Streetwise Professor

Turkish president Recep Tayyip Erdoğan is clearly insane, by the doing/saying-the-same-thing-repeatedly-and-expecting-different-results standard.

Apparently not content with the mere 22 percent drop in the TRY on Thursday and Friday which was attributable completely to his overheated, boneheaded economic rhetoric and his egging on a confrontation with the US, today he gave not one, not two, but three speeches that put his economic idiocy and bullheadedness on display.  And the markets reacted immediately, with the lira breaching 7 to the USD in early Asian trading.

Among the howlers:

Speaking in the northeastern city of Trabzon on Sunday, Erdogan warned business executives to not “rush to banks to withdraw foreign currency.”

He added that businesses should “know that keeping this nation alive and standing isn’t just our job, but also the job of industrialists, of merchants.”

“We are working day and night for alternative markets.”

Just what alternative markets is he talking about? Presumably steel and aluminum, which Trump imposed higher tariffs on on Friday.  But those aren’t the markets that matter now: it’s the currency and capital markets that matter, and every word out of Erdoğan’s mouth freaks out those markets even more.  Not least because talking about metals indicates a complete failure to grasp the true nature of the situation.

Importuning “industrialists and merchants” to take one for the team is futile.  They have already conceded, after taking brutal losses for heeding his earlier call.  The fact that Erdoğan seems oblivious to the fact that his previous nostrums have been disasters only convinces further those at home with money and those in the financial markets that he is utterly clueless–as do his continued imprecations against evil interest rates.

His chucklehead finance minister (whose main attributes appear to be that a) he is Erdoğan’s son-in-law, and b) he is less of a chucklehead than Erdoğan’s son) gave a don’t worry-be happy-everything will work out great talk to a group of assembled business leaders.  A Turkish friend said that Berat (not Borat!) Albayrak’s clownish performance was met by long faces from the assembled bankers and industrialists.

Erdoğan’s other stock response is that Turkey’s economic fundamentals are sound, but the country is being subjected to an economic attack from the US, and that he will fight back.  Arguendo, assume it is true that the US has targeted Turkey.  What is the best response, especially when someone like Trump is doing the targeting? Defiance is foolhardy, though perhaps emotionally gratifying in the short run, both to Erdoğan and his fervent followers.  A prudent leader would execute a tactical withdrawal in the face of overwhelming odds, and live again to fight another day.  You don’t fight battles you can’t win.  And again, Erdoğan’s apparent willingness to do so just stokes the panic.

Erdoğan says that he will find other allies.  Like who, exactly?  Speculation is that Russia, Qatar, and/or China might contribute financial support.

The first name makes me laugh.  Russia has its own issues right now, to put it mildly.  Its access to capital markets is extremely limited, and its currency is also under pressure.  Qatar is still battling an economic embargo with its Arab neighbors.  China’s own financial situation is somewhat tenuous now, and although it has shown a willingness to throw money down ratholes (cf. Venezuela) it is doubtful that it will stump up the tens of billions of dollars necessary to rescue Turkey from the brink, especially in the very limited time–maybe even hours–available.

And all of these candidates will no doubt think twice, and then think again, based on uncertainty of how Trump would react to their riding to the rescue of his current target.

Nope.  Erdo is on his own here.  And that’s the irony of all this.  Erdoğan asked for supreme power in Turkey.  He got it.  Now he owns all of it: the bad as well as the good.  As the old adage says, Erdo: Be careful what you ask for.  You might get it.

Two class action lawsuits have been filed against Tesla and Elon Musk, claiming that he artificially inflated the price of Tesla stock through his going private tweets, thereby unleashing a “nuclear attack” that “completely decimated short sellers.”*

It is a plausible claim.  However, the damages here are likely to be minimal.  Tesla’s stock fell below the pre-tweet price within a day, as reality set in.  Therefore, only those who bought during that brief window of tweet-induced euphoria (and inflation)  would have a claim (and this would include shorts who covered).  Not likely a huge class here.

No, the mother of Tesla class actions awaits a big stock price drop, which would likely follow either a disclosure of past mis-statements and fraud, or an SEC announcement of litigation against the firm.  (Hey, has the statute of limitations run out on the 2013 squeezes?)  I think it’s a matter of time, but who knows?

The whole going private thing looks more bizarre by the day, especially given Elon’s odd ideas about what going private means:

Tesla Inc. Chief Executive Officer Elon Musk and advisers are seeking a wide pool of investors to back a potential take-private of the automaker to avoid concentrating ownership among a few new large holders, according to people familiar with the matter.

Tesla is holding early discussions with banks about the feasibility and structure of a possible deal, the people said, asking not to be identified as the details aren’t public. They are canvassing investors including large asset managers, the people said.

Billionaire founder Musk would prefer to amass a group of investors who could each contribute part of the funds because he wants to avoid having one or two large new stakeholders in the company, the people said. Deliberations are at an early stage and the company hasn’t yet formally hired a bank to work on the process or made a final decision on how to proceed, they said.

In other words, Elon wants his cake and to eat it too.  He wants diffuse ownership and total control, and to deny the diffuse owners the investor protections that a public listing brings with it.

Come to think of it, Elon wants to bring the Russian model to the US–think of Rosneft, Gazprom.

The Tesla board of sheep–I mean, directors–is apparently scrambling furiously to try to recover from Elon’s blunder by “investigating” a going private transaction.  A little late!

I really want to know who Tesla’s O&D insurer is, so I can short it.

*Pedantic pet peeve.  You can’t “completely decimate” anything–that’s an oxymoron. Decimate means execute one out of ten.  It was a punishment exacted against mutinous Roman legions.  I think the word the lawyers are looking for is “annihilate.”

In June, I spent 9 days in Turkey.  For someone as interested in history as I am, it was a phenomenal visit.  From the Hittites to the tomb of Midas in Gordium to Ephesus to Cappadocia, it is a series of historical marvels, and I only scratched the surface.

Since I am fascinated by Mustafa Kemal Ataturk, one of the most interesting historical figures of the 20th century,  one of the highlights of my visit was a trip to his mausoleum and museum in the Atakabir in Ankara.  The visit was particularly timely, given that Ataturk’s legacy and handiwork is currently at risk.

The political environment in Turkey was febrile during my visit.  I left exactly one week before the (snap) presidential election, and the deep political divisions in Turkey between the Islamist followers of Recep Tayyip Erdoğan (concentrated in central Anatolia, where I visited) and the remaining adherents of Kemalism (mainly in the west, centered in Izmir, where I visited as well) were on full display.

I had some thoughts (hopes, maybe) that enough Turks would realize that Erdoğan would use an election victory to Islamize and revolutionize (and not in a good way) the country further, and would deny him an outright victory that would allow him to realize his Ottoman pretensions.  But the tribal loyalties to Erdoğan are too wide, deep, and intense, and he won a victory.  Not a landslide, but not all that close, either.

And true to form, he took a couple of point election win as an invitation to act out his political and economic fantasies.  Turkey has fared well growth-wise for the past decade-plus, but it exhibits many of the fragilities of an emerging market, and especially a fast-growing emerging market.  Navigating this situation requires prudence, and some willingness to let the monetary authorities rein in excess.

But these are two things that Erdoğan quite clearly lacks, and indeed scorns.  In particular, he has a fixation about interest rates, which he believes are evil, and should be zero.  His natural inclinations are egged on by some of his biggest business supporters, who are construction magnates addicted to cheap credit.

Fear of Erdoğan’s monetary profligacy had already caused substantial declines in the lira prior to the election, and his statements shortly before the election on Bloomberg TV about taking control of monetary policy caused a further selloff. Then post-election, he appointed his son-in-law as finance minister.  (I guess it could have been worse: at least he did not appoint his truly idiotic son.) That stoked fears even more.

Then, post election, he has gotten into a confrontation with the US over buying S-400 air defense systems from Russia, and over the arrest of an American pastor accused of treason.  He has refused to give an inch on the preacher, despite warnings from the US, and a shot across the bows in the shape of sanctions imposed on two Turkish government ministers.

This is an utterly stupid and pointless conflict, and likely reflects Erdoğan’s obsession with FETO and the Gülenist movement led by his former confrere, and now archenemy, Fetullah Gülen–an obsession that has been at a fever pitch since last July’s abortive coup.  One needs to pick battles carefully, and this is not one that a rational man would choose to fight.

The escalation of this conflict has been mirrored by further declines in the lira.

Perhaps Erdoğan could have gotten away with this with Obama, or a Bush, or a Clinton in the White House.  But it is beyond insane to wave a red flag in front of Trump, and Trump has responded predictably to what he perceives to be a challenge.

Today Erdoğan gave a speech that was intended to ease fears, but it didn’t.  It fed them, as his answer to the currency crisis was for Turks to sell foreign currency and buy lira.  Great plan! Except the Turks who adore Erdo don’t have dollars and euros, and the Turks who have dollars and euros pretty much hate Erdo.  So the speech triggered an implosion in the lira.

At which point Trump put the boot in, announcing punitive tariffs on metal imports from Turkey (steel being a particularly big industry there), embellished with a Trumpian suck-on-this-one-Recep tweet.  The free-fall intensified. Now a full-fledged crisis looms, and Erdoğan is constitutionally temperamentally incapable of dealing with it, as this would require him to make a humiliating public climb-down on firmly held beliefs and positions–the most notable of these being the greatness and destiny of Recep Tayyip Erdoğan.

So Erdoğan has doubled down, ranting about economic warfare and economic hitmen.  That may play in Anatolia, but it won’t in the currency and capital markets.

Once upon a time the military would have stepped in.  But Erdoğan has neutered it as a political force.  Some of the neutering took place after the coup, but the utter incompetence of the coup suggests that his earlier efforts to destroy the foundations of Kemalism had made considerable progress.  (The coup was so botched that it is not unreasonable to think that Erdoğan let it proceed, knowing it would fail and that he could exploit it.  Indeed, it’s not outside the realm of possibility that he facilitated it.  He has certainly been the beneficiary.)

Erdoğan is sometimes compared to Ataturk.  Ataturk was a transformative figure, and Erdoğan certainly wants to be one, and has indeed already engineered considerable transformation of Turkish state and society (although in this he was aided greatly by demography, which has seen the population of the Anatolian heartland explode and the population of the Rumelian regions stagnate.)

But although Mustafa Kemal had grand visions to Make Turkey Great Again, he was remarkably prudent in his actions.  Most importantly, whereas Erdoğan has pretensions to make Turkey a regional hegemon, and indeed, a new Ottoman Empire, Ataturk concentrated on nation building at home.  He was incredibly wise in avoiding entanglements in the looming European war, and his successor İnönü followed that lead and stayed out of WWII. Erdoğan’s involvement in Syria was a catastrophe from the word go, and his religiously-driven antagonism towards Israel, a natural ally, has been foolish in the extreme.

Under Ataturk and his successors, by focusing on domestic changes, Turkey had the breathing space to construct a functioning state and avoided the disaster that afflicted every other country in Eurasia from 1939 to 1945.   Erdoğan is not so wise.

Where does it end?  I can’t seeing it end well.  Erdoğan will likely be able to rely on his fervent political base to remain in power, and has shown no reluctance to crush opposition by any means necessary.  He has already used, and likely will continue to use, the economic crisis to stoke the us vs. them passion that has been an important part of his political success.  Turks are nationalistic (a legacy of Ataturk, ironically), many past the point of chauvinism.

We see too many examples from around the world (Venezuela, Syria, Iran) of how autocratic leaders can survive economic crisis.  Turkey is not even close to becoming one of those basket cases, and if a Maduro can hang on, so can Erdoğan.  As Adam Smith said, there is much ruin in a country, and Recep Erdoğan is likely to show how much ruin there is in the Turkish nation.

An aside. Trump has been playing Godzilla the currency markets.  Yes, Turkey is the worst (well, not counting hyperinflating Iran and Venezuela), but most other emerging market currencies have been cratering, and the dollar has been advancing.  Of particular interest is the decline in the ruble (and the simultaneous sharp drop in Russian stock prices).  Sanctioning Russia over Skripal, and the threat of more, have caused the RUB to fall by around 8 percent, 5 percent on Thursday alone.

Obviously he’s in Putin’s pocket.

Well, if he is, he’s picking it.  So much for collusion.

Putin has been conspicuously silent through this, and Russia has made sounds about trying to reach some rapprochement with the US.  Of course, Medvedev was trotted out to denounce the US.  But that just illustrates that Putin is playing it smarter than Erdoğan: Medvedev is meaningless, and his only role is to take the heat for Putin.  `

Today on Twitter Elon Musk floated the possibility of taking Tesla private.  Perhaps coincidentally, it was revealed that the Saudis have accumulated a stake in Tesla worth a couple of billion.  Adding two and two, many have leaped to the conclusion that the Saudis will be in essence the private equity firm behind the deal, perhaps as part of some futuristic hedge against the end of oil.

As with all things Elon, look for the con.  Case in point.  He hyped the Tesla takeover of Solar City as the creation of a visionary vertically integrated clean energy company.  I saw it as a way of preventing an embarrassing bankruptcy of Solar City, and of bailing out Musk relatives using Tesla shareholder money.  The wind-down of Solar City’s business pretty much has proven me correct.  And  all talk of the visionary vertical integration strategy has ceased.  Indeed, the lack of discussion of the solar business reminds me of the old expression “don’t speak ill of the dead.”

So what’s the angle here?  I conjecture as follows.  Tesla is still losing money hand over fist.  It is burning less cash–but only because it has slashed expenses and capex–which puts a crimp in its growth plans.  And “burning less” is a relative statement–it is still a world class incendiary.

In the past Elon has fed the cash machine with stock and bond sales.  But he has publicly stated repeatedly that no future capital raises will be necessary.  It is clear, however, that such promises are not credible.  He has also promised that profits are just around the corner.  But that promise is also hardly credible, especially after serial failures to deliver on past promises.

This puts Elon in a bind.  He needs money, but a capital raise would (a) hammer is already tottering reputation, and (b) more seriously, create a huge risk of shareholder lawsuits and an SEC securities fraud case.

Further, it is clear that Elon finds many aspects of running a public company distasteful.  He particularly hates analysts (stock analysts, not psychiatrists, though maybe he hates them too!) who question his judgment, his statements, and sometimes his sanity.

He also hates short sellers.

So how to escape these problems? Easy–go private! Especially if the world’s deepest pockets are behind it.  No need for a public capital raise.  No more pesky outsiders questioning his competence, strategy, or behavior.  No more short selling a-holes.

The trifecta.

Of course, maybe Elon is just attempting to goose the stock price and inflict some pain on the shorts.  But if this is the case, he is digging his securities fraud hole deeper.

As for the Saudi angle.  A big bet on Tesla would be a rather foolhardy way to hedge against the end of oil.  It is a hedge rife with idiosyncratic risks–Tesla’s mercurial CEO being just one of them.  A more diversified strategy–investing in battery technology, and cobalt mines, and the like–would make more sense.

It will be entertaining to watch this spectacle unfold.  The one thing I can be sure of is that the story that Elon tells will not be the true story.  So look for the angle, and watch for the con.  My conjecture is plausible, but it is not the only possible scenario.  But whatever scenario plays out, it is likely to be as crooked as a dog’s leg.

Imagine my great surprise at reading a Bloomberg piece titled: “Blockchain, Once Seen as a Corporate Cure-All, Suffers Slowdown.”

That was sarcasm, by the way.  I’ve long and publicly expressed my skepticism that blockchain will have revolutionary effects, at least in the near to medium term.  In my public speaking on the topic, I’ve explored the implications of three basic observations.  First, that blockchain is basically a way of sharing/communicating information, which can in turn be put to various uses.  Second, there alternative ways of sharing/communicating information, with different costs and benefits.  And third, it is necessary to distinguish between sharing information within an organization and between organizations.

Much of the hype about blockchain relates to the potential benefits of more efficient sharing and validation of information.  But this does not address the issue of whether blockchain does this more efficiently than alternative means of sharing/communicating/validating.  As in all institutional/technology issues, a comparison of alternatives is necessary.  This comparison has been sadly lacking in public discussions of the potential for blockchain, beyond incantations about blockchain eliminating the need for trusted third parties which is (a) often untrue (in part because trusted parties may be required to enter information into a blockchain, and (b) is not necessarily a feature, because trusted third parties may be able to operate more efficiently than consensus based systems employed on a blockchain.

The most developed implementation of blockchain (Bitcoin) involves very large cost to solve a particular problem that (a) is unique to cryptocurrency, and (b) is not necessarily important in other contexts–namely, the double spend problem in crypto.  Maybe blockchain is the best way to solve that particular problem (which itself begs the question of whether cryptocurrency`is an efficient solution to any economic problem), but that doesn’t mean that it will be a more efficient way of solving the myriad types of opportunism, fraud, and deceit that plague other kinds of transactions.  Double spend is not the alpha and omega of transactional challenges.  Indeed, it might be one of the most trivial.

Thinking in Williamsonian transaction cost terms, where the transaction is the unit of analysis, transactions are highly diverse.  Different kinds of transactions are vulnerable to different kinds of information and opportunism problems, meaning that customized blockchain approaches are likely necessary.  One likely cause for the waning enthusiasm mentioned in the Bloomberg article is that people are coming to the recognition that customization is not easy, and it may not be worth the candle, compared to other ways of addressing the same issues.  Relatedly, customization makes it harder to exploit scale economies, and recognition of this is likely to be making initially enthusiastic commercial users less keen on the idea: that is, it may be possible to use blockchain in many settings, but it may not be cost-effective to do so.

The siloed vs. cooperative divide is also likely to be extremely important, and the Bloomberg article mentions that issue a couple of times.  The blockchain initiatives that do seem to have been implemented, at least to some degree, as with Maersk in container shipping or Cargill with turkeys, are intra-firm endeavors that do not require coordination and cooperation across firms, and can exploit the governance structure that a firm has in place.  Many of the other proposed uses–for instance, in trade finance, or in commodity trading, both of which require myriad parties in a single transaction to communicate information among one another–are inherently multilateral.

This creates all sorts of challenges.  How can commercial rivals cooperate?  How are the gains from cooperation divided?–this is a problem even when participants supply complementary services, such as a trading firm, banks providing trade finance, and the buyer and seller of a commodity.  As oil unitization has shown, battles over dividing the gains from cooperation can dissipate much of those gains.  Who gets to see what information?  Who makes the rules?  How?  How are they enforced? What is the governance structure?  How is free riding prevented?  Who pays?

Ironically, where the gains from cooperation are seemingly biggest–where there are large numbers of potential participants–is exactly where the problems of coordination, negotiation, and agreement are likely to be most daunting.

I’ve drawn the analogy between these cooperative blockchain endeavors and commodity exchanges, which (as I showed in a 1995 JLS paper) were formed primarily as ways to reduce transactions costs via cooperative rule making and enforcement.  The old paper shows that exchanges faced serious obstacles in achieving the gains from cooperation, and often failed to do so.  Don’t expect blockchain to be any different, especially given the greater complexity of the transactional problems that it is being proposed as a fix.

Thus, I am not surprised to read things like this:

“The expectation was we’d quickly find use cases,” Magnus Haglind, Nasdaq’s senior vice president and head of product management for market technology, said in an interview. “But introducing new technologies requires broad collaboration with industry participants, and it all takes time.”

or this:

Most blockchains also can’t yet handle a large volume of transactions — a must-have for major corporations. And they only shine in certain types of use cases, typically where companies collaborate on projects. But because different businesses have to share the same blockchain, it can be a challenge to agree on technology and how to adopt it.

One of my favorite illustrations of the hype outstripping the reality is the endeavor launched with much fanfare in the cotton market, where IBM and The Seam announced an endeavor to use the blockchain to revolutionize the cotton supply chain.   It’s been almost two years, and after the initial press releases, it’s devilish hard to find any mention of the project, let alone any indication that it will go into operation anytime soon.

Read the Bloomberg article and you’ll have a better understanding of R3’s announcement of an IPO–and that they might have missed their opportunity.

In 2017 and a little before, Blockchain was a brand new shiny hammer.  People have been looking everywhere for nails to pound with it, and spending a lot of money in the effort.  But they’re finding that many transactional problems aren’t nails, that there are other hammers that might do the job better, and there are other problems that require many parties to agree on just how the hammer is to be used and by whom.  Given this, it is not surprising that the euphoria is fading fast.  The main question that remains is in what shrunken domain will blockchain actually be employed, and when.  My guess is that the domain will be relatively small, and the time until employment will be pretty long.

The Sechin business model is clearly not to generate profit through canny investment, careful stewardship of capital, and containing cost.  Rather, it could be called The Rent Seeking Variations.

One of Sechin’s favorite variations is to pump up a flagging bottom line by shaking down his erstwhile partners.  The classic in this genre is the takeover of Bashneft at a knockdown price extracted by putting its owner Sistema under extreme legal pressure, which Sechin followed by suing Sistema for alleged misappropriations, which were only vaguely pleaded, and which if anything suggested that Rosneft was delinquent in its due diligence.

Sechin is now replaying this gambit, this time with its partners is Sakhalin I–which include ExxonMobile.  Again, the allegation is lacking in specifics.  Rosneft accuses the partners of “unjust enrichment” in 2015 and 2016.  In a world-class, epic act of projection, Rosneft accuses Exxon Neftgaz and the others of “interest gained by using other people’s money.”

The case was filed on Sechin’s home court–the arbitrage court on Sakhalin.  I seriously doubt that Exxon would have put itself into a situation where it was at the mercy of a Russian kangaroo court, so no doubt the first battle will be jurisdictional.

Sechin succeeded against Bashneft and Sistema in large part because Russia put its main shareholder Vladimir Yevtushenkov in jail at one point, and clearly was in a position to do it again.  ExxonMobil and the others in the partnership are less vulnerable, and Exxon in particular is used to these sorts of bruising battles.  So Igor has his work cut out for him.

For a while–during the Tillerson years–Exxon and Rosneft were chummy.  Sanctions put a kaibosh on the relationship, and this is clearly a signal that they are sooooo over.  Which just leaves Rosneft even more isolated than before, and unlikely to attract technology, expertise, and money from a major foreign power anytime soon absent some exchange of hostages that will curb Sechin’s predatory instincts.

The fallout for Russia more broadly is also clearly negative.  This is just another indication of its opportunistic and predatory approach to foreign investment, which just will raise further barriers to such investment in the future.

Operating on Shakedown Street can be lucrative in the short run, but pretty soon you run out of suckers to shake down.

Perhaps counterintuitively to some, this is an indication of why freaking out over Russia is so overdone.  Its internal dysfunction has hampered, hampers, and will hamper in the future its economic performance, and hence its potential to build capability to challenge the US in a serious way.   Yes, it can be a pain, but the very aspects of its system that make it so objectionable also serve to undermine its ability to pose a serious threat to any major power.

When I wrote about the demise of GEM Trading a few weeks ago, I hypothesized that sharp movements in various spreads had been its undoing.  A story in Reuters says that GEM was not the only firm rocked by these changes.  Big boys–including BP, Vitol, Trafigura, and Gunvor–have also suffered, and the losses have caused traders their jobs at Gunvor and BP:

The world’s biggest oil traders are counting hefty losses after a surprise doubling in the price discount of U.S. light crude to benchmark Brent WTCLc1-LCOc1 in just a month, as surging U.S production upends the market.

Trading desks of oil major BP and merchants Vitol , Gunvor and Trafigura have recorded losses in the tens of millions of dollars each as a result of the “whipsaw” move when the spread reached more than $11.50 a barrel in June, insiders familiar with their performance told Reuters.

The sources did not give precise figures for the losses, but they said they were enough for Gunvor and BP to fire at least one trader each.

The story goes on to say that binding infrastructure constraints are to blame, which is certainly the case.  But implicit in the article is a theme that I have emphasized for literally years (I recall incorporating this into my class lectures in about 2004).  Specifically, bottlenecks imply that marginal transformation costs (e.g., marginal costs of transporting oil between Cushing and the GOM) tend to rise very steeply when capacity constraints are reached.  That is, when you are operating at say 90 percent of capacity, variations in utilization have little impact on marginal transformation costs, but going from 95 to 96 can cause costs to explode, and basically go vertical as capacity is reached.

This has an implication for spreads.  Another part of the Pirrong Commodities Catechism is that spreads equal marginal transformation costs, and are essentially the shadow prices on constraints.  The behavior of marginal transformation costs therefore has implications for spreads: in particular, spreads can be very stable despite variations in the utilization of transformation assets, but as utilization nears capacity, the spreads become much more volatile.  Moreover, and relatedly, small changes in fundamentals can lead to big moves in spreads when constraints start to bind.  The relationship between fundamentals and spreads is non-linear as capacity constraints become binding, and well, here spreads have gone non-linear, to the chagrin of many traders.

Put differently, spread trades aren’t always “widowmakers” (as the article calls them)–sometimes they are quite safe and boring.  But when bottlenecks begin to bind, they can become deadly.

There is one odd statement in the article:

“As the exporter of U.S. crude, traders are naturally long WTI and hedge their bets by shorting Brent. When the spreads widen so wildly, you lose money,” said a top executive with one of the four trading firms.

Well, why would you hedge WTI risk with Brent?  You could hedge your WTI inventory by selling . . . WTI futures.  The choice to “hedge” WTI by selling Brent is effectively a choice to speculate on the spread.  That brings to mind the old Holbrook Working adage that hedging is speculation on the basis.  The difference here is that most, say, country grain elevators about which Working was mainly writing had no choice in hedging instrument (at least not in liquid ones), and perforce had to live with basis risk if they wanted to eliminate flat price risk.  Here, BP and Gunvor and the rest had the choice between two liquid instruments, and if the “top executive’s” statement is correct, deliberately chose the one that exposed them to greater spread (basis) risk.

So this isn’t an example of “sometimes stuff happens when you hedge.”  The firms chose to expose themselves to a particular risk.  They took a punt on the spread, which was effectively a punt that infrastructure constraints would ease.  They lost.

In my 2014 white paper on commodity trading firms (sponsored by Trafigura, ironically) I noted that to the extent that they speculate, commodity trading firms tend to speculate on the spreads, rather than flat prices, because that’s where they have something of an information advantage.  But as this episode shows, that advantage does not immunize them against risk.

This also makes me wonder about the risk models that the firms use, which in turn affect the sizes of positions traders can put on, and where they put them on.  I, er, speculate that these risk models don’t take into account the non-linearity of spread risk.  If that’s true, traders would have been able to put on bigger positions than they would have been had the risk models accurately reflected those risks, and further, that they were incentivized to do these trades because the risk was underpriced.

All in all, an interesting casebook study of commodity trading–what can go wrong, and why.

Correction: Andrew Gowers, head of corporate affairs at Trafigura says in the comments that (a) Trafigura did not suffer a loss, and (b) the company had told this to Reuters prior to the publication of the article.  I have contacted the editor of the story for an explanation.

Ethereum wunderkind Vitalik Buterin delivered a rant against centralized crypto exchanges:

“I definitely personally hope centralized exchanges burn in hell as much as possible,” Buterin said speaking to TechCrunch.

When bitcoin, the original cryptocurrency, was founded in 2008 by the anonymous Satoshi Nakomoto, the point was to create a decentralized financial future that renders middlemen useless. Nearly 10 years later, the centralized exchanges — those folks sitting in the middle of buyers and sellers — are among the most powerful players in the market for digital currencies such as ethereum and bitcoin.

Bloomberg News estimates they brought in $3 million a day last year. And exchanges such as Gemini and Coinbase are expanding at a clip, bringing on talent from Wall Street.

“It’s hard to ignore the irony that an asset created to allow decentralization is currently almost completely traded on centralized exchanges,” Peter Johnson, a vice president at Jump Ventures, said in an interview. Buterin, however, wants the crypto community to focus more on decentralization so that cryptos can more frequently trade peer-to-peer. Buterin’s remarks come as so-called decentralized exchange gain more attention.

Like many of his arrogant ilk, Buterin ignores the lesson of Chesterton’s fence: why does this thing you do not like and do not understand exist?

Yes, blockchain and cryptocurrencies allow peer-to-peer transactions.  They were largely designed to facilitate such transactions.  For some, the motivation is ideological: an anarchic belief in radical decentralization, and a deep distrust of centralized institutions.

But just because blockchain and related technologies reduce the costs of peer-to-peer transactions, doesn’t mean that such transactions are cheaper than centralized trading on exchanges.  Transacting requires finding a counterparty.  It requires negotiating a price (for a standardized thing, like a Bitcoin–negotiations of other terms for more complex things).  Negotiating a price is costly when information about value is diffuse, so in a decentralized setting not only is it necessary to search for counterparties, it is advantageous to search for information about prices to (a) find the best price, and (b) to be able to negotiate with better information about value .

Centralization reduces the cost of finding a counterparty.  It enhances competition, which tends to reduce bargaining costs.  It leads to better and more symmetric information about prices, which also tends to reduce bargaining costs.  Further, centralized markets can support specialized intermediaries–market makers–who specialize in smoothing out idiosyncratic temporal imbalances in buy and sell order flow, which further reduces trading costs.

Because of these features, centralized trading is frequently an emergent outcome of individual decisions, and one that economizes on transactions costs.  This is clearly what is happening in crypto world.  Indeed, the main puzzle at present is why there are so many exchanges.  The centripetal forces of liquidity will likely result in a huge consolidation in this space.

Buterin and others are attempting to find ways of mitigating some of the disadvantages of bilateral trading (bilateral just being another, more conventional, way of saying “peer-to-peer”).  Reducing the ways of finding people who want to take the other side of a transaction, for example.  But I am highly skeptical that these measures will overcome the inherent advantages of centralizing trading of homogeneous things that large numbers of people want to buy and sell pretty much 24/7, to the point that peer-to-peer will supplant centralized trading.  Buterin can rant all he wants, but centralization is here to stay, and if anything, this segment of the market will become more centralized.

Buterin’s error is seemingly the opposite of those who bewail the lack of centralization in some markets, e.g., those who want to make swaps trading more centralized and who rail against bilateral OTC transactions, but it is really the same mistake. Those who see too much centralization in some markets, and those who see too little in others, fail to recognize that trading mechanisms are emergent orders that develop diverse niches to accommodate the fact that transactors and transactions are heterogeneous.  Centralization is efficient for some transactors and transactions: bilateral/OTC for others.  That’s why we see both.

(This is a point I made at a Platts blockchain conference in November, BTW.  The theme of my talk was where decentralization can work, and where it is likely inefficient.  Trading of standardized instruments was one of the main cases I discussed.)

Alas, the ignorance of techno-geniuses is not limited to trading mechanisms.  One of the supposed benefits of blockchain that is that it allows the ownership of anything–a painting, a house, you name it–to be divided into shares, with the fractional interests recorded in an immutable register, and traded peer-to-peer.  That is, block chain facilitates equitization of assets.  A breakthrough!

Uhm, not really. The benefits of equitizing assets and risks has been long, long understood by economists.  In particular, it has long been understood that equitization facilitates more efficient risk sharing.

But long ago, economists also recognized that despite these apparent benefits, in fact very few assets and risks are equitized.  A vast literature has come up with explanations why.  Information and incentive problems–moral hazard and adverse selection–are notable among these.  A prosaic example: If I sell off shares in my car, what incentive do I have to maintain it properly and to economize on wear and tear and to reduce the probability of theft?  Who pays for maintenance? Who decides on what maintenance is needed?  When I sell the shares, I am likely to have better information about the value and condition of the vehicle, which would subject the buyers to an adverse selection problem, meaning that I am likely to get a low price for the shares–so why bother selling them?  There are other transactions cost problems associated with measurement (who verifies exactly what the asset is?) and opportunism and governance and control.   Related to the centralized trading point, if an asset is highly idiosyncratic/unstandardized, the desire to trade fractional shares will be small.

A potentially slightly cheaper way of recording and transferring fractional ownership does not address these far, far, far more fundamental impediments to equitizing (or should I say, “tokenizing”?) assets and risks.  But the coder geniuses miss the forest for the trees.  They see the issue that their technology can address, and think that it will be revolutionary, only because they do not understand the broader economic issues in play, and therefore think everyone born before them or who does not code must be an idiot.

No, not really.  They are looking at the capillaries, and missing the heart, veins, and arteries.

It reminds me of the Mark Twain quote: “When I was a boy of fourteen, my father was so ignorant I could hardly stand to have the old man around. But when I got to be twenty-one, I was astonished at how much he had learned in seven years.”  Except seven years haven’t passed for the Buterins of the world, and frankly, I seriously doubt that they will.  Instead, they inhabit a techno-Groundhog Day.

All of this is symptomatic of blockchain hype and froth.  There is an indication that we have reached peak hype.  R3, a bank-led blockchain consortium, is contemplating an IPO.  To me this is a signal that those on the inside of blockchain development, especially in the area where its benefits have been particularly hyped (finance/payments/settlement/fintech) understand that the reality will never match the hyperbole, so it’s best to sell out while hyperbole reigns supreme.  (Yes, they claim that they are being approached by those looking to buy the whole thing, but take that with a big grain of salt–I view it merely as part of the sales pitch.  “This is a hot little property right now.  Better get in before someone snatches it away.”)

In brief: don’t be the greater fool.

I think that blockchain and DLT will have some viable commercial applications.  But I am highly confident that they will not be nearly as revolutionary as the True Believers claim.  This is in large part due to the fact that it is clear that the True Believers have an extremely narrow, blinkered understanding of the broader economic issues associated with transacting, ownership, risk transfer, incentives, and governance.  Blockchain may address some issues, but many–if not most–of these issues are secondary or tertiary, not fundamental.  Some things are done more efficiently in a centralized fashion–the trading of standardized instruments being one.  Some things are not equitized/tokenized not because it is technically infeasible/prohibitively costly to issue and record fractional interests, but because fractional ownership entails substantial incentive and information problems.

So don’t believe the hype.  And take a pass on those R3 shares, if they do come to market.

Addendum: the dominance of crypto exchanges is even more remarkable, given how they, well, pretty much suck.  They are hardly comparable to modern futures or equities trading exchanges.  Yet people still strongly prefer to trade on rather clunky platforms with major potential security issues where you can’t easily convert digital into fiat currency and which are likely rife with manipulation than peer-to-peer.  That tells you something.

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

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

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

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

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

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

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

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

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

Last week Tesla achieved Elon Musk’s stated milestone of building 5000 Model 3’s in a week.  After an initial burst of enthusiasm which saw the stock price jump upwards, the market was unimpressed: the stock turned down on the day, and is now down $41.3 since 29 June (that’s almost 12 percent).

The company only hit the target (well, in actual fact it missed by a few hours) by making  extreme–and I mean extreme–efforts.  Putting a new assembly line in a tent.  Cannibalizing spare parts.  Cutting production on higher margin Model S vehicles.  Jettisoning quality tests.  Dragooning people into overtime without warning contrary to previous company policy.

Thus, the market’s reaction is not surprising.  Tesla didn’t prove that it could meet a production target under normal conditions: it proved absolutely that it couldn’t.  That is, it proved exactly the opposite of what Musk had intended.

After the “achievement,” Elon Musk tweeted that Tesla had proved that it was finally a real car company.  No, it hadn’t: a normal car company would never been in the situation of behaving like some Soviet enterprise in the 1930s rushing and cutting corners to meet The Plan, lest everyone wind up in The Gulag.

Which is perhaps an especially apt analogy, given Elon’s behavior during this period, and the cult of personality that he has cultivated.

When Musk tweeted about “a real car company” the thought that came to mind was Pinocchio, who wanted to be a real boy.  Given Elon’s propensity to stretch the truth–well, lie, actually–in a way that would shame Pinocchio, that’s an apt analogy too.

There will no doubt be a serious hangover as a result of the rush to meet Musk’s self-imposed target.  Labor relations at Tesla were already poor–they are no doubt awful now.  The company also has had serious build quality and service issues.  I shudder to think of the build quality of the cars thrown together in that last minute frenzy.  Musk’s already crumbling credibility has taken a hit.

For the last, Elon has no one to blame but himself.  His repeated failures to achieve any of the lofty predictions he has made  (failures that would have brought the SEC down on pretty much anyone else) meant that failure to meet the 5000 cars or bust pledge would have been devastating.  So Elon had to pull out all the stops, even though by doing so he in fact revealed the emptiness of his boastful prediction, and could well have produced 5000 busted cars.

For Tesla to become a real car company, Elon will have to become a real boy–or at least a real CEO, rather than a cult leader impersonating a CEO.  Alas, I doubt that will happen, because of one difference between Elon and Pinocchio: Pinocchio realized he wasn’t real, but I don’t think Elon has the same self-awareness.