Streetwise Professor

Given the actions of the Rada in Ukraine and the flight of the regime leadership to Harkiv, it is evident that (a) the Russian financial assistance that barely kept the country aloft financially will end, and (b) Russia will engage in economic warfare against the country (even if it does not engage in armed warfare).   Thus, Ukraine faces economic collapse.

This is something that the west-the EU and the US-and international organizations-notably the IMF-can prevent.  It’s only a matter of money.   Emergency economic assistance is imperative.

Concerned about the cost? Don’t be penny-wise, and pound foolish.

And one hopes that after its bitter experience in the past, that Europe has contingency plans in place to respond to a Russian cutoff of gas.  Not just gas going through Ukraine, but through Nordstream as well.  For Russia is blaming Europe for what is happening in Ukraine.  A full cutoff would cut against Gazprom’s interests (and hence the interests of the Russian power structures which feed off it), but the stakes in Ukraine are big enough for Putin that he could well consider that a price worth paying if he believes it will stampede the Europeans into abandoning the opposition-or, I should say, the new government in Ukraine.

Putin is playing for keeps, and this setback to his schemes will only enrage him and steel his resolve to prevail.  He will pull economic levers to do so.  The west should pull the economic levers of its own.

The situation in Ukraine has reached something of a denouement. The opposition leadership and the regime have reached an agreement whereby the government will amnesty arrested protestors, and the protestors will end the occupation of government buildings and permit traffic to move on Hrushevskyy Street, although they will not dismantle the barricades altogether.

This deal has been met with some dismay (and in cases, anger and bitterness) on Maidan, and with good reason.  The protestors have given up their main leverage, and although they have threatened to re-occupy the buildings and Hrushevskyy Street if Yanukovych’s regime backslides, this is likely an empty threat.  The regime was surprised once, but is unlikely to be surprised twice, and will be ready to respond aggressively to any attempt to take the buildings again.

Conversely, the government can easily re-arrest those that it has amnestied-and many more to boot.  There is thus a pronounced asymmetry between the concessions made by the government, and those made by the opposition.

In brief, although Yanukovych has not triumphed, the threat to him has abated considerably and the correlation of forces has shifted palpably in his direction.

Perhaps reflecting this, Putin has relented and will proceed with the purchase of the next tranche of $2 billion in Ukrainian Eurobonds.

Truth be told, the real threat to the Yanukovych regime is economic.  The Ukrainian currency, the Hryvnia, is the best readily available indicator.  It has plunged from 8.2 to the dollar at the beginning of Maidan, to 8.8/8.9 to the dollar at present.  Although it rallied to 8.4 a week ago, when the outlines of a deal were in prospect, and when Ukraine imposed capital controls, it weakened almost immediately thereafter.  The current depressed level augers poorly for Ukraine’s future prospects.

And here is the tragedy.  An economic collapse, which would be accompanied by a further collapse in the currency, would be the most likely cause of Yanukovych’s political demise.  But then the opposition would inherit a horrible situation which would require it to take measures that would inevitably lead to it becoming hated and despised.  It is also not an environment conducive to the completion of the constructive economic and political reforms the country so desperately needs.  Think of Russia ’91-’92, or ’98-’99.   The reformers ended up totally discredited and hated, paving the way for the emergence of Putinism.

The end result is unlikely to be a Ukraine that resembles Poland, on a path to converging with the EU. A more likely outcome is a perpetual Sovokistan, and one that is a satrapy of Russia to boot.

An incipient collapse would put Putin in a hard place.  He would be forced to double down and increase economic assistance-likely throwing bad money after worse-or to stand aside and watch the whole thing collapse.

Cynic that he is, perhaps he would stand aside, on the calculation that he could take advantage of the collapse, and swoop in and pick up the pieces of a shattered country.  And a prostrate Ukraine would hardly be attractive to the EU.

It pains me, but I just can’t see a clear path forward for the unlucky country.  Belarus-light on the upside.  Perpetual basket case as the middle  scenario.  Economic collapse and revolutionary chaos as the worst case

The Sovok legacy is too powerful: the country’s institutions are weak and fundamentally corrupt.  Europe is feckless and disinterested, long on soaring rhetoric, short on  Euros and will.  Obama doesn’t give a rat’s rump about foreign policy generally, except for his Iranian legacy project: if he won’t bestir himself over the daily slaughter of hundreds in Syria, he’s not going to lift a finger to keep Ukraine from sullenly settling into a Russian orbit.  In contrast, Putin is far more motivated, driven by his dream of undoing the results of the Cold War.  He views Ukrainian independence from Russia as a historical monstrosity.  He would no doubt prefer to eliminate Ukrainian sovereignty de jure, but would no doubt settle to eliminate it de facto–for now.

Ukraine is too close to Putin-and subjugation of Ukraine is a goal too close to Putin’s heart.  Ukraine is far from the EU, farther still from the US, and farther still from the help of God.

I wish this weren’t so.  I pray I am wrong.  But as much as I admire the idealists on Maidan, and pull for their victory, I can’t see it happening.  The mutilating historical legacy of the USSR is too powerful,  a malign Russia is too close, and succor is very, very far away.

I haven’t written much at all about Elon Musk and Tesla since the middle of last year.  I have no reason to change my opinion that the prices of Tesla and Solar City stock were manipulated in April-May, but by the same token don’t believe that their subsequent increases are primarily the result of manipulation.  Those stock prices are partying like a 1999-era dot com company.  I think the party will end soon, but I don’t know when and I could be wrong.

But my main issue with Musk was not about the stock price.  It was about the fact that all of his companies were heavily dependent on government subsidies and support.  This support socialized the potential losses, and allowed Musk (and other major investors, notably Goldman) to capture the upside.  My point was if his products and business models were so great, he could succeed on his own, by attracting private capital.

One company that I mentioned in passing was SpaceX, his  space launch venture.  Inevitably, this company is dependent on government contracts, given that a very large fraction of space launches carry government payloads.  This is something different from Solar City and Tesla, where the government is providing subsidies but not receiving any product or service in return.  But still, it means that Musk depends crucially on cultivating government support.  Government contracting-especially big ticket contracting-is hardly a pristine activity.  A firm does not succeed or fail at it primarily on the basis of the superiority of its product, but instead on the basis of its ability to influence politicians and bureaucrats.  And a lack of scruple is often a feature not a bug in that regard.

SpaceX was  looking for a commercial launch site, and  seeking state subsidies in order to build it.  The company has been playing states off against one another, looking for tax benefits. My current home state, Texas, has been one of his targets.

Cynically, Musk focused on one of the poorest parts of the state-Brownsville-and dangled the prospect of a mere 600 jobs, in exchange for  $20 million dollars or so in tax benefits.  Some of which will come from the taxpayers of that very poor community.  And sadly, the state legislature has succumbed.

I’ve been to downtown Brownsville.  I testified at a trial there in 2008.  (The reason that what was the biggest bankruptcy case in US history was being heard in Brownsville is a story in itself.)  The law office for the local counsel in the case was at the edge of downtown, and during breaks I wandered around.  It was an educational experience.  I had just flown in from Milan (another story), and to be honest, I felt more foreign in downtown Brownsville than I did in Italy: and I certainly got far more puzzling and suspicious looks in Brownsville than around Lake Como.  Let’s just say it ain’t the Bay area.  And that Elon Musk wouldn’t be caught dead there.  Well, maybe if he did go there . . .

The poorest people in Brownsville will not benefit the slightest from the SpaceX venture.  But he and his lobbyist successfully importuned the state and county to take taxpayer money and give it to SpaceX by invoking their poverty.  It was utterly cynical for a billionaire to extract tens of millions from Texas taxpayers in the name of the poor Mexican Americans of Brownsville.

I know this is the way the game is played.  And that’s the problem: the game is cynical and wrong.  It is mere rent seeking.  Musk is particularly appalling because he is a rent seeker posing as a technological visionary.  His businesses all depend on extracting rents from the government, which he pockets.

But he has a cult of personality that portrays him as some towering visionary genius.

Maybe he is.  If he is, he should be able to make it all on his own, like some 19th century titan (Rockefellar, Carnegie), without collecting hundreds of millions from taxpayers.

I say let him try.  And I am dismayed that the Texas legislature didn’t.

To return to the CBO Obamacare report.  It is really amazing that the admin spin (but I repeat myself) is that this is no big deal because hey, the job losses are a supply side effect, not a demand side effect.  Amazing, and embarrassing to my profession, because some who have made this claim are economists who should-and I am sure do-know better.

The effect that the CBO points out is related to the fact that the phase-out of subsidies as income increases under Obamacare is effectively a tax on labor income. There is a very basic tenet in economics called Tax Incidence Analysis, which says that the effect of a tax out output (or in this case, input usage) doesn’t depend on whether the tax is imposed on the buyer or the seller.  Impose it on the buyer (in this instance, employers), the demand curve shifts down: In Obamacare Spinworld, that’s BAD!.  Impose it on the seller (in this instance, workers), the supply curve shifts up, crucially by the same amount as the demand curve would shift down if the tax is imposed on the buyer.  End result: both routes lead to the same destination in terms of the amount of employment and the take-home pay of workers.

The tax-and remember, the subsidy phase out is equivalent to a tax-drives a wedge between the price that buyers (employers) pay and sellers (workers) receive.  It is this wedge that distorts decisions.  It is the size of the wedge that determines the size of the distortion, and the size of the wedge is the same whether a given tax is imposed on the buyer, the seller, or split between them in any arbitrary way.

Again, this is the most basic economics.  So how come some economists are saying the CBO report is nothing to worry about because the effect it identifies is due to a shift in the supply curve, rather than the demand curve?

Put differently, the workers who are (according to Admin Spin) going to enjoy freedom from the drudgery of labor as a result of the subsidy phase-out would be the very same workers who would be out of work if an equivalent tax had been imposed on employers.  But I guess those people in the latter scenario (again: the very same people) wouldn’t be enjoying freedom from the drudgery of labor, or something, so that would be bad.  (This brings to mind the scorn  that Keynesian economists heaped on New Classical and RBC economists who suggested that unemployment is voluntary.  What’s good for the goose . . . )  I guess you’re free to enjoy leisure when you decide it isn’t worth working, but you are not free to enjoy leisure if someone decides not to hire you.

Like I say.  Truly embarrassing to the profession that any economist would do anything but call bullshit on the spin.  Instead we see economists picking up their shovels and adding more manure to the pile.

I am not alone in this opinion.  Indeed, I should defer to Casey Mulligan, because he has been the one who has been assiduously documenting the perverse supply side effects of myriad Obama policies.  His painstaking work nudged the CBO to revising its earlier conclusions about employment declines, though he still thinks they underestimate the effect.  And he is also embarrassed and disgusted by the performance of many of our peers:

Mr. Mulligan reserves particular scorn for the economists making this “eliminated from the drudgery of labor market” argument, which he views as a form of trahison des clercs. “I don’t know what their intentions are,” he says, choosing his words carefully, “but it looks like they’re trying to leverage the lack of economic education in their audience by making these sorts of points.”

A job, Mr. Mulligan explains, “is a transaction between buyers and sellers. When a transaction doesn’t happen, it doesn’t happen. We know that it doesn’t matter on which side of the market you put the disincentives, the results are the same. . . . In this case you’re putting an implicit tax on work for households, and employers aren’t willing to compensate the households enough so they’ll still work.” Jobs can be destroyed by sellers (workers) as much as buyers (businesses).

When Mulligan says “we know it doesn’t matter on which side of the market you put the disincentives, the results are the same” he is summarizing the implications of tax incidence analysis.  When he says “when a transaction doesn’t happen, it doesn’t happen” he means that the wedge between what employers pay and what workers receive causes some people not to be employed, and it doesn’t matter whether this is because an employer finds them too expensive to hire, or they find their take home too little to justify giving up leisure (or, enjoying “freedom” if you will).

Basic economics tells you that the Administration spin is wrong.  Is it to much to ask that economists not only not spin along, but actually criticize it?

Catching up on Obamacare news.  The absurdity and flackery are coming fast and furious.  Indeed, the flackery is intensifying because the absurdities of ACA are becoming more evident by the day, so more obfuscation is needed.

The most notable instance relates to the CBO’s report that Obamacare will cause employment to fall by over 2 million.  My first reaction was: NOW they tell us.  Because it’s not like the incentive effect that the CBO bases its analysis wasn’t known or understood at the time Obamacare was debated and passed.  The phasing out of subsidies as income rises is effectively a large increase in the marginal tax rate on earned income.  Combined with the related effects in other forms of government assistance, the marginal tax rate on work becomes very high, and many individuals will rationally respond to this by reducing labor supply, either by cutting hours (working part time) or withdrawing from the labor force altogether.  Again, it’s not like this is some novel concept: why the hell didn’t CBO take this into account when evaluating ACA in 2010? (Aside: since when are liberals so enamored with regressive tax systems?)

But the administration says: “Employment falls?  No big deal.  This is a supply side effect, not a demand side effect.  So no problem!“:

That, proponents say, is a good thing. White House Press Secretary Jay Carney pushed back on the “job-killing” claim, saying that “CBO’s findings are not driven by an assumption that [the Affordable Care Act] will lead employers to eliminate jobs or reduce hours.”

“Americans would no longer be trapped in a job just to provide coverage for their families,” he added.

Various liberal publications and administration acolytes are saying this is a wonderful thing.  No more job lock!  Um, “job lock” was defined as people not moving to another job because of a fear of losing coverage from their current one: it was never-never-defined as people being locked into working instead of pursuing their dreams to become puppeteers.   (Well, maybe it was, but not by serious people.)

Indeed, to read some of the commentary, it seems that this is just great news.  Indeed, to hear them tell it, Obamacare is making it possible to realize Marx’s dream:

He is a hunter, a fisherman, a herdsman, or a critical critic, and must remain so if he does not want to lose his means of livelihood; while in communist society, where nobody has one exclusive sphere of activity but each can become accomplished in any branch he wishes, society regulates the general production and thus makes it possible for me to do one thing today and another tomorrow, to hunt in the morning, fish in the afternoon, rear cattle in the evening, criticise after dinner, just as I have a mind, without ever becoming hunter, fisherman, herdsman or critic. This fixation of social activity, this consolidation of what we ourselves produce into an objective power above us, growing out of our control, thwarting our expectations, bringing to naught our calculations, is one of the chief factors in historical development up till now.

Come to think of it, Nancy Pelosi said something similar when Obamacare was being debated.  But again, I specifically said I was referring to serious people:

Think of an economy where people could be an artist or a photographer or a writer without worrying about keeping their day job in order to have health insurance.

One of the biggest flacks for Obamacare, Pulitzer Prize winner Michael Hiltzik of the LA Times, went into overdrive saying how the job loss is actually great news.  But that’s not the most annoying of Hiltzik’s columns.  This one from the weekend really got me:

Insurance companies, bless their hearts, seem determined to remind us why we need the Affordable Care Act. The latest example comes from Anthem Blue Cross, which has just hit 306,000 customers in California with premium increases of up to 25%.

As reported by my colleague Chad Terhune, the increases average 16% and are scheduled to kick in April 1, unless the state Department of Insurance jawbones Anthem into backing down.

Here’s the kicker: No one can blame these increases on the mandates of the Affordable Care Act, a popular argument among critics of the act. That’s because the increases are for grandfathered policies exempt from the act.

There’s stupid, and there’s Pulitzer Prize winning stupid.  (And yeah, I’m looking at you, David Kocieniewski.)

Let’s walk through this, shall we, and use some actual economics.  Yes, ACA grandfathered policies.  But in so doing it effectively crushed competition in the market for individual policies.  Pre-ACA, there was competition in the market for individual policies.  Not perfect competition, but someone buying on the individual market could go to another provider if his/her current provider jacked up premiums too much.  This ability to switch provided an element of competition on prices and terms (e.g., deductible, coverage) that limited the ability of any individual insurer to charge supercompetitive premiums.

Post-ACA, everything changed.  If you have a grandfathered policy, you now have two choices: the grandfathered policy or Obamacare.  Due to the coverage mandates, community rating, cross-subsidies and other factors, for many of those currently purchasing on the individual care market find the Obamacare policies to be very expensive on a quality-adjusted basis (e.g., taking into account deductibles and other policy terms).  So consider the seller of a grandfathered policy.  The insurer knows that your only choices are (a) buy an outrageously expensive Obamacare policy, or (b) do without insurance altogether.  The insurer knows that you cannot get a policy equivalent to your current policy from another insurer.  So there is no competition to speak of.  The expensive Obamacare package provides a very high price ceiling.  As long as the insurer charges a premium that is not so high as to get you to go without insurance, it can get away with it with no fear of losing you as a customer.

That is to say, the rise in premiums on grandfathered policies is clearly the result of the ACA.  In particular, it is the result of the pricing structure of Obamacare and its effect on competition in the market for individual policies.  The pricing structure means that the only competition for a grandfathered policy is a very expensive ACA policy.

And we’re supposed to be shocked that insurers take advantage of the gift of reduced competition?

It is beyond bizarre to see those on the left who rail against the rapacity of insurance companies-people like Hiltzik-defend Obamacare even though it puts people at the complete mercy of said rapacious insurers.

There is so much else to choose from, but it’s late and I’m tired after teaching, so I’ll just mention one more absurdity.  No deep economics here.  (As if the effects of Obamacare on competition and the incentive to work are all that deep: Econ 101 really.)

No, just add this to the Sovok Hacker category:

U.S. intelligence agencies last week urged the Obama administration to check its new healthcare network for malicious software after learning that developers linked to the Belarus government helped produce the website, raising fresh concerns that private data posted by millions of Americans will be compromised.

The intelligence agencies notified the Department of Health and Human Services, the agency in charge of the Healthcare.gov network, about their concerns last week. Specifically, officials warned that programmers in Belarus, a former Soviet republic closely allied with Russia, were suspected of inserting malicious code that could be used for cyber attacks, according to U.S. officials familiar with the concerns.

The software links the millions of Americans who signed up for Obamacare to the federal government and more than 300 medical institutions and healthcare providers.

“The U.S. Affordable Care Act software was written in part in Belarus by software developers under state control, and that makes the software a potential target for cyber attacks,” one official said.

But yeah, I’d feel totally comfortable in giving all my most sensitive private information to a website that includes software written by Belarussian programmers linked to the Lukashenko government.  What could possibly go wrong?

But hey, if being hacked by Sovoks is not a problem for you, once you’ve signed up for Obamacare, get thyself to Sochi.  And make sure to bring your smartphone, laptop, iPad. Fire them all up at once:

“The State Department warned that travelers should have no expectation of privacy, even in their hotel rooms,” NBC’s Richard Engel said in a report on Brian Williams’s show last night. “And as we found out, you are especially exposed as soon as you try to communicate with anything.”

According to Mr. Engel, hackers are waiting stealthily on the sidelines to break into your devices as soon as you log on to the Internet (and let’s face it—what the hell else are you going to do after a 75-hour-long flight to southern Russia?)

To illustrate his point, Mr. Engel brought two new laptops to Sochi. With the help of an American security expert, he uploaded a fake identity and fake contact list onto the computers—both were hacked within the day. “It had taken hackers less than one minute to pounce,” he said, “Within 24 hours, they’d broken into both computers and started helping themselves to my data.”

So I’m totally cool with Belarussian programmers writing Obamacare website code.  You aren’t?  What is your problem, anyways?  You have to believe!

So sign up, get your identity stolen, and then fulfill your dream of being a puppeteer!

Bloomberg Business Week has a long profile of Igor Sechin that illustrates perfectly why Putinism is an economic dead end.  Huge, inefficient state companies run by Putin cronies who have no clue about economics or how to create value.  But you’ll say: “Sechin has a PhD in economics!”  Well, a PhD in economics from a Soviet university is best described as an advanced degree in idiocy.

The piece describes Sechin as having an encyclopedic knowledge of Communist Party congresses dating from before the Revolution. So yeah, that definitely comes in handy in maximizing the value of the largest oil reserves of any publicly traded oil company.

Sechin refused to be interviewed for the article (probably a wise idea), but Putin’s Carney, Dmitri Peskov shared this description of Sechin’s penetrating economic philosophy:

“Sechin is a believer in the role of the state in his economic philosophy while at the same time not excluding a free-market approach. And he is firm in pursuing his viewpoint.”

Clear as mud. Problem is, I am sure that  it is an accurate characterization of Sechin’s muddled thinking.

Peskov is actually quite revealing, though almost certainly unintentionally so, in revealing the “thinking” that is propelling Russia into an economic cul de sac:

“For example, in shipbuilding it’s absolutely pointless to carry out privatization,” he says. “You can privatize enterprises, but they won’t be competitive; they will be doomed to failure. So consolidating the assets under the state’s wing is the only way to preserve key sectors of the economy.”

The reason for relying on markets, and privatization, is to determine the industries and firms that are economically viable.  The ones that generate more value than it costs to produce it.  Propping up those that would otherwise fail using state resources-which, never forget, are extracted by force from the citizenry-destroys wealth.   If Russian shipbuilding can’t compete against the Chinese or Koreans, it’s because Russian costs are higher.  Since costs are driven by the value of resources in alternative uses, the losses suffered by Russian shipbuilders in open competition means that the resources the Russian companies use would generate more value if deployed elsewhere.

That is, the success or failure of firms in the market is the mechanism that communicates where resources should be deployed, and where they shouldn’t be.  But that’s not the way statists-and Putinists-think.   Rather than having the market reveal which firms and industries should survive, the Putinists stand things on their head: they decide what industries they think are important, and provide the state resources necessary to ensure their survival. Their determination of the importance of industries is driven largely by history and political economy: the managers (and some workers) of legacy industries importune the state for support, and through personal and political connections largely succeed.  Thus the dead hand of the past rules the present and the future.  Rather than embracing the creative destruction of unviable firms and sectors, Putin embraces the destructive maintenance of legacy companies and industries.

It is a fundamentally uncreative system, because it is bounded by the cramped imaginations and interests of those who benefit from the status quo.  The interests of those who run the state are inherently biased to the status quo.  The more dominant the state becomes, the greater the tendency to stasis, and the greater the resistance to dynamism and change.

This affects even industries that are viable: the Russian oil and gas industries are clearly viable, due to the the capriciousness of nature which has endowed the country with bounteous reserves.  But the statist, Putinist system squanders that bounty.  The statistics don’t lie:

Compared with non-state-owned energy giants such as Exxon, Rosneft is inefficient. Even though Rosneft’s lifting costs — the cost of getting oil out of the ground — are less than a third of Exxon’s, the Russian company’s workforce is less productive.

Net profit per employee at Rosneft was $70,815 in 2012, versus $620,026 for Exxon. Rosneft’s price earnings ratio was 5.4, compared with Exxon’s 13.2 as of Jan. 13. Rosneft shares fell 6.87 percent in 2013, while Exxon shares rose 16.93 percent during the year.

But many find the company’s reserves to be an irresistible allure:

“The main reason to hold Rosneft is the reserves,” Greenwich Capital’s Snykov says.

But the point is that the value of these reserves is radically diminished by putting them under the control of a mullet-headed ex-KGB mouth breather.

The mental world of Sechin and Putin and the like was shaped in the USSR.  They don’t want to recreate it down to every last detail, but they do want to restore its broad outlines.  This is a recipe for stagnation.

And it will only get worse.  There is no mechanism for changing the leadership: indeed, Putin’s priority project in the past several years has been to neuter-or worse-any possible challenge to the incumbents.  So the current gang-and it is a gang, in all essential features-will remain in control for the foreseeable future.  And as they age, they will become even more resistant to change, and more sentimental about the world of their youth.

I still shake my head at those who understood the problems with the existing system, and assumed that Putin would too, and would be forced to institute changes and reforms to prevent the system from lapsing into senescence. How can one be so oblivious to the implications of the interests of the rulers of a system combined with the conservative impulses of aging men? Together, these forces work relentlessly to resist change and reform, and to attempt to maintain the status quo–or even roll back the clock.

Indeed, just this week, one of the few tepid reforms instituted by Medvedev has been rolled back.  The eunuch prime minister announced that state officials will be allowed to serve on the boards of state corporations, reversing a policy instituted a few years ago.  Remember when Medvedev’s original announcement was viewed as a dire defeat for Sechin, in particular?  Hardly.  Medvedev is being kept around to serve as the sacrificial lamb to pay for Putin’s mistakes, and Sechin is the second most powerful man in Russia.

So read the BW profile to understand Russia’s past, present, and future in a single story.  For Igor Sechin is the poster boy for Sovokistan, and Sovokistan is what Putin has created.

One interesting part of the Cœuré speech was his warning that the clearing business was coming to be dominated by a few large banks, that are members of multiple CCPs:

Moreover, it appears that for many banks, indirect access is their preferred way to get access to clearing services so as to comply with the clearing obligation. Client clearing seems thus to be dominated by a few large global intermediaries. A factor contributing to this concentration may be higher compliance burdens, where only the very largest of firms are capable of taking on cross-border activity. This concentration creates a higher degree of dependency on this small group of firms.

There are also concerns about client access to this limited number of firms offering client clearing services. For example, there is some evidence of clearing firms “cherry picking” clients, while other end-users are commercially unattractive customers and hence unable to access centrally cleared markets.

These are all developments that I believe the international regulatory community may wish to carefully monitor and act on as and when needed.

And wouldn’t you know.  He supports a longstanding SWP theme: That Frankendodd and EMIR and Basel create a huge regulatory burden that is essentially a fixed cost.  This increase in fixed costs raises scale economies, and this inevitably leads to an increase in concentration-and arguably a reduction in competition, in the provision of clearing services.

It now seems rather quaint that there was a debate over whether CCPs should be required to lower the minimum capital threshold for membership to $50 million.  That’s not the barrier to entry/participation.  It’s the regulatory overhead.

It’s actually an old story.  I remember a Maloney and McCormick paper from the 80s-hell, maybe even the late 70s-about the effects of the regulation of particulates in textile factories (if I recall).  The cost of complying with the regulation was essentially fixed, and the law essentially favored big firms and they profited from it.  It raised the costs of their smaller rivals, led to their exit, and resulted in higher prices and the big firms profited.  Similarly, I recall that  several papers by the late Peter Pashigian (a member of my PhD committee) found that environmental regulations favored large firms.

The Cœuré speech suggests this may be happening here: note the part about client access to a “limited number of clearing firms.”

And it’s not just pipsqueaks that are exiting the clearing business.  The largest custodian bank-BNY Mellon-is closing up shop:

More banks are expected to follow BNY Mellon’s lead and pull out of client clearing, as flows have concentrated among half a dozen major players following the roll-out of mandatory clearing in the US last year.

The decision of the world’s largest custodian bank to shutter its US clearing unit was the first real indication of how much institutions are struggling with spiralling costs and complexity associated with clearing clients’ swaps trades – a business once viewed as the cash cow of the new regulatory regime.

You might recall that BNY Mellon was one of the firms that complained loudest about the high capital requirements of becoming a member of ICE Trust and LCH.  Again: it’s not the CCP capital requirements that are the issue.  It’s the other substantial cost of providing client clearing services, and regulatory/compliance costs are a big part of that.

Ah yes, another Gensler argument down in flames.  Remember how he constantly told us-lectured us, actually-that Frankendodd would dramatically increase competition in derivatives?  That it would break the dealer hammerlock on the OTC market?

Remember how I called bull?

Whose call looks better now?  Sometimes I wonder if JP Morgan, Goldman, Barclays, etc., weren’t playing the role of Brer Rabbit, and Gensler was playing Brer Fox. For he done trown dem into dat brer patch, sure ’nuff.

Though it must be said that this was not Gensler’s biggest contribution to reducing competition in derivatives markets in the name of increasing competition.  His insane extraterritoriality decisions have fragmented the OTC derivatives markets, with Europeans reluctant to trade with Americans.  The fragmentation of the markets reduces counterparty choice in both Europe and the US, thereby limiting competition.

This is not just a matter of competition.  There are systemic issues involved as well, and these also make a mockery of the Frankendodd evangelists.  They assured the world that Frankendodd and clearing mandates would reduce reliance on a few large, highly interconnected intermediaries in the derivatives markets. That is proving to be another lie, on the order of “if you like your health plan, you can keep your health plan.”  The old system relied on a baker’s dozen or so large, highly interconnected dealers.  The new system will rely on probably a handful or two large, highly interconnected clearing firms.

The most important elements in the clearing system are a small number of major banks that are clearing members at several global CCPs.  The failure or financial distress of any one of these would wreak havoc in the derivatives markets and the clearing mechanism, just as the failure of a major dealer firm would shake the bilateral OTC markets to the core.

Just think about one issue: portability.  If there are only a small number of huge clearing firms, is it really feasible to port the clients of one of them to the few remaining CMs, especially during times of market stress when these might not have the capital to take on a large number of new clients?

What happens then?

I don’t want to think about it: there’s only so much I can handle.

But Cœuré assures us the regulators are on top of it.  Or at least they are thinking about getting on top of it: “the international regulatory community may wish to carefully monitor and act on as and when needed.”  “May wish to act as needed.”  Sure. Take your time! What’s the hurry? What’s the worry?

I won’t dwell on the  irony of those who advocated the measures that got us into this situation pulling their chins and telling us this might be a matter of concern, especially since they were deaf to warnings made back when they could have avoided leading us down the path that led us to this oh-so-predictable destination.

A board member of the ECB, Benoît Cœuré, gave a speech that discussed “the new risks associated with central clearing.” It is evident that Cœuré is a proponent of central clearing, though it is annoying to see him identify multilateral netting as the main benefit (<holds head in hands>).  But it is good to see yet again that central bankers are aware that central clearing does create new risks, and that regulators must be proactive in addressing them.

The problem is that he overlooks the most important risks.  Reading between the lines, like most regulators, Cœuré focuses on the solvency risks of CCPs, and about policy tools that can limit the probability of CCP insolvency and mitigate the adverse impacts of such an insolvency.

But as I’ve written repeatedly in the past, it’s not the insolvency risk per se that should keep people up at night.  Indeed, the measures taken to address the solvency risk can actually exacerbate the real risk a dramatic expansion of central clearing creates for the financial system: liquidity risk.

Liquidity crises are what threaten to bring down financial systems.  For most financial institutions, there is a connection between liquidity risk and solvency: banks become illiquid because (in a world of imperfect information) people believe they might become insolvent.  Maturity mismatches plus imperfect information plus possibility of insolvency combine to create liquidity crises.

CCPs don’t have the maturity mismatches, and they aren’t leveraged.  They cannot experience liquidity crises in the same way banks can.  The direct liquidity risk of CCPs is related to their ability to turn collateral into cash in the event of a member default.

But as I’ve said over and over, clearing affects the needs for liquidity by market participants.  Central clearing can be a source of, or accelerant of, liquidity crises.  Big price moves lead to big margin calls lead to spikes in liquidity demand. These are most likely to occur during periods of financial stress, and can greatly exacerbate that stress.  Moreover, failure of a CCP is most likely to occur due to the inability of traders to fund margin calls due to the shortage of liquidity.   This old article by Andrew Brimmer discusses two episodes I’ve analyzed on several occasions-the Hunts in silver and Black Monday-and shows how it is liquidity/credit/funding of margin calls for CCPs that can create stresses in the financial system.

This is where the systemic risk of clearing arises.  But the subject is totally absent from Cœuré’s speech.  Which is worrisome.

There is also the fallacy of composition problem.  The measures that Cœuré advocates to make CCPs stronger do NOT necessarily make the system stronger.  Strengthening CCPs can actually exacerbate the liquidity problems that clearing causes during a crisis.  The CCP may survive, due to these measures, but the stresses communicated to the rest of the system (and the stress has to go somewhere) can cause other institutions to fail.

This is what scares the bejeezus out of me.  Regulators don’t seem to get the fallacy of composition, and aren’t focused on the liquidity implications of greatly expanded central clearing.

These fears are heightened by reading this DTCC report about collateral and collateral management.

It contains this heading that should make every central banker and financial regulator soil his armor:

Margin Call activity to increase By up to 1000%

Then there’s this:

Operational Capabilities and Settlement Exceptions Management: The potential ten-fold increase in margin call volumes, and the resulting complexity due to market changes, could overwhelm the current operational processes and system infra-structures within banks, buy-side firms and their administrators. As a result, firms will need to invest in technology and also reengineer the settlement, exceptions management and dispute resolution processes in place today. According to a 2011 De- loitte paper, investments in operations required to build and sustain advanced collateral capabilities is estimated at upwards of $50 million annually for top-tier banks.

Be afraid.  Be very, very, very afraid.

The dramatic increase in the scope of clearing substantially increases the operational complexity of the system.  More importantly, it increases the system’s operational rigidity, because cash has to flow quickly, and according to a very precise schedule.  From client to FCM to CCP to FCM to client.  Any failures in that chain can bring down the entire system.

I say again.  Systemic risk in financial systems is largely due to the fact that these systems are tightly coupled.  Clearing increases tight coupling.  This almost certainly increases systemic risk.

More players have to move more money in more jurisdictions as a result of clearing mandates.  As the DTCC report makes plain, this is a new responsibility for many of these players, and they do not have the capability or experience or systems.  Greater operational complexity involving more parties, many of whom are relatively inexperienced, creates grave risks in a tightly coupled financial system.

The irony of all this is that the evangelists of clearing, including notably Timmy! and GiGi in the US, argued that central clearing would reduce the interconnectedness of the financial markets.  Wrong. Wrong. Wrong. Wrong.

It reconfigures the interconnections.  The entire collateral management system the DTCC document describes is a dense web of interconnections.  And to reiterate: under central clearing (and the mandate to margin and mark-to-market uncleared derivatives) these connections (couplings) are tighter than in the old system.  Both old and new systems are highly interconnected.  The connections in the new system are tighter, and are more vulnerable to failure as a result.

I’ll tell you what makes me have to go change my armor: the regulators seem oblivious to this.  To the extent they are focused on collateral, they are focused on initial margin. No! It is variation margin calls during periods of large market movements that will threaten the stability of the system. Now there will be more such calls–1000 pct more, according to DTCC–and more participants are involved, meaning that there are more links and nodes.  The tightly coupled nature of the system means that the breakdown of a few links can bring down the entire thing.

In other words, there seems to be a disconnect on interconnections, most specifically on how clearing has not reduced interconnections but reshaped them, and how the new system’s interconnections are much more rigid, tightly coupled, and time-sensitive.

Not to pick on Cœuré: his speech is just one example of that disconnect.  The thing is that most speeches by regulators and central bankers exhibit the same disconnect.  Target fixation on making CCPs invulnerable does not address the main systemic risk that an expansion of clearing creates.  That systemic risk involves the financial/funding and operational risks of meeting large margin calls in a stressed environment on a precise time schedule.

It’s about liquidity, liquidity, liquidity.  Clearing transforms credit/solvency risk into liquidity risk.  The operational aspects of clearing-the need to move cash and collateral around in large amounts on a tight time schedule-affects the demand for liquidity, and also create points of failure that can cause the liquidity mechanism to seize up, threatening the entire system.

This is what should be the focus, but I’m seeing precious little evidence that it is.  Someday we’ll pay the price.

After years of wending through to what is to an American an incomprehensible legislative process that involves a three body problem (the trialogue of the Commission, the EU Parliament, and member states), Europe has agreed on its version of the trade execution portion of Frankendodd: Mifid II.  (The clearing and OTC collateralization equivalents are covered under a different law, EMIR.)  A good summary is here.

It contains many of the objectionable features of Frankendodd, namely, a mandate that swaps be executed on SEF-like entities (Organized Trading Facilities, or OTFs, in Euro parlance), and commodity position limits.  The former were pretty much a done deal after the Pittsburgh G20 meeting, the latter a reflection of the global suspicions of “speculation” in commodities, but intensified by European NGO convictions that speculation in food is evil.  (The shade of Adam Smith is shaking his head, noting that his observation about the equivalence between the popular terrors and suspicions against speculation and  the popular terrors and suspicions involving witchcraft is as apt today as it was in 1776.  Except that witchcraft is probably much more socially acceptable these days.)

But the EU has added its own idiosyncratic idiocies to its law.  Two things stand out.

First, the EU has mandated open access to derivatives exchange CCPs, in an attempt to demolish the vertical silo model.  Yes, the mandate is delayed-by as much as 5 years-but “I will wait 5 years to be stupid” hardly seems to be much of  a defense.  As I’ve written for years-a year or two before SWP began, in point of fact-the vertical silo makes economic sense (from a transactions cost economics perspective), and the pro-competition justification for it (namely, to encourage competition in execution) is inconsistent with what economists have known since the 1960s (the “one monopoly rent” theorem).

Second, and even more inanely, Mifid II caps the dark pool share in the trading of any individual equity at 8 percent.  Overlooking the operational difficulties of enforcing a collective constraint on volume across multiple venues, this reflects a suspicion of dark pools (a pejorative name in itself) that is again not grounded in good economics.  In a second best world, where competition between exchanges is imperfect, off-exchange venues (block markets in the old days, internalization, dark pools) can be welfare enhancing.  The fact that many market participants find them the lowest-cost venue to transact in should at least give pause to regulators, and ask them to inquire why this is true, and do the appropriate cost-benefit analysis of the trade-offs involved.  But no, fools rush in.

It strikes me that the  Euros have created a new Pixar character.  Buzz Darkpool: “To stupidity and beyond!” Derivatives trading mandates and position limits are stupid, but they’ve decided to go beyond that.

Meaning that the US can perhaps adopt what I’ve often said is the Russophile motto: “Not the worst!”

One of the annoying things about the debate over HFT, particularly related to the quality of liquidity supplied by HFT traders, is the lack of any historical context.  HFT firms are criticized for pulling liquidity suddenly, particularly when volatility ticks up, thereby exacerbating price moves and the impact of order flow on prices.

The thing is, that market makers/liquidity suppliers have been doing this since time immemorial. Liquidity suppliers have always chosen flight over fight.

I’ve written about that in the past (focusing, for instance, on Black Monday).  This recent blog post provides some excellent historical color that illustrates the point quite well.

Having traded the markets since 1985, I would like to explain what market liquidity actually meant in the pre-electronic days and what it means in the world of electronic trading.

During the 1987 October crash, Black Monday, I was a junior trader in government bonds and futures. Black Monday was not a crash which was over in seconds or minutes; no, the world stopped turning actually for days. The mini crash of 1989 had a similar pattern. Chernobyl 1986, Gorbachev crisis in 1991 and UK election day in 1992, were all similar liquidity gap events seen by market traders.

The beauty of those days (the late 80s) for a trader, was that markets were very often in a ‘fast market’ condition. This meant that one was able to trade at any price and all rules were thrown overboard until the board officials were able to control the pit again. Without computers, we simply could not deal with the enormous amount of activity in the markets at those times and simply stopped (or delayed) sending price information out, not just for seconds, but minutes and even (during the week of Black Monday) days. Clearers had backlogs to clients for days.

What investors, customers, institutions looked at in those days were screen prices on systems like Reuters or Bloomberg: feeds fed by the voice of the official. If the official did not yell a price in the mic, the data group would not enter a price, and the world would never see this price. Under fast markets no prices were entered and the screen would just read ‘fast’ (if you were lucky). Future and option prices on screen were seen as tradeable prices and in slow markets they may have been pretty close to the truth. In fast markets they were inaccurate and it was not possible to trade the price indicated on the Reuters screen. Yet the world still thought this was the correct price.

Being in the pit, one cannot keep buying or selling an instrument, so traders would hedge their positions. Hundreds of times I have been in situations where there was simply no bid or offer in the instrument to hedge in. The signal from a broker out of the futures pit simply stated, ‘no bid, no bid’, yet all the screens where showing a bid or an offer. Was this liquidity? The world clearly thought it was, but we all knew there was panic on the floor and you were lucky to trade one lot.

Yes, I know Mr. Spanbroek is talking his book.  (The EPTA represents HFT firms.)  But what he writes about the good old days on the floor are accurate.  They were good days mainly for the guys on the floor, who would supply liquidity when it was profitable, but would head for the exits when the order flow was toxic.  Ditto traders upstairs in the OTC markets.  This is a characteristic of liquidity supply and liquidity suppliers pretty much everywhere and always.

This subject always brings to mind a legendary-and I mean legendary-trader, who told me in the early-00s he was all in favor of the markets going electronic because he was “sick of getting raped by the floor.”  About 2 years ago he told me that he couldn’t compete with HFT.  I guess there was a Goldilocks “just right” era in between, say 2002-2007 or so, but the criticisms of liquidity suppliers is a hardy perennial.  And there is some justice to the charges.  The point is that it is not new, and it is not unique to HFT.  It is inherent in the economics of liquidity supply.

And there is no easy policy solution.  A policy intended to fix one problem will just create others.  Again, the problems inhere in the economics of liquidity supply.