Streetwise Professor

If Elizabeth Warren were to have her way, you’d see my mug on the wall of your local Post Office. What have I done to become to earn her nomination as Public Enemy? Having the temerity to oppose position limits, and co-authoring a report summarizing the deliberations of the CFTC’s Energy & Environmental Markets Advisory Committee, which strongly criticized the need for, and details of, the Commission’s proposed position limits rule.

The backstory is this. In 2015 I was an associate member of EEMAC. (As of 10 days ago, I am a full member.) The Committee’s sponsor, Commissioner Christopher Giancarlo, asked me to write the (Dodd-Frank mandated) report summarizing the Committee’s deliberations at two meetings in 2015. I agreed, and along with Jim Allison (who just retired from ConocoPhillips), I wrote a relatively short draft that just summarized the transcripts of the two meetings. The report went through some additional edits, and was then submitted to the nine full members of EEMAC for their approval. It was approved by an 8-1 vote.

The conclusions and recommendations of these meetings were rather straightforward to recapitulate, because there was considerable agreement on the major issues of (a) whether position limits were necessary, (b) the proposed rule’s bona fide hedging exemptions, and (c) whether to implement limits for spot months only initially, or to implement for all months.

If you read the transcript, and read the final report, you will see that the report is a faithful record of what happened during the meetings. As I said in yesterday’s meeting, I viewed my role to be that of “faithful scribe,” and that’s what I was.

But since the message in the report was NOT what Elizabeth Warren (and one of the EEMAC members, Public Citizen’s Tyson Slocum) wanted to hear, Warren, Slocum, and Warren’s journalistic creatures (most notably the New York Times) decided to kill the messenger. Warren wrote a letter to the CFTC, demanding that the report be withdrawn. Slocum wrote a dissent to the majority report. Assorted journos scurried along behind. Each called foul on my authorship. Here’s what Warren said about yours truly:

The second panelist I am concerned about is Dr. Pirrong. According to the New York Times, “Mr. Pirrong has positioned himself as the hard-nosed defender of financial speculators – the combative, occasionally acerbic academic authority to call upon when difficult questions arise in Congress and elsewhere about the multitrillion-dollar global commodities trade…. [who] has reaped financial benefits from speculators and some ofthe largest players in the commodities business,” and played a key part in “a sweeping campaign [by the financial industry] to beat back regulation.”10

With specific regard to the position limits rule, Dr. Pirrong served as a consultant for the International Swaps and Derivatives Association – a lead plaintiff suing to block the very rule he was asked to provide his views on for the EEMAC.11 There is no record indicating that these conflicts were even disclosed by Dr. Pirrong when he served as a witness, let alone addressed by the EEMAC.

Platts is preparing for a Brentless future by introducing a new Dated Brent CIF Rotterdam assessment.  The idea is that as North Sea production continues its decline, other streams of light crude that are imported into Rotterdam can be added to the assessment. Adding (or substituting) say Nigerian crude to the FOB Brent assessment would be much more difficult because of locational differences: FOB Nigeria and FOB North Sea can be quite different, even adjusting for quality, due to freight differentials. A CIF contract eliminates that.

The decline in North Sea production has been occurring for some time, so the need to adjust the pricing mechanism has been apparent. Plants has been thrashing around for a while, mooting the possibility of adding other crude (e.g., Urals Med) to the assessment.  It had already widened the delivery window to make more cargoes eligible (remember 15 Day Brent? 21? It’s now 25 Day.) This problem has become more pressing though, as the decline in prices is hastening the decline in North Sea production.

It is ironic that at the same time that Platts (and therefore, ICE) are grappling with the problem of  declining supply, the main rival to Brent has the exact opposite problem. The WTI contract is currently drowning in oil. Storage at Cushing is bumping up against capacity, and there are reports that some storage operators there are refusing requests to store additional crude.

Although the current situation at Cushing (and in the North American market generally) is as much a demand story as a supply story, the facts are that (a) the NYMEX WTI contract is linked to a much more robust and flexible production base than Brent, and (b) the WTI contract’s periodic difficulties are due to infrastructure issues that are more readily, cheaply, and rapidly addressed than production issues. Thus it has been for the past five years or so, as I discussed when I wrote that those foretelling the demise of WTI were fundamentally mistaken:

But these problems are all surmountable.  WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

Brent’s problems are more fundamental, because they arise from declining supply.  Even as paper volumes continue to rise, physical volumes available for delivery are falling inexorably.  The Brent complex had faced this problem before, and confronted it by adding Forties, Oseberg, and Ekofisk to the eligible stream.  But BFOE production has declined from 1.6 mm bbl/d in 2006 to barely more than half that today.  And the decline continues apace.  This makes the contract vulnerable to squeezes of a kind that were chronic in the 1990s and early 2000s, and which spurred Platts to add the three other grades to the benchmark.

. . . .

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.  But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production.  There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount.  Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

The CIF alternative makes sense, and is probably superior to the “economic par” contract I suggested in the 2011 post. But once you move to a Rotterdam pricing basis, why remain tied to an assessment mechanism based on transactions in immense full cargoes? The large size of the lots inherently limits the number of transactions, which makes the assessment mechanism more erratic and subject to manipulation. The lumpiness of the market has also led Platts to design a baroque process involving bids and offers, contracts for differences, futures prices, spreads, etc., to increase the number of trades that go into the assessment.

The WTI contract, in contrast, is based on delivery in store of modest-sized (1000 barrel) units of crude. This is much more flexible, and permits a large number of firms to participate in the delivery process. This makes delivery and the threat of delivery a reliable and efficient way of ensuring convergence of futures to cash market values. The mechanism is not immune to all types of manipulation: delivery squeezes are still possible (though relatively unlikely in current market conditions). But small numbers of transactions can’t have a pronounced impact on pricing, and the in store delivery mechanism does not rely on an arcane and mysterious assessment mechanism (which also helps to enrich the party making the assessment).

So rather than shifting to a Rotterdam CIF mechanism, why not shift the futures market to a Rotterdam in store delivery contract? This mechanism is more flexible and resilient in the short run, and is readily adjusted in the long run to respond to changes in the underlying physical production base as NYMEX did by adding foreign crude streams (including Brent) to address the (then) declining domestic production base.

I can see why Platts wouldn’t like this, but it has some decided advantages for ICE, not the least of which is reducing its dependence on Platts. Given the difficulties of changing contract specifications, or generating liquidity for even a better contract introduced in competition with an established liquid one, I doubt this will happen. Which means that ICE, and the market generally, will have to continue to endure periodic changes the “Brent” assessment mechanism as North Sea production continues to decline.

I put “Brent” in quotes because the handwriting is on the wall: any future European-based contract may be called “Brent” even after Brent (and Forties, and Oseberg, and Ekofisk) no longer represent the bulk of the benchmark stream. The contract will come to resemble the old Harry Anderson comedy bit, where he juggled a chainsaw and an axe. He would stop juggling, hold up the axe and say: “This is George Washington’s axe. The handle was replaced years ago, and I just put on a new head, but it’s George Washington’s axe!” So it will be with Brent, and sooner than anyone would have thought even a few short years ago.

I am not a Trump supporter, for many reasons. But the depth and intensity of support that he has attracted is an important social and political phenomenon, that needs to be understood before the deep concerns and anger that he has tapped can be addressed with good policies.

I made a preliminary attempt here. Others have done a much more thorough job. Most notable of these is Walter Russell Mead, on whose idea of Jacksonian Americans I drew upon in my post. His Andrew Jackson, Revenant, is a must read on the subject. So are Charles Murray’s Trump’s America and Angelo Codevilla’s Does Trump Trump?

Then there is Tom Nichols. The Naval War College professor’s theory is–I am being serious here–“Facebook envy.” Specifically, social media has made middle and working class Americans newly and keenly aware that there are people with more stuff than them. This has made them green with envy, and their envy-fueled anger has driven them to support Trump.

I think that is a very fair summary. Read for yourself:

In other words, Trump (and Sanders) have convinced people that the same socioeconomic arrangements that once benefitted them are actually screwing them, mostly on the premise that it’s not benefitting them enough.

No one factor explains Trump, but this underlying resentment is at least in part a result of the Information Age, which is spurring one of the biggest experiments in relative deprivation in human history. People who once had little idea how others outside of their social circle lived now constantly compare themselves not just to their neighbors, but to the wealthy, and even to the super-wealthy. They are not just keeping up with the Joneses next door, but via the Internet and cable they’re keeping up with the Reeds down the street, the Browns in the next town, the Smiths in the next state, and the Kardashians all the way across the country.

As one wag on Twitter put it, call it the “HGTV Effect.”

This is only possible because of new technology.

Igor Sechin comes in a close second to Rogozin the Ridiculous in providing Russian comic relief. Perhaps there are others in Russia that excel them, and I am only aware of these two because they have a bigger presence in the West, but both can be relied upon for some levity–unintentional, to be sure.

Sechin no longer has the outrageous mullet to amuse, but his public utterances suffice. Today at International Petroleum Week in London are a case in point. The mood at the event was gloomy, with pretty much everyone predicting that we are in a prolonged era of low prices, and everyone had their favorite culprit. But Sechin’s scapegoat was unique: Robots! Well, “robot traders”, anyways:

He blamed ‘financial players’ and automated ‘robot’ traders for driving down the price, saying the collapse to near $30 had little to do with supply and demand.

I presume he means algo traders and HFT. Just how these “robots” trading at subsecond frequencies have mesmerized producers and consumers to behave so as to lead to relentless buildups of inventory–including a looming topping out of capacity at Cushing–is beyond my mere economist’s skills to fathom.

Maybe Igor can commiserate with US cattle producers, who blame HFT for causing excessive volatility in beef prices.

Igor also seems to misunderstand that the “US” is not analogous to Saudi Arabia as a producer (although the phrasing is ambiguous, but I interpret this to include the US in “they”):

“At the end of 2014 some Middle East producers followed the US in their desire to increase production,” Mr Sechin told London’s International Petroleum Week. “They have deliberately created this situation and they are committed to low prices.”

The US oil sector is not a unitary decision maker in the way the Saudis are. The US industry is extremely fragmented and diffuse, with dozens of producers acting independently. They are price takers, not price makers. Very different from KSA or other producers with NOCs. (Relatedly, this is why calling the US the “new swing producer” analogous to the Saudis is dumb.)

It’s also more than a little hypocritical of him to criticize others for increasing output: Russian production has been increasing steadily over this same period.

Sechin also engaged in a little wishful thinking:

He forecast prices would recover later this year as US shale output slows. “We believe that in the coming years US shale will lose its grip on the market,” he said.

Good luck with that, Igor. US shale output has proved to be far more resilient than anyone had expected. Productivity gains and lower input costs have mitigated the impact of low prices. More importantly, the shale sector has the ability to ramp up output rapidly if prices do rise, either due to a rise in demand, or an attempt by other major producers to cut output. Indeed, this is likely the real reason the Saudis resist cutting output: they know it is futile because the supply of non-OPEC output is much more elastic than it used to be. This makes the demand for the output of the major producers, notably the Saudis (and the Russians!) more elastic than it used to be. This implies that it is not in the individual interest of any major producer to cut output unilaterally.

Which brings us to the most informative and refreshingly different part of Sechin’s remarks: his discussion of the prospects of a coordinated output cut involving OPEC and Russia.

This idea has captivated traders, who chase the idea like Randy Chasing the Dragon, shooting (the price!) up every time the rumor is floated, only to watch it fly away from their grasp. Once upon a time, Igor was notorious for encouraging such notions. Not this time around:

The most powerful figure in Russia’s oil industry on Wednesday signalled his steadfast opposition to combining with Opec to reverse the crude price rout through co-ordinated cuts in production.

. . . .
“Who are we supposed to be talking to about cuts?” Mr Sechin said when asked by the Financial Times if he was considering working with Opec, the producers’ cartel, to try to shore up the oil price. “Will Saudi Arabia or Iran cut production?”

Methinks that the real story is that the Saudis have made it clear that they trust neither the Russians nor (especially) other members of OPEC to adhere to any agree upon cuts, even assuming a deal can be cut, which is highly doubtful. So Sechin is acting as if he is the one rejecting the idea, primarily because he knows that it is DOA.

Not that this will stop all those Randys from chasing the next rumor of a coordinated cut.

Which raises the questions: Is Randy a robot? Are robots programmed to buy whenever a rumor of a Russo-Saudi oil deal is announced?

Maybe Igor will enlighten us in his next public appearance. Maybe he can do it to some musical accompaniment. Might I suggest this?:

Putin held a meeting with the CEOs of seven state-owned enterprises to discuss the sale of minority stakes in their companies (a move sometimes mischaracterized as “privatization”). Putin frankly admitted that the impetus for this discussion is Russia’s dire budgetary situation. Putin caused some confusion by saying the “new owners of privatized assets must have Russian jurisdiction,” leading some to conclude that he was ruling out foreign investment. Peskov clarified the next day, saying that Russia welcomed foreign investors, but “If the question is about a foreign investor, that’s one thing. If it’s about a Russian investor, it must not be another offshore scheme.”

I consider it likely that this initiative will be stillborn, at least insofar as sales of stakes to foreigners are concerned. Putin said that the sales must not take place at “knockdown prices.” Well, in the current environment, the prices (especially for Rosneft and VTB) are likely to be very low indeed.

This is especially so since foreign investors will demand a substantial discount to compensate for expropriation risk. Savvy investors with long memories will recall that Putin justified expropriating Shell’s Sakhalin II project by saying that the terms of the Sakhalin PSA were unfair to Russia, and that Shell had exploited Russia’s economic desperation when it signed the deal at a previous time of low energy prices. Putin (or whoever succeeds him) could easily resurrect such rhetoric in the future when oil prices rebound. Further, minority shareholders in Russian enterprises–especially state enterprises–have few protections against schemes that divert assets, or which dilute their holdings.

Given that prices are likely to be very low, if there are sales to foreigners, it will indicate (1) that Russia is desperate indeed, and (2) Putin et al consider it unlikely that sanctions will be relaxed anytime soon.

If there are sales, it is likely to be to Russian oligarchs, and in particular those with extensive holdings outside Russia. Just as Putin dragooned them into paying for Sochi and other prestige projects, he could well pressure them into overpaying for stakes in the state enterprises. This would allow him to kill two birds with one stone. It would help stanch the budgetary bleeding. It would also advance Putin’s longstanding goal of onshoring Russian capital. That would fit with the “owners must have Russian jurisdiction” remark.  And Putin has substantial leverage to get oligarchs to do his bidding–literally.

Even if partial sales take place, it will be merely a stopgap budgetary measure: it will not indicate a fundamental reconsideration of Russian economic policy.  Putin is still obviously a firm believer in the state control/state champion model, despite its manifest inefficiency. Putin prefers the control over resources that state control provides to having an efficient economy. Which is why he finds himself in his current straits.

The frantic sewing of parachutes in a plane that is 30,000 feet in the air continues apace. Last week the Office of Financial Research (a Son of Frankendodd) released its 2015 Annual Report. This tome received attention mainly because it raised alarm about potential systemic risks arising from central clearing mandates. An improvement, I guess, but like most official evaluations of the systemic risks of CCPs, it misses the real problems.

It gets off on the wrong foot by misstating the real benefits of CCPs. According to OFR, the top two benefits of clearing are related to the ability of CCPs, and via them regulators, to get more complete, accurate, and timely information on derivatives positions and trading prices. But these can be achieved by transaction reporting alone, without going the full monty to clearing, which also entails collateralization (including both initial and variation margining) and mutualization of default risk. (Trade reporting has turned into a nightmare, which I will write about further soon. But the point is that you don’t need clearing to get the benefits OFR touts.)

But the main problem, yet again, is that OFR focuses on the “single point of failure”/interconnectedness/default loss contagion channel for CCP systemic risk. This is not immaterial, but it is not the main thing. The main thing is that CCPs create potentially massive contingent demands for liquidity, where the liquidity contingency is likely to occur precisely at the worst time–when the system is undergoing a financial crisis.

Further, OFR gets it wrong when it states that CCPs “reduce the risk of counterparty default.” CCPs redistribute the risk of the insolvency or illiquidity of a large financial institution away from its derivatives counterparties towards its other creditors. It protects one group of creditors at the expense of others.

It is very much open to question whether this reallocation is systemically stabilizing, or is instead a means whereby one relatively concentrated group of market participants can advantage themselves at the expense of others.

Reading Izabella Kaminska’s excellent FT Alphaville post on Real Time Gross Settlement (RTGS) mechanisms makes plain that this phenomenon of substituting liquidity risk for credit risk, and redistributing credit risk away from core banks, is not limited to derivatives clearing. RTGS replaced deferred net settlement (DNS) because of banks’ and central banks’ concern that in the latter, interbank credit balances could accumulate, resulting in a default loss to settlement banks in the event that an net payer bank failed before the next netting cycle. RTGS eliminates interbank credit exposure.

But, of course, this doesn’t make credit exposure go away. It redistributes it to settlement banks’ other creditors. To a first approximation, the total losses from the inability of a bank to meet its obligations are the same under RTGS and DNS. The difference is who gets a chair when the music stops. Settlement banks–and crucially, the central banks–like RTGS because they almost always are going to get a chair.

Furthermore, as even its proponents acknowledge, RTGS is much more liquidity intensive. To be able to make every payment in real time, a settlement bank either has to have the cash on hand, or the ability to borrow it on demand intraday from the central bank. Liquidity needs scale with gross payments, which are substantially larger than net payments. Thus, like CCPs, RTGS substitutes liquidity risk for default risk.

This risk is exacerbated by the fact that a prisoner’s dilemma problem exists in RTGS. Participants concerned about the creditworthiness of other banks have an incentive to delay payments and hoard liquidity, since once a payment goes into the system, it is final and the payer is at risk to loss of the entire gross amount if a bank that owes it fails before it pays. This can lead to a seizing up of the liquidity supply mechanism, as the prisoner’s dilemma logic kicks in and everyone starts to hoard.

Since holding cash in sufficient amounts to meet all payment obligations is extremely expensive, RTGS has evolved to permit central banks to lend intraday on a collateralized basis. But as was seen in the 2008 crisis, collateralization poses its own risks, including ballooning haircuts that can set off price spirals due to collateral fire sales. Further, due to the potential for the breakdown of long and large collateral chains, this creates an interconnection risk, and represents a further coupling of the system. And it is coupling, remember, that is at the root of most catastrophic accidents. Secured lending can create a false sense of security.

Izabella’s post also points out another problem with RTGS, which is common to central clearing. It creates a much more tightly coupled system that is very vulnerable to operational risk. This risk crystalized in October, 2014, when a seemingly innocuous change to the system (deleting a member bank) caused the failure of the UK’s CHAPS  settlement system for a day. Ironically, this was the result of an interaction between one part of the system, and another part (the Liquidity Savings Mechanism) that was intended to economize on the liquidity demands of RTGS, and essentially created an RTGS-DNS hybrid. As in most “normal accidents”, unexpected interactions between seemingly unrelated parts of a complex system led to its failure.

There is another way to see all of this. Both central clearing and RTGS are intended to create “no credit” systems. That is true only in a very limited sense–a profoundly unsystemic sense. Yes, CCPs and RTGS are designed so that participants in those arrangements don’t have credit exposure to one another. But those participants aren’t the entire system, just a part of it: the exposure is pushed away from them to others. Further, the method for reducing credit exposure among the participants is to require extensive reliance on liquidity mechanisms that are prone to breakdown in stressed market conditions. Further, these liquidity mechanisms are based on credit: banks (or the CCP) borrow from other banks, or from central banks in order to obtain liquidity. Further, the credit moves into shadowier places.

Not to sound like a broken record, but things like CCPs and RTGS redistribute and transform risks, rather than eliminate them altogether. Unfortunately, these transformations do not necessarily reduce the risk of a systemic crisis, and arguably increase it in some cases. The failure of officialdom, and large swathes of the banking sector, to recognize or address this reflects in large part a failure to take a systemic perspective. Perhaps cynically, this can be explained by the fact that the central banks and banks that drive these reform efforts mistake their own interests for the interest of the system as a whole: le système, c’est nous. As a result, “Devil take the hindmost” could well be applied as the motto of RTGS and central clearing.

This illustrates a broader problem in public policy. Government is too often invoked as a deus ex machina that internalizes externalities. But the fact that most regulatory change efforts are driven by, or ultimately controlled by, a small subset of interested parties who have the most concentrated stake in an issue. Given the diffuseness of other impacted parties this is inevitable. But it means that in practical terms internalizing externalities via regulation of something as complex as the financial system is a chimerical goal. The externality hot potato gets tossed from one segment of the financial sector to another. Government regulation, as opposed to self-regulatory initiatives, mainly affect the makeup of the subset of participants who are involved in influencing the process, and the distribution of the bargaining power. This works through the entire process, from the crafting of legislation, to the writing of regulations, to their implementation. This is why we get things like RTGS or CCP mandates, which make a certain set of participants better off, but which it is heroic indeed to believe are truly welfare increasing.

The WSJ reports that the CME Group’s new Euro-Denominated cocoa futures contract is floundering, due to a pronounced lack of liquidity. (h/t @libertylynx) The incumbent ICE Futures Europe Sterling-denominated and ICE Futures US USD-denominated contracts dwarf the CME contract’s volume, even though European hedgers face some currency risks in using these contracts.

This is not a surprise, not by a long shot. It is always very difficult for upstart contract to make inroads, let alone dominate, in competition with an established incumbent. Liquidity is king, and the established contracts have a liquidity advantage that new entrants almost never overcome, even if the new contract is superior on some dimensions.

The only real example of the displacement of an incumbent is Eurex’s wresting of the Bund contract from LIFFE in 1997-1998. That story, which I analyze in a forthcoming paper in the Journal of Applied Corporate Finance, is the exception that proves the rule.

First, because it was supported by German banks who direct a lot of order flow to it, Eurex (and its predecessor, Deutsche Terminborse) had a base of liquidity on which to build.

Second, because it was electronic, it was possible for Eurex to offer faster and easier access to US users once the CFTC approved Eurex’s application to install terminals in the US.

Third, and most important, Eurex exploited LIFFE’s smug complacency. Eurex aggressively cut fees, and LIFFE did not match: it was convinced that its superior liquidity, and the inherent superiority of floor trading, would prevent its customers from defecting to Eurex to save a few DM per contract in fees.

Wrong! As I document in the JACF paper, the liquidity cost difference between the markets wasn’t that great by 1997 (due to the German bank support and the influx of US customers), and taking into account the lower trading fees it was actually cheaper to trade on Eurex. Volume started to leak to Eurex, and the leak turned into a flood. LIFFE belatedly cut fees, but by then it was too late. The market had tipped completely to Eurex, and LIFFE had a near-death experience.

I can speak first hand of LIFFE’s overconfidence. In 1992, I produced a study for DTB that showed that its electronic market’s liquidity was comparable to that of the floor-based LIFFE. The study was not intended for release: it was commissioned to determine whether it was advisable for DTB to add a new membership type analogous to locals in order to improve liquidity. But the results were so surprisingly favorable for DTB that they released the study, much to the derision of LIFFE and the futures trading community generally, which was truly in the grip of the Cult of the Floor.

The CEO of LIFFE was quoted in the FT and Risk Magazine to the effect that I was an ivory tower academic who had no idea the way the real world works, because everybody knows the floor is more liquid and always will be. Real bulletin board material. Literally, in my case.

He who laughs last. When Eurex launched its assault on LIFFE in 1997, it distributed my 1992 study broadly. I doubt that had much of an impact on the final outcome, but it couldn’t have hurt.

The LIFFE CEO ended up resigning after LIFFE capitulated, and voted to close the floor and go electronic. I was a good boy. I resisted the very strong temptation to send him clippings of the FT and Risk articles.

Every other exchange learned a lesson at LIFFE’s expense, and responded to a fee cutting entrant by cutting fees immediately. For instance, the CBT saw off Eurex’s attempt to compete in the Treasury market in short order by cutting fees to zero, raising them after Eurex capitulated.

So CME shouldn’t feel bad. It has plenty of company in launching a contract that fails to make headway against an established incumbent. Indeed, the experience should be comforting, because it is the dominant incumbent in USD STIRs, govvies, equity indexes, FX, grain, precious metal, livestock, and energy futures. It benefits massively from the liquidity entry barrier. Compared to that, the failure to penetrate ICE’s cocoa monopoly doesn’t amount to a hill of beans.

The Bank of England has received a lot of attention for its just-released study on the liquidity impact of swap execution facilities (SEFs). It finds that:

as a result of SEF trading, activity increases and liquidity improves across the swap market, with the improvement being largest for USD mandated contracts which are most affected by the mandate. The associated reduction in execution costs is economically significant. For example, execution costs in USD mandated contracts, where SEF penetration is highest, drop, for market end-users alone, by $3 million–$4 million daily relative to EUR mandated contracts and in total by about $7 million–$13 million daily.

The basic methodology is to use a difference-in-difference approach to compare measures of liquidity pre-and-post SEF mandate, and which exploits the fact that non-US banks can avoid the mandate by avoiding trading with US banks: this avoidance issue will is important, and I will discuss it later.

The study is carefully done, but I am not persuaded. For one thing, the measures of liquidity employed are driven by data availability (transactions prices), and are not the ideal measures of liquidity. The primary liquidity measures employed are really measures of price dispersion, rather than preferred measures of liquidity such as bid-ask spreads, depth, or price impact (although greater (lower) price dispersion could be associated with lower (greater) price impact).

There is also the issue that transaction characteristics are endogenous. For instance, it may be the case that it is cheaper to do large deals off-SEF than on-SEF. These deals will tend to be done at prices that are further away from the mean price (or the end-of-day midpoint price), and in the volume-weighted measures employed in the paper, these deals get a bigger weight in the liquidity measures. Thus, price dispersion may be greater pre-mandate, and in Europe, where the mandate can be avoided not because SEFs improve liquidity, but because it is prohibitively costly to transact large deals on SEFs. That is, the results could be symptomatic of a loss of liquidity on some dimensions, rather than proof that the mandate improves liquidity.

The paper documents that there is less dealer intermediation where the mandate is binding. This could also reflect changes in transactions characteristics. Dealers are more likely to be needed to intermediate big deals, or deals that are exceptional on some other dimension.

The paper doesn’t break down transaction characteristics by mandate-impacted and non-mandate-impacted subsamples, and in particular doesn’t include a measure of the dispersion of transactions sizes. As a result, it’s not possible to determine whether the mandate has altered the mix of transaction characteristics.

This relates to another finding of the study: namely, that the mandate has led to the fragmentation of the interest rate swap markets along geographic/currency lines, with SEFs gaining far lower penetration in Euro-denominated swaps that are dominated by European banks who can avoid the mandate by trading with one another, and by trading with European end-users. There is confirmation of this result from Tabb Group, which finds that “European derivatives market continues to resist electronic trading.”

Well, this raises the dog food question: If the dog food is as great as the ads say, why don’t the dogs eat it? if SEFs are so much more liquid, why don’t traders flock to them?

When given a choice between a statistical finding, and revealed preference, I go with the latter. Those who actually internalize the cost of trading largely avoid SEFs. This suggests that they are actually costlier to use, at least for some users, such as those who want to trade in large size, or have other idiosyncratic needs. The choices of those who have the choice strongly suggests that the statistical evidence purportedly showing lower execution costs on SEFs is flawed and misleading.

With this in mind, it was gratifying indeed to see CFTC Chairman Massad stating that he favors allowing market participants to decide whether they transact swaps electronically or using traditional voice execution. There was never a compelling case-or even a weak one-for forcing diverse market users with diverse transactional needs to use a one-size-fits-all execution method. Massad’s free-to-choose approach is therefore a vast and welcome improvement over his predecessor Gary Gensler’s monomaniacal determination to bash everybody over the head with a CLOB.

Update. Here’s a more detailed description of the Tabb Group study I linked to above. One important takeaway: European end users really hate electronic execution, and really love voice execution:

Despite the cost benefits of e-trading, institutional investors still prefer to interact with their dealers via phone. Nearly 80 [!] per cent of the more than 200 European investors interviewed as part of the Greenwich Associates 2015 European Fixed-Income Study confirmed their trading protocol of choice was the phone.

“These trades often require white-glove treatment, and clients work with dealers that are best at limiting market impact and providing the support needed to get the trade done,” says Greenwich Associates Managing Director Andrew Awad (pictured). “As a result, clients still place a high value on the support provided by swaps salespeople in executing complex and large trades.”

This strongly suggests that there are likely to be considerable differences between deals done on SEFs and those done the old fashioned way. Not particularly the point about “limiting market impact.” Those who want to do trades that are “complex and large” go to dealers to trade bilaterally to avoid price impact. If they are not able to do that, because of an electronic execution mandate, they will almost certainly trade differently. Fewer big, complex trades. If that is correct, then the Bank of England study is comparing grapes to grapefruit. If so, the difference in price dispersion documented in the study does not demonstrate greater liquidity on SEFs: it demonstrates worse liquidity, at least for some kinds of trades.

Mind you: end users were the supposed beneficiaries of the SEF mandate. According to GiGi et al, they were being shamelessly exploited by dealers, and SEFs would set them free. Apparently they like their chains just fine, thank you very much.

Again: revealed preference rules. Believe it over a stat every time.

My grandfather had a wealth of colorful expressions, most of which were the product of his Appalachian upbringing. One, however, was a little different. Whenever it was too late to do something about a particular problem, he’d say: “Well, it’s a little late for herpicide.” In context, I understood what he meant, but the exact meaning escaped me. I asked him one time, and it turns out that Herpicide was a (quack) hair loss cure in the ’30s or ’40s. The company’s add campaign pictured a cue ball-bald man with the caption: “A Little Late for Herpicide.” I guess now it would be “A Little Late for Rogaine.”

This expression came to mind when I read in the FT that “Russia considers hedging part of its oil revenues.” It would have been a good idea when the price was $100, or $90, or even $50. At $30 (or below, as happened on Wednesday and Thursday), well, it’s a little late for hedgicide. Yes, oil could indeed go lower, but hedging today would lock in prices that are low by historical levels.

Hedging would make sense for Russia, just as it does for a highly-leveraged corporate. It clearly incurs financial distress costs when prices are very low. Hedging would reduce the expected costs of financial distress.

Presumably Russia would implement a program like Mexico’s, buying large quantities of out-of-the-money puts. This would allow it to capture the upside but obtain protection on the downside. It would also avoid a problem that it might face if it sold swaps/forwards: finding a counterparty. Selling a put to Russia doesn’t involve counterparty risk. Buying swaps from them would. Although this would be a right-way risk, one could readily see Russia balking on performance if oil prices were to spike, putting a short swap position well out of the money. It would have the cash to pay: the willingness to pay, not so much. Further, although Russia’s ability to pay is closely related to oil prices, it is exposed to other risks that could impair that ability, and these risks would create credit risks for anyone buying swaps from Russia.

Buying puts does create an issue, though: this would require Russia paying a rather hefty premium upfront, at a time when it is cash-strapped. As an illustration of its financial straits, note that it is attempting to avoid having to come up with cash to stabilize troubled megabank VEB. Borrowing to pay the premium is also problematic, given its dicey creditworthiness. Russia’s CDS spread is around 370bp (which, although it has turned up as oil prices took their latest plunge, is still below post-Crimea levels, and even below the levels seen in August). Current sanctions and the prospect of the crystallization of future political risks may also make lenders reluctant to front Russia the premium money.

One interesting thing to consider is how hedging would affect Russia’s output decisions going forward. Hedging, whether by buying puts or selling swaps, would reduce its incentive to cut output in low price environments. As I’ve written before, Russia doesn’t have a strong incentive to cut output anyways because  market share, market demand elasticity, and the cost of shutting down production in Siberia make it a losing prospect (as its refusal to cut output in 2009 and in the past 18 months clearly indicate). However, whatever weak incentives Russia has to cut (in cooperation with the Saudis for instance) would be even weaker if it was hedged. If cooperation on output between OPEC and Russia has proved hard up to now, it would be harder still if Russia was hedged.

A Russian hedging program, if big enough, could affect market pricing, but not the price of oil (at least not directly*): hedging is a transfer of risk, and a big Russian hedge would affect the price of oil risks. Its hedging pressure would tend to increase market risk premia (i.e., reduce forward prices relative to expected spot prices). If done using puts, it would also tend to steepen the put-wing volatility skew and increase volatility risk premium. Adding its hedging pressure to the market would also necessitate the entry of additional speculative capital into the market in order to mitigate these effects. Sechin has criticized speculators in the past: hedging Russian oil price risk would be prohibitively expensive without them.

Although Russia has mooted the possibility, I doubt it will follow through. I would imagine that the combination of the cash cost of options and criticism within the ruling clique of locking in low prices will cause them to pass. If and when oil prices rise substantially, I predict they will forego hedging because they will convince themselves that prices won’t fall again, just as they did post-2009.

In sum, this sounds like an idea that the technocrats have advanced that will die at the hands of the siloviki, like various privatization initiatives.

* The spot price of oil depends on output and demand. Hedging affects spot prices to the extent that it affects output. One way that could happen is that if it reduced Russia’s incentive to cut output. Another way it could happen is that hedging increases Russia’s capacity to finance investments in oil production by reducing capital costs. In this case, investment would be higher and output would be higher.

In each of these scenarios hedging reduces spot oil prices in some states of the world, not because of the direct effects of forward selling, but because the hedging provides incentives to increase output. This is a good thing.

The oil collapse continues apace, after a one day breather on Monday. As I write, WTI and Brent are off almost 8 percent. Equity indices around the world are going in the same direction.

This recent co-movement between crude (and other commodities, especially non-precious metals) has unleashed torrents of twaddle. One of the most egregious pieces thereof was a recent Krugman column:

When oil prices began their big plunge, it was widely assumed that the economic effects would be positive. Some of us were a bit skeptical. But maybe not skeptical enough: taking a global view, there’s a pretty good case that the oil plunge is having a distinctly negative impact. Why?

Well, think about why we used to believe that oil price declines were expansionary. Part of the answer was that they reduced inflation, freeing central banks to loosen monetary policy — not a relevant issue at a time when inflation is below target almost everywhere.

Beyond that, however, the usual view was that falling oil prices tended to redistribute income away from agents with low marginal propensities to spend toward agents with high marginal propensities to spend. Oil-rich Middle Eastern nations and Texas billionaires, so the story went, were sitting on huge piles of wealth, were therefore unlikely to face liquidity constraints, and could and would smooth out fluctuations in their income. Meanwhile, the benefits of lower oil prices would be spread widely, including to many consumers living paycheck to paycheck who would probably spend the windfall.

Now, part of the reason this logic doesn’t work the way it used to is that the rise of fracking means that there is a lot of investment spending closely tied to oil prices — investment spending that has relatively short lead times and will therefore fall quickly.

Where to begin? I guess the place to start is to note that Krugman commits a cardinal economic error (you’re shocked, I’m sure): he argues from a price change. What is frightening is that if you believe his characterization of the received wisdom in macroeconomics, this is the standard way of thinking about these things in macro.

Prices do not move exogenously. Prices can go down because of supply shocks. They can go down because of demand shocks. The price movement is the same direction, but the implications are very different. In particular, the implications for co-movements between oil prices and asset prices are very different. You cannot analyze based on the fact of the price change alone: your analysis must be predicated on what is driving that change.

A price decline because of a favorable supply shock is generally positive for the broader world economy. Yes it is bad for oil producers, but especially for advanced and most emerging economies who are oil/commodity shorts, a supply-driven price decline is beneficial and should be associated with higher stock prices, economic growth, etc. The production possibility frontier shifts out, leading to higher incomes overall although in a world with incomplete risk sharing there are distributive effects. But the adverse consequences for producers are almost always swamped by consumer gains.  In this scenario, growth and asset prices on the one hand, and commodity prices on the other, move in opposite directions.

Things are very different for demand shocks-driven price changes. A price decline because of an adverse demand shock is generally negative for the broader world economy, because it is a weakening world economy that is the major source of the demand decline. This is a matter of correlation, not causation. Causation runs from a weakening economy to lower demand for oil (and other commodities) to lower commodity prices and lower asset prices.  Oil price (and asset price) changes are an effect not a cause.

The current situation is much closer to the latter case than the former. Yes, there have been oil production increases in the last couple of years, but if world economic growth had continued on its pre-mid-2014 pace, demand would have grown sufficiently to absorb this increase. In fact, the decline in oil and other commodity prices starting around June 2014 occurred right about the time that world growth forecasts declined appreciably. Subsequent months have seen a litany of bad growth news from the main sources of commodity demand growth in the boom years, most notably, of course, China. And the news from China keeps getting worse. This is reflected in cratering stock prices there, and other indicia of economic activity. (Notably all of these indicia are pretty much non-official. Official Chinese statistics should be nominated for the next Nobel Prize in Fiction.)

But rather than go back to basics, Krugman assembles a Rube Goldberg contraption to explain what is going on. And of course, austerity and the liquidity trap play a starring role:

But there is, I believe, something else going on: there’s an important nonlinearity in the effects of oil fluctuations. A 10 or 20 percent decline in the price might work in the conventional way. But a 70 percent decline has really drastic effects on producers; they become more, not less, likely to be liquidity-constrained than consumers. Saudi Arabia is forced into drastic austerity policies; highly indebted fracking companies find themselves facing balance-sheet crises.

Or to put it differently: small oil price declines may be expansionary through usual channels, but really big declines set in motion a process of forced deleveraging among producers that can be a significant drag on the world economy, especially with the whole advanced world still in or near a liquidity trap.

Since because of his cardinal error Krugman does not identify what caused the price decline that begins his chain of “reasoning,” it’s hard to understand fully what he means. The most charitable interpretation is that there was a favorable supply shock that was so big that it caused such a large price decline in oil that this caused world “aggregate demand” to decline because of the severe adverse consequences on indebted and liquidity constrained producing countries and companies.

Inane. For one thing, these economies and sectors are very small in comparison to the world economy. Commodity producing countries have historically suffered major financial crises with little, if any, effect on growth world-wide, or on asset prices world-wide. The US oil and gas sector has also undergone some severe crises (e.g., 1986-1987) with limited fallout on US and world growth: the impacts tended to be concentrated regionally in the producing states, such as Texas. Not much fun there, but the rest of the country and the world didn’t much notice. In fact, they benefited from the favorable oil supply shock.

For another, even if there is some asymmetry between the “liquidity constraints” of producers and consumers, Krugman has been arguing strenuously that US and European consumers are liquidity constrained, hence his constant attacks on austerity. In Krugman’s argue-from-a-price-change story, that liquidity constraint has eased, and therefore one would expect to see improvement in consumption growth in places like the US, but the reverse is in fact true. The US economy is slowing rather noticeably.

No. The back-to-basics-trace-the-cause-of-the-price-change story is much more plausible. And here’s the irony. The epicenter of the commodity demand and world growth shock is China, which has binged on credit stimulus since 2009 in a way that Krugman should approve. But that cannot go on forever, and indeed, the main source of problems in China is the recognition that it can’t go on forever. China faces colossal balance-sheet issues that make deleveraging inevitable. When that happens, the commodity crisis will enter a new phase. How bad it is depends on how well the Chinese handle it. Given their mania for central control, I do not believe they will handle it well.

Macro panjandrums, like Oliver Blanchard, are puzzled, because official data do not yet reflect any large decline in growth. But that’s because official data are backward looking, and markets look forward relentlessly. They are signaling current and future problems, which official data will eventually validate. (And that’s when the data aren’t made up, as is notoriously the case in China.)

Commodity prices are particularly important, because commodities are consumed in the here and now. When demand declines, consumption declines, and prices decline contemporaneously. For all the talk about financialization, that can’t overcome the decisions of billions of commodity consumers around the world. Thus, at present, the high positive correlation between commodity prices and asset prices, like in 2008-2009, is a symptom and harbinger of broader economic problems. You don’t need Rube Krugman contraptions to explain that.