instead, the buyer in Italy will pay the capped TTF front month price.

In other words, the mechanism mitigates the impact of a very common pricing mechanism adopted in normal times against the impacts of very abnormal times. A buyer outside of NW Europe takes on basis risk by purchasing at TTF plus a differential, but usually that basis risk is sufficiently small as to be outweighed by the benefits of trading in a more liquid market (with TTF being the most liquid gas market in Europe, just as Henry Hub is in the US). However, the stresses of the past year plus have greatly increased that basis risk. The price cap limits the basis risk on legacy contracts tied to TTF, without unduly interfering with the physical market. The marginal molecules will still be priced in the (unconstrained) physical market.

So there you have it. Beneath all the political posturing and smoke and mirrors, all the rule does is limit the potential “windfall” gains of those who sold gas forward basis front month TTF, and limit the “windfall” losses of those who bought basis front month TTF. If demand spikes and the infrastructure constraints bind (or if someone exploits these constraints to squeeze TTF futures) causing the basis to blow out, the rule will constraint the impact on those who benchmarked contracts to the front month TTF.

In some respects this isn’t surprising. All regulation, in the end, is distributive.

Putting it all together, this is probably the least bad price control I’ve seen. It is unlikely to go into effect, and even if it does its impact is purely distributive rather than allocative.

The meltdown of FTX continues to spark controversy and commentary. A recent theme in this commentary is that the FTX disaster represents a failure of centralization that decentralized finance–DeFI–could correct. Examples include contributions by the very smart and knowledgeable Campbell Harvey of Duke, and an OpEd in today’s WSJ.

I agree that the failure of FTX demonstrates that the crypto business as it is, as opposed to how it is often portrayed, is highly centralized. But the FTX implosion does not demonstrate that centralization of crypto trading per se is fundamentally flawed: FTX is an example of centralization done the worst way, without any of the institutional and regulatory safeguards employed by exchanges like CME, Eurex, and ICE.

Indeed, for reasons I have laid out going back to 2018 at the latest, the crypto market was centralized for fundamental economic reasons, and it makes sense that centralization done right will prevail in crypto going forward.

The competitor for centralization advocated by Harvey and the WSJ OpEd and many others is “DeFi”–decentralized finance. This utilizes the nature of blockchain technology and smart contracts to facilitate crypto trading without centralized intermediaries like exchanges.

One of the exemplars of the DeFi argument is “automated market making” (“AMM”) of crypto. This article provides details, but the basic contours are easily described. Market participants contribute crypto to pools consisting of pairs of assets. For example, a pool may consist of Ether (ETH) and the stablecoin Tether (USDT). The relative price of the assets in the pool is determined by a formula, e.g., XETH*XUSDT=K, where K is a constant, XETH is the amount of ETH in the pool and XUSDT is the amount of Tether. If I contribute 1 unit of ETH to the pool, I am given K units of USDT, so the relative price of ETH (in terms of Tether) is K: the price of Tether (in terms of Ether) is 1/K.

Fine. But does this mechanism provide price discovery? Not directly, and not in the same way a centralized exchange like CME does for something like corn futures. DeFi/AMM essentially relies on an arbitrage mechanism to keep prices aligned across exchanges (like, FTX once up an time and Binance now) and other DeFi AMMs. If the price of Ether on one platform is K but the price on another is say .95K, I buy ETH on the latter platform and sell Ether on the former platform. (Just like Sam and Caroline supposedly did on Almeda!) This tends to drive prices across platforms towards equality.

But where does the price discovery take place? To what price do all the platforms converge? This mechanism equalizes prices across platforms, but in traditional financial markets (TradFi, for the consagneti!) price discovery tends to be a natural monopoly, or at least has strong natural monopoly tendencies. For example, it the days prior to RegNMS, virtually all price discovery in NYSE stocks occurred on the NYSE, even though it accounted only for about 75-80 percent of volume. Satellite markets used NYSE prices to set their own prices. (In the RegNMS market, the interconnected exchanges are the locus of price discovery.)

Why is this?: the centripetal forces of trading with private information. Something that Admati-Pfleiderer analyzed 30+ years ago, and I have shown in my research. Basically, informed traders profit most by trading where most uninformed traders trade, and the uninformed mitigate their losses to the informed by trading in the same place. These factors reinforce one another, leading to a consolidation of informed trading in a single market, and the consolidation of uninformed trading on the same market except to the extent that the uninformed can segment themselves by trading on platforms with mechanisms that make it costly for the informed to exploit their information, such as trade-at-settlement, dark pools, and block trading. (What constitutes “informed” in crypto is a whole other subject for another time.)

It is likely that the same mechanism is at work in crypto. Although trading consolidation is not as pronounced there as it is in other asset classes, crypto has become very concentrated, with Binance capturing around 75-80 percent of trading even before the FTX bankruptcy.

So theory and some evidence suggests that price discovery takes place on exchanges, and that DeFi platforms are satellite markets that rely on arbitrage directly or indirectly with exchanges to determine price. (This raises the question of whether the AMM mechanism is sufficiently costly for informed traders to insure that their users are effectively noise traders.)

The implication of this is that DeFi is not a close substitute for centralized trading of crypto. (I note that DeFi trading of stocks and currencies is essentially parasitical on price discovery performed elsewhere.) So just because SBF centralized crypto trading in the worst way doesn’t mean that decentralization is the answer–or will prevail in equilibrium as anything more than an ancillary trading mechanism suited for a specific clientele, and not be the primary locus of price discovery.

The future of crypto will therefore almost certainly involve a high degree of centralization–performed by adults, operating in a rigorous legal environment, unlike SBF/FTX. That’s where price discovery will occur. In my opinion, DeFi will play an ancillary role, just as off-exchange venues do today in equities, and did prior to RegNMS.

One last remark. One thing that many in the financial markets deplore is the fragmentation of trading in equities. It is allegedly highly inefficient. Dark pools, etc., have been heavily criticized.

Fragmentation and decentralization is also a criticism leveled against OTC derivatives markets–here it has been fingered as a source of systemic risk, and this criticism resulted in things like OTC clearing mandates and swap execution facility mandates.

It’s fair to say, therefore, that in financial market conventional wisdom, decentralization=bad.

But now, a failure of a particular centralized entity is leading people to tout the virtues of decentralization. Talk about strange new respect!

All of these criticisms are largely misguided. As I’ve written extensively in the past, fragmentation in TradFi is a way of accommodating the diverse needs of diverse market participants. And just because some hopped up pervs found that running a centralized “exchange” was actually a great way to steal money from those blinded by their BS doesn’t mean that centralization is inherently unfitted for crypto because decentralized mechanisms also exist.

If crypto trading is to survive, well-operated centralized platforms will play an outsized role, supplemented by decentralized ones. Crypto is not so unique that the economic forces that have shaped market structure in stocks and derivatives will not operate there.

So don’t overgeneralize from a likely (and hopefully!) extreme case driven by the madness of woke crowds.

The latest Biden energy brain wave is a possible requirement that fuel suppliers hold a minimum level of diesel inventory:

US President Joe Biden is considering forcing the nation’s fuel suppliers to keep a minimum level of inventory in tanks this winter as a means of preventing heating oil shortages and keeping prices affordable. It may actually do the opposite. 

Well actually actually, there’s no “may” about it. It will, if the administration indeed forces away.

As I’ve written previously, there are times when economic conditions make it optimal to hold low (and perhaps no) inventories. When the supply/demand balance is expected to improve in the future, holding inventories moves a commodity from when it is relatively scarce, to when it is relatively abundant. It is better to do the opposite. But since you cannot transport future production to meet present consumption, the best thing to do is to draw down inventories–perhaps to zero.

There is no reason to believe that the market has “failed” to respond efficiently to fundamental conditions. There is absolutely no reason to believe that Joe Biden or anyone who works for him has solved the Knowledge Problem and knows how to allocate scarce diesel over time better than the markets do. Do you really think Joe et al know that the supply/demand balance in diesel is actually going to get worse, when the market judgment is the opposite? If you do, seek help.

So yes, if carried out, this action would increase spot prices because the only way to increase inventories is to reduce current consumption, and the only way to increase current consumption is through higher spot prices. Further, this action would tend to depress deferred prices because it will increase future consumption.

So if he does this, it would be totally correct to put one of those “I did that” stickers on a diesel pump.

It’s ironic to note that mandatory government stockholding programs, sometimes seen in agricultural markets, are intended to increase prices (to help farmers, for instance). It’s also ironic that Biden is floating this after months of drawing down on government inventories of crude in the SPR–in order to reduce prices.

What Biden is proposing could be seen as a government run corner: the antitrust case of U.S. v. Patten (1913) identifies one of the salient features of a corner as “withholding [a commodity] from sale for a limited time” with the purpose of “artificially enhancing the price.” Biden is proposing “withholding” diesel from the market.

Or, using more archaic language, it is government run “engrossing” or “forestalling,” something that speculators are often (wrongly) accused of, as Adam Smith wrote about in The Wealth of Nations.

The only good news to report here is apparently market participants think this idea is so stupid that not even this administration will implement it. Diesel flat prices and calendar spreads haven’t moved much after Biden’s announcement.

But it would be much better if the administration actually had some good ideas rather than a stream of bad ones, some of which are so obviously bad that they will never come to fruition.

As day follows night, the vaporization of FTX has spurred calls for regulation of crypto markets. Well, what kind of regulation, exactly? It matters.

It appears highly likely that SBF and his Merry Gang (of pervy druggies?) broke oodles of laws, in multiple jurisdictions. Class action lawsuits are definitely incoming, and the DOJ’s SDNY attorneys’ office is commencing a criminal investigation. No doubt criminal investigations will follow in other locations. So what would more laws accomplish, and what kind of laws and regulations would help?

It is interesting to note that SBF was going around DC and the media talking up regulating the industry, and winning effusive plaudits (but not from CZ!) for doing so, but his proposals didn’t come within a million miles of his alleged wrongdoing. I’m sure you’re shocked.

On CNBC, Bankman-Fried endorsed three regulatory endeavors: stablecoin auditing, “markets regulation” of spot trading, and token registration (at about the 4:30 mark):

None of which touches on the fundamental issue in the FTX fiasco, and in crypto market structure generally: the role of “exchanges” in supplying broker dealer and banking services, including liquidity, maturity, and credit transformations.

No doubt SBF was adding to his savior glow by pushing regulation that he knew was utterly irrelevant to the core of his business (and the business of all other crypto “exchanges”). And look at how many suckers fell for it.

So what would help? As I noted at the outset, FTX, Bankman-Fried, et al likely violated numerous laws. So what additional laws would reduce the likelihood and severity of such actions?

In thinking about this, remembering the distinction between ex ante and ex post regulation is important. Ex post regulation involves the imposition of sanctions on malfeasors after they have been found to have committed offense: the idea is to deter bad conduct through punishment after the fact. In contrast, ex ante regulation attempts to prevent bad acts by imposing various constraints on potential wrongdoers.

The choice between ex ante and ex post depends on a variety of factors. Two of the most important (and related) are whether the bad actor is judgment proof (i.e., will have the resources to recompense those he has harmed) and the probability of detection. (These are related because a low probability of detection requires a higher penalty to achieve deterrence, but a higher penalty increases the chances that the wrongdoer is judgment proof).

In the case of things like what has apparently happened here, the probability of detection is high (1.00 actually), but the magnitude of the harm is so great and the (negative) correlation between the harm and the wrongdoer’s ability to pay is so high (essentially -1.00) that ex post deterrence is problematic.

(Judgment proof-ness is actually a justification for criminal law and the use of incarceration as punishment. Deterrence through fines doesn’t work with broke bad guys, so non-monetary punishment is necessary–but often not sufficient!)

So there is a case for ex ante regulation here, just as there is a case for ex ante regulation of banks and intermediaries like broker dealers and FCMs. Banking examiners, regulatory audits, customer seg rules, and the like.

But these are obviously not panaceas. Bank fraud still occurs with depressing regularity, and the things that facilitate it, like valuation challenges, accounting shenanigans, and so on, occur in spades in crypto. And, even in highly regulated US markets, violation of seg rules and misuse of customer assets occurs: yeah, I’m looking at you John Corzine/MF Global.

The big problems in crypto markets are essentially agency problems, especially since the crucial agents–crypto “exchanges”–are so concentrated and so vertically integrated into both execution and various forms of financial transformations.

Ex ante regulation focused on such issues could be a boon, and could help stabilize crypto markets generally. The spillovers we are seeing from FTX’s vaporization are essentially a reputational contagion: the mini (so far) runs on other “exchanges” reflect FUD about their probity and solvency. (NB: Binance, as the biggest “exchange,” and as opaque as FTX, is a serious run risk. BlockFi and AAX may already be in the crosshairs here: glitch in the systems upgrade. Riiiiigggghhhht.)

The challenge is that the demise of financial intermediaries is well-described by a famous Hemingway quote:

“How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually, then suddenly.”

An intermediary can go along swimmingly, meeting all seg requirements and the like, and a big market move or bad bet or an operational SNAFU can put it on the brink very suddenly–and encourage gambling for resurrection by using customer funds to extend and pretend. So don’t expect such regulation to be a panacea, and prevent the recurrence of FTXs. Regulation or no, this happens with intermediaries that engage in liquidity, maturity, and credit transformations that are inherently fragile. (And may be fragile by design, as Doug Diamond has pointed out.)

On the regulation issue, one fascinating sidebar is my old bête noire, Gary Gensler. You don’t need to play 6 Degrees From SBF to ensnare most of the Democratic establishment: one or two degrees will do, and Gensler definitely qualifies.

In addition to the MIT connection, Gensler apparently had other interactions with Bankman-Fried. And of course Gensler is a player in the Democratic Party (he was Hillary’s campaign’s finance chair, after all), and Bankman-Fried was a major Dem donor (second largest after Soros in the most recent cycle, and he had talked about spending up to a billion in the 2024 campaign).

Questions have been raised.

When initially questioned about FTX, Gensler was very defensive:  “Building the evidence, building the facts often takes time.”

I am reserving judgment, but I hope someone takes the time to examine the links and interactions between SBF/FTX and Gensler (and other DC creatures)–and build the evidence and facts, if it comes to that.

My guess is that Gensler will try to pull a judo move and use this fiasco as a justification for expanding the power of the SEC. Indeed, I expect him to be in high dudgeon precisely to deflect attention from his (and his party’s) links to SBF. Don’t let him get away with it.

And don’t think that these links can be exposed through a FOIA. Gensler has long been known for using his private email to conduct official business. (Which is precisely why I didn’t bother FOAI-ing him years ago regarding my suspicions of his interactions with David Kocieniewski.) So deeper digging is required, and it should commence, post haste.

There is a huge amount of hysteria going on about the diesel market. Tucker Carlson is prominent in flogging this as an impending disaster:

Thanks to the Biden administration’s religious war, this country is about to run out of diesel fuel.https://t.co/51oLY1LDak pic.twitter.com/mwuBQcLu5u

— Tucker Carlson (@TuckerCarlson) October 28, 2022

Like so much of Tucker these days, this is an exaggerated, bowdlerized, and politicized description of what is happening. There is a kernel of truth (more on this below) but it is obscured and distorted by the exaggerations.

First off, it is complete bollocks to say “in 25 days there will be no diesel.” Current inventories–stocks–are about equal to 25 days of consumption. But production continues, at a rate of about 4.8 million barrels per week. So, yes, if US refineries stopped producing right now, in 25 days the US would be out of diesel. But this isn’t France! US refineries will keep chugging along, operating close to capacity, supplying the diesel market.

Stocks v. flows, Tucker, stocks v. flows.

Yes, by historical standards, stocks are very low, although there have been other periods when inventories have been almost this low. But low stocks are not a sign of a broken market, or of impending doom.

Low stocks do happen and periodically should happen in a well-functioning market. That is, “stock outs” regularly occur in competitive markets, for good economic reasons.

Assume that stock outs never occurred. Well that would mean that something was produced but never consumed. That makes no economic sense.

The role of inventories is to buffer temporary (i.e., short term) supply and demand shocks. I emphasize temporary because as I show in my book on the economics of storage, storage is driven by scarcity today relative to expected scarcity in the future. A long term demand or supply shock affects current and expected future scarcity in the same way, and hence don’t trigger a storage response. In contrast, a temporary/transient shock (e.g., a refinery outage) affects current vs. future scarcity, and triggers a storage response.

For example, a refinery outage raises current scarcity relative to future scarcity. Drawing down on stocks mitigates this problem. For an opposite example, a temporary demand decline raises future scarcity relative to current scarcity. This can be mitigated by storage–reducing consumption some today in order to raise consumption in the future (when the good is relatively scarce).

To give some perspective on what “short term” means, in my book, I show that for the copper market inventory movements are driven by shocks with a half life of about a month.

Put differently, storage of a commodity (diesel, copper) is like saving for a rainy day. When it rains, you draw down on inventories. When it rains a lot for an extended period, you can draw inventories to very low levels.

And that’s basically what has happened in the diesel market.

Carlson is right about one thing: the Russian invasion in Ukraine precipitated the situation. This is best seen by looking at diesel crack spreads–the difference between the value of a barrel of diesel (measured by the Gulf Coast price) and the value of a barrel of oil (measured by WTI):

Although the crack was gradually increasing in 2021 (due to the rebound from COVID lockdowns) the spike up corresponds almost precisely with the Russian invasion. After reaching nosebleed levels in late-April, early-May, the crack declined to a still-historically high level and roughly plateaued over the summer, before beginning to widen again in September. This widening is in large part a seasonal phenomenon–heating oil (another middle distillate) demand picks up at that time.

In terms of storage, the initial market response made sense. The war was expected to be of relatively short duration. So draw down on inventories. However, the war has persisted longer than initial expectations, and the policy responses–notably restrictions on Russian exports, including refined products to Europe–have also taken on a semi-permanent cast. So the shock has endured far longer than expected, but the (rational) response of drawing down on stocks has left us in the current situation.

To extend the rainy day example, if you don’t expect it to rain 40 days and 40 nights (or for 9 months) you will draw down on inventories and you’ll go close to zero if the rain lasts longer than expected. That’s what we’ve seen in diesel.

As in any textbook stockout situation, price will adjust to match consumption with productive capacity. Inventories will not buffer subsequent supply and demand shocks, meaning that prices will be pretty volatile: storage dampens volatility.

I should note that low inventory levels can create opportunities for the exercise of market power–manipulations/corners/squeezes. So it is possible that some of the price and spread moves in benchmark prices may reflect more than these tight fundamentals.

Hopefully the hysteria will not trigger idiotic policy responses. The supply shock has been most acute in Europe (because it consumed a lot of Russian middle distillate). This has resulted in a substantial uptick in US exports (diesel and gasoline) to Europe, which has led to suggestions that the US restrict exports, or ban them altogether. This would be beggar–or bugger–thy neighbor, and would actually feed the recent narrative advanced by Manny Macron and others in Europe that the US is exploiting Europe’s energy distress.

Further, this would reduce the returns to refinery capital, reducing the incentive to invest in this sector–which would be a great way of perpetuating the current scarcity.

But this administration, and in particular its (empty) head, somehow think returns to capital are a bad thing:

This is throwing pearls before a swine, but here goes. Investment raises wealth and wages, and lowers prices. People invest only if they expect to earn a return. https://t.co/LjC2zdrlg4

— streetwiseprof (@streetwiseprof) October 28, 2022

Believe it or not, there are even worse proposals than export bans, windfall profits taxes, and restrictions on returning cash to investors bouncing around. In particular, supposedly serious people (who travel in the best of circles) like Columbia’s Jason Bordoff are suggesting nationalization of the US energy industry.

Yeah. That’ll fix things.

What we are seeing in diesel (and in other energy markets as well) is their efficient operation in the face of extreme supply and demand shocks. You may not like the message that prices and stocks are sending–that fundamental conditions are really tight–but suppressing those signals, or other types of intervention like export bans–will make the situation worse, not better.

And yes, energy market (and commodity market generally) conditions should definitely be considered when evaluating how to handle Russia and the war in Ukraine. But that evaluation is not advanced by hysterical statements about the nation grinding to a halt at Thanksgiving because we’ll be out of diesel.

I have long called myself “the Clearing Cassandra” for my repeated and unheeded warnings about the dangers of letting the Trojan Horse of clearing (and the margining of uncleared trades) into the financial citadel. Specifically, clearing/margining can create financial shocks (and indeed financial crises) rather than preventing them (which is the supposed justification for mandating them).

We have seen several examples of this in the past several years, including the COVID (lockdown) shock of March 2020 (a subject of a JACF article of mine) and the recent energy market tremors. The most recent example, and in many ways the most telling one, is the recent instability in the UK that led the Bank of England to intervene to prevent a full-on crisis. The tumult fed a spike in UK government yields and contributed to a plunge in the Pound.

The instability was centered on UK pension funds engaged in a strategy called Liability Directed Investment (LDI)–which should now be renamed Liquidity Danger Investment. In a nutshell, in LDI defined benefit pension funds hedge the interest rate risk in their liabilities through interest rate swaps that are cleared or otherwise margined daily on a mark-to-market basis, rather than investing in fixed income securities that generate cash flows that match the liabilities. The funds hold non-fixed income assets (sometimes referred to as “growth assets”) in lieu of fixed income. (I discuss the whys of that portfolio strategy below.)

On a MTM basis, the funds are hedged: a rise in interest rates causes a decline in the present value of the liabilities, which matches a decline in the value of the swaps. Even if there is a duration match, however, there is not a liquidity match. A rise in interest rates generates no cash inflow on the liabilities (even though they have declined in value), but the clearing/margining of the swaps leads to a variation margin outflow: the funds have to stump up cash to meet VM obligations.

And this has happened in a big way due to interest rate increases driven by central bank tightening and the deteriorating fiscal situation in the UK (which has been exacerbated substantially by the energy situation, and the British government’s commitment to absorb a large fraction of energy costs). This led to big margin calls . . . which the funds did not have cash to cover. So, cue a fire sale: the funds dumped their most liquid assets–UK government gilts–which overwhelmed the risk bearing capacity/liquidity of that market, leading to a further spurt in interest rates . . . which led to more VM obligations. Etc., etc., etc.

In other words, a classic liquidity spiral.

The BofE intervened by buying gilts in massive amounts. This helped stem the spiral, though the problem was so acute that the BofE had to extend its purchases beyond the period it initially announced.

So yet again, central bank intervention was necessary to provide liquidity to put out fires created by margining.

FFS. When will people who should know better figure this out? How many times is it necessary to hit the mule upside the head with a 2×4?

I just returned from France, and while walking by the Banque de France I thought of a conference held there in the fall of 2013 at which I spoke: the conference was co-sponsored by the BdF, BofE, and ECB. It was intended to be a celebration of the passage and implementation of various post-Crisis regulations, clearing mandates most prominent among them.

I did my buzz kill Clearing Cassandra routine, in which I warned very specifically of the liquidity spiral dangers inherent in clearing as a source of financial instability. I got pretty much the same response as the Trojan Cassandra–a blow off, in other words. Indeed, I quite evidently got under some skins. The next speaker was Benoît Cœuré, a member of the ECB governing council. The first half of his talk was a very intemperate–and futile–attempt at rebuttal. Which I took as a compliment.

Alas, events have repeatedly rebutted Cœuré and Gensler and all the other myriad clearing cheerleaders.

The LDI episode has validated other arguments that I made starting in late-2008. Most notably, clearing was touted as a “no credit” system because the clearinghouse does not extend any credit to counterparties: variation margin/mark-to-market is the mechanism that limits CCP credit exposure. Since one (faulty) narrative of the Crisis was that it was the result of credit extended to derivatives counterparties, clearing was repeatedly touted as a way of reducing systemic risk.

Not so fast! I said. Such a view is profoundly unsystemic because it neglects the fact that market participants can substitute other forms of credit for the credit they no longer get via derivatives trades. And indeed, in the recent LDI episode exemplifies a very specific warning I made over a decade ago: those subject to clearing or margining mandates would borrow on the repo market to fund margin obligations, including both initial margin and variation margin.

And indeed the UK funds did exactly that. This actually increased the connectedness of the financial system (contrary to the triumphant assertions of Gensler and others), and this connectedness via the repo channel was another factor that drove the BofE to intervene.

My beard is not quite this long (though it’s getting there) but this is pretty much spot on:

Again: Clearing converts credit risk into liquidity risk. And all financial crises are liquidity crises.

Maybe someday people will figure this out. Hopefully before I snuff it.

And the idiocy of this is especially great with respect to the UK pension funds because they posed relatively little credit risk in the first place. So there was not a substitution of one risk (liquidity risk) for another (credit risk). There was an addition of a new risk with little if any reduction of any other risk.

The LDI strategies were right way risks. Interest rate movements that cause swaps to lose value also increase the value of the funds (by reducing the PV of their liabilities). The funds were not–and are not-leveraged plays on interest rate risk. So the prospects of defaults on derivatives that could be mitigated by clearing were minimal.

Here I have to part ways with someone I usually agree with, John Cochrane, who characterizes the episode as another example of the dangers of leverage. He cites to a BofE document about the LDI episode that indeed mentions leverage, but the story it tells is not the classic lever-up-and-lose-more-when-the-market-moves-against-you one that John suggests. Instead, in figure in the BofE piece that John includes in one of his posts, the increase in interest rates actually makes the pension fund better off in present value terms–even including its LDI-related positions–because its assets go down less in value than its liabilities do. In that sense, the LDI positions are an interest rate hedge. But there is a mismatch in the liquidity impacts.*. It is this liquidity mismatch that causes the problem.

The BofE piece also suggests that the underlying issue here is pension fund underfunding. In essence, the pension funds needed to jack up returns to close their funding gap. So instead of investing in fixed income assets with cash flows that mirrored those of its pension liabilities, the funds invested in higher returning assets like equities. Just investing in fixed income would have locked in the funding gap: investing in equities increased the odds of becoming fully funded. But just investing in equities alone would have subjected the funds to substantial interest rate risk. So the LDI strategies were intended to immunize them against this risk.

Thus, the original sin was the underfunding. LDI was/is not a way of adding interest rate risk through leverage to raise expected returns to close the gap (gambling on interest rate risk for resurrection). Instead it was a way of managing interest rate risk to permit raising returns to close the gap by changing portfolio composition. (No doubt regulators were cool with this because it reduced the probability that pension fund bailouts would be needed, or at least kicked that can down the road, a la US S&L regulators in the 1980s.)

No, the real story here is not the oft-told tale of highly leveraged intermediaries coming to grief when their speculations turn out wrong. Instead, it is a story of how mechanisms intended to limit leverage directly lead to indirect increases in debt and more importantly to increases in liquidity risks. In that way, margining increases systemic risk, rather than reducing it as advertised.

*The BofE document describes an LDI mechanism that is somewhat different than using swaps to manage interest rate risk. Instead, it describes a mechanism whereby positions in gilts are partially funded by repo borrowing. The borrowing is necessary to create a position large enough to create enough duration to match the duration of a fund’s liabilities. But a swap is economically equivalent to a position in the underlying funded by borrowing, so the difference is more apparent than real. Moreover, the liquidity implications of the interest rate hedging mechanism in the BofE document are quite similar to those of a swap.