Wrong, wrong, wrong–or at least the correlation between the two is insufficient to demonstrate causation. This is another example of the error of reasoning from a price/price change.
The “logic” here is particularly dubious for derivatives (“selling vol” is a synonym for selling options) because they are in zero net supply. Quantity bought is equal to quantity sold. So “short volatility trades come roaring back” also means “long volatility trades come roaring back.” Determining what drives what is not immediately obvious.
Here’s another story. Some believe volatility is to cheap and want to buy it. Or some what to hedge volatility risk, and at the current low levels it appears attractive to do so. So rather than pushing into the vol market, shorts are being pulled in.
You can’t tell which is happening just looking at the level of vol and open interest. And here’s the key thing: derivatives are risk transfer markets. What is determined in these markets are primarily risk premia. And so to see who’s pushing and who’s pulling, you need to look at risk premia.
The long pull story should see the vol risk premium rise, specifically implied vols should rise relative to expected future vols (in the physical measure). A crude proxy for this is implied vols rising relative to realized vols.
The short push hypothesis predicts the opposite. It doesn’t predict that the level of implied vol should fall absolutely: it predicts that implied vols should fall relative to realized vols.
And according to CBOE’s vol maven Mandy Xu, it’s the former and not the latter:
Second, if volatility selling strategies were to blame for the low levels of the VIX index, you would expect the volatility risk premium (VRP) to shrink as the implied-realized volatility spread narrows (i.e. the VRP is what option sellers aim to monetize and thus should decrease as more sellers enter into the market). Instead, what we’ve seen over the past year is the opposite — the S&P 1M volatility risk premium (as measured by the difference between the VIX index vs SPX 1M realized volatility) actually increased quite meaningfully, from 1.5% in 2022 to 3.6% in 2023. Implied volatility may be low, but it’s not trading particularly cheap compared to realized volatility (SPX 1M realized vol went from averaging 24% in 2022 to just 13% in 2023).
Xu also notes that the vol curve has been more skewed to the call wing, i.e., out-of-the-money call vols have been rising relative to ATMs. This could be explained by a demand to hedge against volatility spikes from today’s current levels (a scenario that played out in the “Volmageddon” of 2018). (Pay attention class–by which I mean my real, actual classes–we’ll be discussing that after Spring Break.)
So the short vol crowded trade driving down vols story is certainly logically weak and factually unsupported, and the alternative that the rise in vol-related derivatives notionals is driven by buyers does have support in the data.
Remember children: never argue from a price change. Especially in derivatives markets with arguments based on open interest/volume.
There does appear to be some interesting intermediation going on. There has been a lot of activity in individual stock options (e.g., Nvidia). It appears that some buying pressure has been accommodated by hedge funds selling those options, and buying index options. This is a form of spread trading (in a way not dissimilar from the infamous basis trades) that hedge funds specialize in. It would tend to contribute to higher notionals in index vol positions–both long and short. There is also spreading between short-dated (especially “zero day”) options and longer-dated options.
Regardless of the underlying driver here (index vol bets or individual stock vol bets) it does appear that the surge in volatility trading has been buyer driven, not selling driven, as indicated by the behavior of risk premia.
There’s an old expression: “If it ain’t Boeing, I ain’t going.” Well, nowadays the only place you are going on a Boeing is to corporate hell.
Of course the severe problems with its civil aviation operation–specifically, the 737 Max and before that the 787 Dreamliner–are the current focus of attention. But Boeing is a full spectrum failure.
The KC-46 tanker program has been a disaster since day 1. The program was delayed for years, and was catastrophically over budget. Problems included a FOD (“foreign object debris”) issue, in which tools and random metal stuff was littered throughout the aircraft–indications that quality control problems are chronic at Boeing, and hence the 737 issues are not surprising. Another problem was faulty cargo locks–which meant that the aircraft could not carry cargo until it was fixed. Then there was a toilet problem. These are not complicated things.
The most mission-critical problem was with the supposedly advanced refueling boom system, which is operated by wire and a crewman located forward in the aircraft viewing the boom through a camera (not dissimilar from a rear view camera now nearly ubiquitous in automobiles) rather than by someone stationed in the tail with eyes on the boom and the approaching aircraft. However, the accuracy of this system leaves much to be desired, and resulted in some mishaps. The tanker can still refuel aircraft, but the accuracy issue has slowed down refueling operations, which is kind of a big deal because it effectively reduces the refueling capacity of the aircraft.
The company has supposedly lost around $5 billion on the program. And the Air Force is now looking to add KC-45 planes–built by Airbus.
Ironically, maybe if the engineers had retained more control of the company the problems that have the bean counters lamenting winning the tanker contract might never have occurred, or at least wouldn’t have been as bad.
The replacement for Air Force One is also way behind schedule and way over budget.
As was the CST-100 Starliner reusable space capsule. It’s satellite programs have also been plagued by problems.
This is correct as far as it goes, but begs the question of how this slow motion plane crash could proceed in plain sight without anyone pulling the company out of its dive. The likely underlying cause is a severe lack of competitive discipline.
The civilian passenger aircraft industry is a duopoly. Customers dissatisfied with Boeing in theory have an option to switch to Airbus, but even in the medium term the ability to do so is limited. For one thing, it would take some time for Airbus to expand capacity to accommodate a large switch of Boeing customers. And given the fixed and sunk nature of capacity costs, it was/is willing to do so only given a high degree of confidence that many Boeing customers would switch–which creates something of a chicken-egg problem. Moreover, switching costs are important. Airlines have made investments in everything from maintenance to pilot training that are manufacturer specific. The cost of a substantial switchover from one manufacturer to another involves more than the cost of the aircraft themselves.
Southwest is an extreme example. A key to its low cost operation was utilizing a single basic aircraft type (737). Adding any Airbus planes to its fleet would disrupt its entire operating model.
With respect to military contracting, the situation is even more extreme. Not only did the Boeing-McDonnell Douglas merger bring over the poisonous management documented in The Atlantic piece: it resulted in the combination of the two manufacturers of multi-engine jets adaptable to military use, most notably refueling planes.
Until recently, competition from Airbus for this business has been even more muted than for civilian aircraft due to the inherently political nature of defense procurement, and the understandable desire to keep this production capacity onshore.
All meaning that Boeing has had a lot of room for chronic performance problems because the lack of serious competitive threats mean that those problems don’t translate into the risk of severe top line losses even in the medium, and to some degree the long, terms.
In the late-90s I was offered the Admiral Crowe Chair at the Naval Academy. The Chair was a research position, with a focus on defense economics issues, and defense industrial base issues in particular. It was a time of an imagined “peace dividend,” and a downsizing of the defense industry. A major part of this downsizing was achieved by industry consolidation. Boeing-MD was just one part of that.
The pitch that got me the job (which I turned down for a mixture of professional and personal reasons) was that I would study the effects of this consolidation, and in particular the effects of declining competition. In the subsequent years I have watched the serial procurement nightmares that have plagued the US military which have largely borne out the concerns that I raised when interviewing for the USNA position.
Lack of competitive discipline enables dysfunctional management. That’s the underlying problem at both the civilian and military sides of Boeing. And it’s not a problem that is addressed easily.
During WWII, management dysfunction at Ford Motor Company (still ruled by the iron hand of Henry Ford and his henchman Harry Bennett) posed a serious threat to the U.S. war effort. The government intervened, and essentially forced out Henry I and Harry, and installed Henry II (“Henry the Deuce”) to straighten out the company. After the war, the Deuce brought in the “Whiz Kids” to drag it kicking and screaming out of the Henry I cult of personality. (My dad was a very junior Whiz Kid, hence my living in West Wayne and Dearborn in my early years.). That brought on its own problems, of course, but it was likely necessary to save Ford Motor.
The situation at Boeing isn’t exactly the same, but it rhymes. So who is going to carry out the necessary intervention? Hard to see who that would be. And the same fundamental market factors that have allowed Boeing to be mismanaged for years will exist even if there is a complete turnover in the top management and the board room. Meaning that since the underlying causes of Boeing’s fall are structural, it’s hard to be optimistic about things turning around anytime soon.
The review will take months and then will be open to public comment which will take further time, Energy Secretary Jennifer Granholm told reporters in a teleconference.
This policy, if one can dignify it with such an appellation, is a sop to the ecoloonies upon whom the administration depends for support:
The growth [in LNG exports] has set off protests from environmentalists, part of Biden’s base. Activists say new LNG projects can harm local communities with pollution, lock in global reliance on fossil fuels for decades, and lead to emissions from burning gas and from leaks of the powerful greenhouse gas methane.
In brief, the administration (regime, really) wants to kneecap the remarkable energy revolution of the past 20 years, which has seen technological innovations that have turned the US from a nation worried about where its next MMBTU would come from to a natural gas production powerhouse, and which have allowed others to share in its bounty with the world.
But you see, to the ecoloonies that’s the bad news. Really bad. Climate change, dontcha know.
But even evaluated on those (dubious) terms, the policy is demented. Because the ecoloonies don’t understand basic economics. They are myopic, linear thinkers who are incapable of analyzing the ultimate impact of their policy.
In their thinking, less LNG exports from the US equals less fossil fuel consumption equals lowers carbon emissions equals saving the polar bears. Even overlooking the (again dubious) last step in the logical chain (hey, I’m a a generous guy) the analysis is flawed. Where it definitely breaks down is the third, and arguably the second, steps.
Yes, reducing US natural gas output (by choking one source of demand) will reduce world natural gas production. But the resulting higher world price will induce higher output by competing producers (e.g., Qatar, Australia, PNG, Africa, etc.), resulting in a net decline in world gas production smaller than the decline in US production–and it is world production that matters when considering “well mixed” GHGs. Further, some production that would have otherwise been exported will be consumed domestically instead, meaning that a given decline in exports does not result in an equal decline in production.
But more importantly, the rise in the price of gas relative to other fuels–notably coal–will induce substitution towards those fuels. Since those fuels are more carbon intensive than natural gas, it is possible, and indeed likely, that the net effect of the policy would be to increase the output of GHGs.
So at the very least, the amount of reduction in GHGs resulting from this policy will be far smaller than the reduction in US LNG exports that it will cause, and plausibly will result in an increase of GHGs.
Well played! All pain, no gain!
But the economic idiocy of ecoloonies is an old story by now. Perhaps you’ve read of the recent finding that the ban on “single use” plastic bags in New Jersey led to a tripling of consumer plastics consumption because of the substitution effects that the ban induced. Again, myopic, linear, one-step ahead thinking led to a policy that produced perverse results.
The foregoing analysis focuses on only one dimension–GHG output. But one also has to consider the cost incurred to achieve any GHG gains (if there are any, that is). But trade-offs (costs vs. benefits) is not something that ecoloonies do. They are monomaniacs, and monomaniacs don’t evaluate trade-offs.
This policy will also shtup European allies, whom in the aftermath of the Russian invasion of Ukraine Biden promised would receive bountiful supplies of US gas.
To paraphrase Animal House: “You fucked up, Europe! You trusted Biden!”
The administration pinky swears that
the pause would not hurt allies, saying the plan will come with exemptions for national security should they need more LNG.
Yeah, because it’s just like turning the faucet on and off, right?
If you believe what they say, you are truly an idiot and probably believe they’ll respect you in the morning.
But none of this should be a surprise. After all, this is an administration that is infested with members of the “elite,” and which counts on the “elite” for its support. According to a recent Rasmussen poll:
An astonishing 77% of the Elites – including nearly 90% of the Elites who graduated from the top universities – favor rationing energy, gas, and meat to combat climate change. Among all Americans, 63% oppose rationing.
Face it. They hate your guts and want you to suffer. This “pause” on LNG exports is just another manifestation of their hatred.
Javier Milei gave a remarkable speech at Davos last week. I won’t say it was a stemwinder, because unlike in his media and campaign appearances, here Milei’s mien was that of an academic delivering a paper at a conference, rather than that of a chainsaw wielding revolutionary. On substance, however, it was extremely provocative–and indeed an anathema to the assembled “elites” in Davos.
Milei's 2024 Davos talk, directly translated to English by AI (by heygen), in his own accent. Better than the dubbed version imo. pic.twitter.com/8OAGELuqxl
Milei robustly advocated the primacy of freedom, and made the moral as well as the utilitarian case for capitalism, and presented a trenchant criticism of socialism, collectivism, and statism. Apostasy–hell, heresy–at Davos. So three cheers!
A good part of Milei’s speech channeled Deirdre McCloskey: he recapitulated McCloskey’s account of the economic miracle of market capitalism that caused a manyfold increase in living standards in a few centuries after millennia of stagnation.
Indeed, Milei presented a maximalist case for the market. Milei is a trained economist, and many who are not trained economists may have missed the import of some of his more arcane and academic arguments. I’ll try to summarize them, and offer some commentary.
As his foil, Milei chose neoclassical economics–the economics of Alfred Marshall, and indeed of two economists (Milton Friedman and Robert Lucas) whom Milei obviously admires given he named three of his beloved dogs after them. Specifically, he took aim at the concept of “market failure” in the vein of Pigou and innumerable economic textbooks since.
Milei is a market Panglossian: he says flat out that there is no such thing as “market failure.” Full stop. Economic failures are solely the responsibility of the state and destructive public policies. Another full stop.
This strongly echoes the Coasean critique of the Pigouvian concept of “market failure.” Neoclassical economics largely ignores transactions costs. What is sometimes referred to as the New Institutional Economics, of which Transaction Cost Economics is a subset, introduces transactions costs as a fundamental concept. When transactions costs are considered, no wealth improving transactions remain unexploited. In this sense it can be said that the market never fails.
Where this argument becomes tenuous is when one considers what determines transactions costs, and whether government regulation can reduce transactions costs and therefore increase the gains from trade and exchange available to be realized through market processes. For example, diffuse harms from air pollution make negotiated deals to maximize welfare challenging. There are free rider problems and large number bargaining problems and asymmetric information problems that make pure “market” arrangements challenging. Perhaps government regulation is a welfare-improving way of overcoming these challenges.
That is, it is possible that sometimes governments can reduce transactions costs, or can be viewed as a transactions cost economizing way of allocating scarce resources. In a transaction cost free world, the allocation of property rights doesn’t matter. With transactions costs, this allocation can affect welfare. By defining property rights, governments might allow the market to reach a better allocation of resources.
But of course, as Milei correctly notes, governments can hardly expected to be altruistic and omniscient, so they are also quite capable of implementing destructive measures rather than constructive ones.
Milei’s market Panglossianism may be exaggerated, but it has the great virtue of pointing out the fundamental analytical problems with textbook “neoclassical” invocations of and treatments of “market failure,” and like Coase did, directing attention at the vitally important consideration these analyses ignore–transactions costs.
Milei also gave a stirring defense of monopoly. In some respects this can be viewed as a specific example of transactions costs in action: as the answer to an old Chicago econ prelim question (maybe it is still used–dunno) demonstrates, in the absence of transactions costs, the “deadweight loss” from monopoly power in the textbook analysis would not exist. Instead, “monopoly power” or “market power” would have only distributive rather than efficiency effects.
But Milei’s defense was somewhat different. The textbook analysis of monopoly is a static one. Following Schumpeter, and certain strands of modern growth theory, monopoly is the engine (or the effect) of the innovation that has driven the massive expansion of wealth and the widespread elimination of poverty that Milei rightly focused on in the beginning of his speech.
This is another maximalist position, but yet again it identifies and amplifies an important consideration that is far too often ignored in public and policy debates.
I would note, however, that it sits somewhat uncomfortably with his view that all failures are government failures. One of the primary dangers of large business enterprises generally, including those that could be characterized as “monopolies,” is that they exercise undue power over governments, and cause them to implement wealth-destroying policies that help these enterprises. How does one reap the benefits of innovation that results from (or may cause) large enterprises without incurring the costs from rent seeking by these enterprises?
As an economist I can quibble with the extent to which Milei pushed some of his economic arguments. But this is mainly a matter of identifying exceptions to the rules he lays down: I definitely see the rhetorical and persuasive benefits of stating the maximalist case, especially to an echo chamber of anti market and anti freedom “elites” who themselves routinely make maximalist claims. It is a challenge to a “smelly orthodoxy,” and such a challenge must be vigorously and provocatively issued in over to stand out against the droning Davos hive.
Once the debate shifts to where Milei went too far, the fundamental truths of his arguments are at least implicitly accepted. And the fundamental truths are these: emergent market orders, including “failures” such as monopoly power, are and have been for centuries the main engine of human progress, and that governments have been the main obstacle to human flourishing .
And this, in turn, will shine a bright light on the dark truth of Davos and the Davosians. Namely, that they are fundamentally anti-humanists who believe that there are too many humans, and humans are too rich. That is, Milei embraces a view of progress that is antithetical to modern misanthropic progressives.
Too many normal people don’t understand that about the Davosians. Attempting to counter Milei’s arguments forces them to reveal that fact. When the only answer to “capitalism made us rich” is “being rich is a bad thing” the battle is all but won.
In the coming year the Supreme Court will rule in two cases that could result in the imposition of substantial constraints on the administrative state. Since federal administrative agencies are progressive pets, the prospect has the left freaking out. And I do mean freaking out.
The first case is Securities and Exchange Commission v. Jarkesy. Here Jarkesy is challenging the legitimacy of the SEC (and by implication other agencies) relying on internal administrative law judges (“ALJs”) to decide enforcement actions brought by the agency. Jarkesy argues that such cases should be tried in Article III courts (i.e., in federal court).
The Constitutional basis for his argument is compelling. Agencies flout the separation of powers: they combine legislative, executive, and judicial functions. In the case of enforcement actions like that against Jarkesy, the SEC brings the charges against the defendant/respondent, prosecutes the case, and if the agency uses an ALJ, tries the case and renders the judgment and assesses the penalty. The case is brought under regulations adopted by the agency in a quasi-legislative role (supposedly under powers delegated by Congress–an issue that is relevant in the other case I will discuss).
Jarkesy argues that being subordinate to, and accountable to, the agency, ALJs are not independent are subjecting him to their judgment violates his Constitutional rights, and in particular his right to due process.
As an empirical matter, Jarkesy has a compelling case. I recall that in an antitrust case, Justice Potter Stewart opined that the “only consistency” in such cases is “that the government always wins.” (That was in the 60s.). And that was before Article III courts. That is even more true in cases before ALJs in agencies like the SEC and FERC. (When is the last time a FERC ALJ decided against the agency in a big matter?)
Jarkesy therefore wants the trier of fact to be an ostensibly independent Article III federal court. He doesn’t want to have his fate decided by an ALJ who is effectively beholden to the commissioners who run the agency who are bringing the charges and prosecuting them.
Reasonable, no? But not to the progs. They are losing their sh!t over the prospect. Case in point, this article in the Atlantic–which is always a reliable barometer of prog opinion.
According to author Noah Rosenblum, this would represent The End of the World as We Know It.
It would “destroy the government”!!!!!!!! (He says this like it’s a bad thing!–JK).
Rosenblum’s argument veers between the hysterical and the dishonest.
This part in particular cracks me up:
Jarkesy’s second claim—that the internal adjudicator who first heard his case held too much independence—is especially galling. These adjudicators should be independent; the alternative would be to put their regulatory powers at the political whim of whichever administration might be in charge.
The relevant question is “independent from whom?” The very essence of Jarkesy’s argument is exactly that ALJs are creatures of “whichever administration may be in charge.” “The political whim of whichever administration might be in charge” is precisely the problem, not the “alternative.”
Article III courts are about as independent of the current administration (whether it be the presidential administration, or the commissioners of an agency) as is possible–and that’s by the Founders’ design. ALJs are definitely not.
Rosenblum loses control over his bowels at the thought that allowing those accused by federal agencies be judged by, you know, federal judges will gut the ability of agencies like the SEC to prosecute financial crimes:
The SEC was created as an independent agency in 1934, after the financial crash of 1929, to thwart the sort of market manipulation that preceded the Great Depression; Congress has granted it additional powers over the years to continue protecting financial markets. Responding to catastrophes and guarding against market manipulation is exactly the kind of work that Congress should empower the executive branch to do. Requiring Congress to legislate in response to every new fraud some crook might dream up would not be a good use of its time. And there’s no reason to think that delegating authority to police markets runs afoul of the Constitution.
Requiring those who “police markets” to prove their cases beyond the relevant burden of proof (preponderance of the evidence in a civil case) to a truly independent trier of fact does not permit manipulators and fraudsters to run rampant, any more than requiring your local police and prosecutor to prove charges before a judge allows murderers and rapists to run rampant.
Given the stakes in federal securities cases, which can easily run into the tens or hundreds of millions, if not more, requiring prosecuting agencies to clear such a hurdle is eminently reasonable.
What is Rosenblum so afraid of? These people would be prosecuted before Article III courts under the same laws and regulations that they are currently prosecuted before ALJs. A decision adverse to the SEC in Jarkesy would not eliminate the Securities Act, or the Exchange Act, or the SEC regulations adopted pursuant thereto. It would just require the SEC to prove cases brought under those acts and regulations in an Article III court rather than on the agency’s home court.
Rosenblum’s ultimate argument is that Jarkesy is a scumbag:
George R. Jarkesy Jr., a right-wing activist and conservative-radio talk-show host.
Heaven forfend that such a MAGA man should have rights! Oh! The humanity!
The kind of ad hominem chickenshit to which the left routinely resorts to today, and uses to stamp “QED!!!!” on its argument. By doing so, Rosenblum betrays the substantive weakness of his arguments.
I note that many seminal Supreme Court cases involving fundamental Constitutional rights have involved scumbags. And the Supreme Court ruled–rightly–that scumbags have rights too.
It is interesting to note that the CFTC now brings most of its manipulation cases–you know, “exactly the kind of work that Congress should empower to the executive branch to do”–in Article III courts. Now, as it happens, there is a tangled and unrepresentative story behind this, namely that the CFTC ALJs proved to be particularly dysfunctional and inveterately opposed to the agency’s enforcement staff. (I have intimate knowledge and experience regarding this history.). But the why is no matter. The reality is that an agency can bring manipulation cases (and fraud cases, for that matter) in federal court. Requiring the SEC (and other agencies) to do so will not “destroy the government” or allow wrongdoers to run rampant.
Indeed, the CFTC’s experience in federal court–most notably, its loss in the DRW/Wilson case–demonstrates the virtue of forcing agencies to play in the big leagues. It reduces the probability of Type II errors, i.e., false convictions.
I also note that there are rights of private action for certain federal securities, antitrust, and commodities law violations. Here private plaintiffs can bring cases in federal court against alleged malfeasors. I believe that such private rights of action are more reliable deterrents of bad conduct than agency actions, for a variety of reasons. (Again, this observation is based on considerable experience and observation.)
The other case that has the progs’ undies in a bunch is FDA v. Alliance for Hippocratic Medicine. This case threatens to demolish so-called “Chevron deference,” a reference to the case Chevron v. Natural Resources Defense Council in which Justice Scalia (!) on behalf of the court opined that courts should defer to agency judgements in cases in which Congress did not unambiguously delegate authority. That is, when there are “gaps” in a statute pertaining to a regulatory agency, Article III courts should defer to agency decisions regarding on how to fill those gaps.
The gravamen of Blinder’s argument is that agencies are experts, and we should defer to their expertise: we are not worthy to challenge them, nor are federal judges!
This has been the mantra of progressives since, well, the Progressive Era. Blinder is channeling his inner Woodrow Wilson. (Scary thought, that.)
There are two major problems with this. The first–and arguably less important–is that their “expertise” is vastly exaggerated. I mean vastly. Again based on extensive personal experience, I conclude that this is definitely the case when it comes to complicated markets (e.g., electricity, commodity derivatives). And yes, I realize that these complexities challenge federal judges, but the relevant question is who is better to resolve these issues: on that, I come down firmly on the side of the judges.
The second is what economists call “agency problems”–which in the present context can be called Agency problems. That is, the progressive view endorsed by Blinder (and Woodrow Wilson et al) is that agency decision makers are acting in the public interest.
This view has been laughable since the 1960s when Stigler posited “capture theory,” and then others like Sam Peltzman and Gary Becker looked at how the regulatory sausage is really made. The Public Choice literature has also utterly discredited the public interest view.
In a nutshell: regulatory agencies have their own agendas and own incentives that are not aligned with the public interest, for myriad reasons.
As valuable and insightful as they are, even the Peltzman-Becker-type analyses are inadequate. They are best suited to model the regulatory laws legislatures pass. They posit a decision maker looking to maximize political support (“votes”). That makes some sense when modeling legislatures that are somewhat accountable to an electorate. But the problem raised by Chevron deference is that regulatory agencies are incredibly insulated from such electoral feedback. If you view Congress as an agent of the public, agencies are agents of agents of the public. As a result, their incentives are extremely attenuated, and they have considerable scope to implement their own agendas regardless of whether they comport with the public interest or not.
Here’s my Cliffs Notes theory of regulation: a large unaccountable bureaucracy combined with Hayek’s “why the worst get on top.” Ideologues with agendas are attracted to agencies with power over their agendas. Ensconced in power, they are largely immune from external check. So ensconced, they wreak havoc, the public be damned.
People, I give you–the EPA.
That’s why deferring to these agencies is disastrous. Their “expertise”–really their specialization in subjects of particular interest to the ideologues who infest them–is positively dangerous when given free rein.
I hope that the Supreme Court decides in Jarkesy’s favor, and also hacks away at Chevron deference. That said, I realize that the Supreme Court usually splits the baby, and that ringing decisions that drastically curtail the scope of agencies’ powers are unlikely. Meaning that the war against the agencies–or more accurately, the war of the agencies against us–will continue.
This argument consists of two parts. The first being that the crude oil futures markets have been disrupted. The second being that the CTAs are the cats behind the disruption. Both plinths are defective.
Insofar as disruption is concerned, Bloomberg claims “Trading oil has perhaps never been more of a roller coaster ride than it is today.” Further:
Just in the past two months, prices threatened to reach $100 per barrel, only to whipsaw into the $70s. On one day in October, they swung as much as 6%. And so far in 2023, futures have lurched by more than $2 a day 161 times, a massive jump from previous years.
Bloomberg
Never more of a roller coaster ride? Well, let’s do something crazy. Like look at historical data.
The conventional measure of the wildness of the ride is volatility. The annualized daily volatility of crude oil during the alleged Rule of the Bots (the last two years) is 41.62 percent. The historical volatility (2010-2020) is 41.2 percent. (This omits 4/20/20 and 4/21/20, the day of the negative oil price and the following day.) Excluding the COVID months of 2020 produces a somewhat lower vol of 36 percent, not that much smaller than in the last two years. Further, extended excursions of realized volatility to above 40 percent are not unusual in the historical record. So to say that oil prices have been more volatile recently than has historically the case is categorically false.
With respect to the big daily moves, the Bloomberg analysis is fatally flawed because it looks at dollar price moves: big dollar price moves are more likely when prices are high than they are low, and by historical standards oil prices have been high in the last several years. It is appropriate instead to focus on percentage price changes (which is how vols are calculated, btw).
Rather than count the number of times an arbitrary threshold (like $2/bbl) is breached, it is more rigorous to look at a statistical measure of the frequency of extreme events: the “kurtosis.” Kurtosis bigger than zero means a distribution has fat tails relative to a Gaussian (“normal”) distribution, i.e., extreme moves up or down are more likely than under a normal distribution. The bigger the kurtosis, the more likely extreme moves are, i.e., the fatter the tails of the distribution.
Looking at the kurtosis of daily percentage changes rubbishes the Bloomberg analysis. The kurtosis in the last two years is 4.15, whereas from 2010-2020 it was 27.9! That is, the frequency of extreme daily price moves in years of alleged CTA disruption is far, far smaller than was the case prior to their alleged emergence as the dominant force in the. markets.
Interestingly, the kurtosis of dollar price changes is not that different between eras: 6.9 post-2020 vs. 7.2 2010-2020. So even extreme dollar price moves are less frequent in the alleged CAT era than previously. The difference is smaller, which demonstrates the need to take into account the level of prices in an analysis of “extremes.”
So the predicate for the article–that oil prices have been unusually volatile and unusually susceptible to extreme moves in the past couple of years–is not supported by the data.
As for the alleged causal factors, the dominance of CTAs is not evident in the data. CTAs are included in the “Managed Money” category of the CFTC’s Commitment of Traders Report. Here is a graph of the net position of Managed Money going back to 2006:
There was a peak in 2017-2018–a drilling boom in the US, to which I will return shortly–followed by a decline–a drilling drought–followed by a rebound to levels comparable to the 2017-2018 levels. Indeed, managed money net positions have actually been relatively low in the past year (with the exception of a recent spike) as compared to the post-2015 period as a whole. Certainly no Alice to the moon spike in CTA presence apparent here.
Bloomberg claims that the CTAs have become dominant in large part due to a sharp decline in producer hedging:
That coincided with the collapse of another source of futures and options trading: oil-production hedging. During the heyday of shale expansion about a decade ago, drillers would lock in futures prices to help fund their growth. But in the aftermath of the pandemic-induced price crash, a chastened US oil industry increasingly focused on returning cash to investors and eschewed hedging, which can often limit a company’s exposure to the upside in a rising market. By the first quarter of this year, the volume of oil that US producers were hedging by using derivatives contracts had fallen by more than two-thirds compared with before the pandemic, according to BloombergNEF data.
It should be noted that this claim that CTAs have achieved greater dominance due to an ebbing of hedging is implausible on its face. Futures are in zero net supply. If producers have reduced their net positions, necessarily non-hedgers–including CTAs–must have reduced their net positions.
Hedging has indeed declined. In the oil market, much (if not most) producer hedging is via the swaps market rather than direct producer participation in the futures market. Banks buy swaps from producers, and then hedge their exposure by selling futures. Here is a chart of net Producer and Merchant Plus Swap Dealer exposure from the CFTC COT data:
Note that there was a big increase in hedging activity (by this measure) in 2017-2018 that was reversed, followed by a partial resurgence, but in the last couple of years hedging activity has indeed ebbed, and reverted to its 2016 levels.
But note that this pattern of hedging mirrors closely Managed Money net positions. As is necessarily the case. If there is less hedging, speculators necessarily hold smaller positions. Meaning that this statement is nonsensical:
The recent wave of dealmaking by US oil producers threatens to further accelerate the decline in hedging. And it’s highly likely that CTAs will continue to fill the vacuum left by those traditional market players.
It’s not as if CTAs–or speculators generally–are “fill[ing] a vacuum.” If hedgers reduce positions, speculators do too.
The Bloomberg writers may dimly glimpse the truth, though they don’t realize it.
How did CTAs come to become so dominant? Like many current phenomena, the answer starts in the depths of the pandemic.
As shutdowns engulfed the world in 2020, fuel consumption collapsed by more than a quarter. All hell broke loose in the crude market. The benchmark US oil price briefly dropped to minus $40 a barrel and investors were in wholly new territory. Some funds that took longer-term views based on supply-and-demand fundamentals quickly pulled out.
Such bear markets proved to be “extinction events” for traditional funds, which made way “for algo supremacy,” the bulk of which are CTAs, said Daniel Ghali, senior commodity strategist at TD Securities. Russia’s invasion of Ukraine gave the CTAs another foothold. Spiking volatility in the futures market drove many remaining traditional investors to the exits, and open interest in the main oil contracts tumbled to a six-year low.
So if CTAs have indeed become more prevalent, it is because they have supplanted other speculators who exited the market. Futures are risk transfer markets. If some of those who previously took on the risk from hedgers have exited the market, either hedgers must hedge less or other speculators must step in. It seems that both things have been happening.
That’s not some ominous development–it’s markets at work. And CTAs shouldn’t be damned–they should be praised for stepping into the breach.
And another paragraph in the Bloomberg article suggests at what is actually happening here:
The unpredictability of this year’s market swings haven’t been kind to human traders, many of whom are making less money on oil than they did last year when they raked in record gains, according to market participants.
What is likely driving this story is whinging by the traditional specs, who have been outcompeted by the bots. “No fair! They are making money and I’m not! They must be cheating.”
Reminds me of my epigram from my manipulation book, where riffing on Ambrose Bierce’s Devil’s Dictionary I wrote something to the effect that a market is manipulated when it moves against me.
Again, this is markets at work. The fact that bots are doing well relatively to trad specs means that they are better at predicting market movements, or have lower costs of bearing risk, or both.
It does not mean that they are making the markets move.
So this Terminator Tackles the Oil Market narrative is really nothing more than Luddism. A new technology outcompetes the old. The incumbents complain. End of story.
On Sunday 19 November 2023 the flamboyant–outré, actually–Javier Milei won the presidential election in woeful, tragic Argentina. “Won” does not really fully capture the result–he trounced his opponent, winning almost 56 percent of the vote.
Milei is repeatedly compared to Donald Trump, but there is really no comparison. He is truly unique among prominent world political figures. So unique that mainstream sources don’t know how to pigeonhole him–though God knows they strive mightily to do so.
Since he is not a leftist, he is of course repeatedly called “far right.” But any epithet that is used to describe both the open borders, anti-collectivist Milei and the nationalist, anti-immigration Alliance for Germany (AfD) is obviously meaningless–except as a signal from the left that someone is beyond the leftist pale.
He is also referred to as a populist, but that also widely misses the mark. Milei is a self-described anarcho-capitalist, whereas most populists now and historically (such as the Populist Party in the United States in the 1890s) are openly hostile to capitalism and markets: modern populists hurl the “neoliberal” insult at those with pro-market views far milder than Milei’s.
Even Milei’s dogs’ names advertise his beliefs and intellectual heroes. They are Murray (for Rothbard), Milton (for Friedman of course), and Robert and Lucas (a twofer for the late Robert Lucas–one of my professors at Chicago). What, no Friedrich? Milei should have cloned another one! (These pets are all clones.)
When I wrote Milei is not a leftist, let’s say that rather understates the matter. Milei loathes leftists and leftism, and repeatedly refers to them on television and in public appearances in scatalogical terms, and calls them “leftards.” He despises collectivism, and asserts bluntly that leftists are out to destroy you. His mission is to destroy them first.
As someone so vehemently hostile to the left and well outside conventional political categories, Milei’s victory has triggered a mass moral panic, especially in the media. The New York Times’ coverage was (unintentionally) hilarious: “Some voters were turned off by his past outbursts and extreme comments over years of work as a television pundit and personality.” Well, obviously a lot more weren’t, but I guess one has to take solace where one can, eh, NYT?
Milei’s agenda is indeed a radical one, especially for a statist basket case like Argentina. To combat the country’s massive (140 percent annualized) inflation, Milei says he will dollarize the economy and eliminate (“burn down”) the central bank. He also wants to reduce radically the role of the state in Argentina’s economy. He says he wants to “chainsaw” the government–and emphasizes the point by campaigning with an actual chainsaw.
His election on this program sparked a rally in Argentine financial markets, with government debt rising modestly and stock prices rallying smartly.
But will Milei be able to deliver? Some early commentary has doubted his ability to govern based on the fact that his party’s representation in the legislature is well below a majority.
Yes, that may be an issue, but not the major obstacle to Milei’s ability to transform Argentina into what it was at the dawn of the 20th century–an advanced, rapidly growing economy and a relatively free society.
The real obstacle is one that is faced by anti-statists everywhere–the bureaucracy. (I do not say “civil service” because that phrase is at best aspirational and more realistically a patent falsehood. Akin to the Holy Roman Empire that was neither holy nor Roman, the “civil service” is neither civil nor a service.)
Argentina’s bloated state is its own clientele with its own interests–mainly self-preservation and an expansion of its powers. Moreover, it has created a whole host of patronage clients in business and labor. Milei’s agenda is an anathema to this nexus of public and private interests. They will go to the mattresses and make war to the knife to subvert Milei and his agenda.
Even a president with an electoral mandate–like Milei–faces formidable obstacles to implementing his agenda. The most important obstacle is what economists call an “agency problem” (which in the U.S. could be referred to as an “Agency problem”). The bureaucrats are agents of the chief executive, but it can be nigh on to impossible to get these agents to implement the executive’s directives if they don’t want to. Their incentives are not aligned with the executive, and are often antithetical. As a result, they resist and often act at cross purposes with the executive.
The modern chief executive’s power to force his bureaucratic agents to toe the line is severely circumscribed. At best, the executive can make appointments at the upper levels of the bureaucracy (such as the heads of ministries or departments), but the career bureaucrats who can make or break the executive’s policy are beyond his reach, and not subject to any punishment if they subvert the executive’s agenda.
This problem is not unique to Argentina. Indeed, it is the main defect in the governance of virtually every country in the world. Cf. Suella Braverman in the UK, who was recently defenestrated as Home Minister for daring to offend the sensitivities of the British civil servants. (I again emphasize this phrase’s oxymoronic nature.)
But the travails of the likes of Braverman (or Trump) are likely to pale in comparison to Milei’s in confronting the gargantuan Argentinian state and bureaucracy. Even if he avoids Trump’s fault of repeatedly appointing those hostile to his agenda to the positions in the bureaucracy he can hire and fire, Milei will still face the immense task of bringing those myriad bureaucrats outside his direct reach to heel.
There are indications that Milei understands this problem, and has devised a solution. Rather than attempting to control particular bureaucracies, he states that he wants to eliminate government departments (like the Ministry of Education) altogether. This is likely the only way to succeed, but whether he can cut the bureaucratic Gordian Knot a la Alexander brings us back to the question of his doubtful legislative backing.
Indeed, Milei needs to be more than a mere Alexander. He must be a Hercules to clean the Augean Stable of the Argentinian state. I don’t hold out much hope–Hercules is a mythical figure, remember. But it is at least refreshing that someone has been elected to play Hercules, and one who is eager to take on this labor. Would that this starts a trend worldwide.
Gary Gensler has been a menace to the market system for as long as he has been in government. Those of you who have followed this blog for a long time know that I relentlessly criticized him during his tenure as CFTC chairman. He apparently took notice, because he banned me from the CFTC building. I also consider it extremely likely that he was the moving force behind the 2013 NYT supposed hit piece on me–for which I should probably thank him, because on net that has turned out to be a major positive.
Gary Gensler. (Though this is how I like to think of him.)
At CFTC, Gensler was merely an Igor implementing the Frankendodd creation of his congressional masters. As head of the SEC, however, Gensler has become a full-fledged Dr. Frankenstein, stitching together regulatory monsters that threaten to stalk the landscape leaving economic devastation in their path.
I have already written several times about the SEC’s misguided Treasury clearing mandate. But that is only one of Gensler’s Monsters. There are many others.
Perhaps the most monstrous is the SEC’s proposed rule on climate-related disclosures. This would mandate that public companies disclose their carbon emissions–and those of their suppliers. This is at best vast speculative endeavor, and and worst an impossibility. It’s main concrete effect will be to provide a pretext for lawsuits against companies targeted by activists who will allege that the companies’ calculations were wrong, or were lies because alternative internal calculations came up with numbers that differed from those reported in their 10Ks.
The regulation would also require companies to make fulsome disclosures of their climate risks. Another speculative endeavor that cannot produce any meaningful or useful information. It requires each company to characterize the interaction between one complex system–climate–and another complex system–the economy–to predict the adverse consequences of this interaction for it, a small part of the economic system allegedly impacted by climate. Prognostications about climate are themselves wildly uncertain–indeed, arguably the biggest risk is model risk. Predicting how climate will impact economic outcomes at the company level under myriad possible climate scenarios is a mug’s game.
And indeed, it is even worse than that. For there is another element to the problem–government policy. This introduces an element of reflexivity that is particularly devilish. Government policy will respond to climate and economic outcomes as well as interest group pressure, and will affect economic outcomes (though whether these policies will actually affect climate outcomes is dubious). This is arguably by far the biggest risk that companies face.
Meaning that if the regulation comes into force, I recommend the following boilerplate disclosure for all companies: “We face the risk that some government agency will adopt a boneheaded policy that will dramatically raise our cost of doing business or eliminate the markets we service.”
This will also be a boon to lawyers. “Company X failed to disclose the risk associated with [insert climate scenario here] described in [poorly executed paper published in obscure journal].”
And I ask: how will this information improve the allocation of capital? It is more likely that this will just add noise that impedes efficient capital allocation, rather than actionable information that improves it. The hive mind of investors is likely far more adept at evaluating the effects of the climate-economics-policy nexus than the managers of corporations.
I further note that this obligation’s burdens are greater for small companies than big ones. Meaning that it will likely lead to exit and consolidation, and greater concentration. Which other parts of this administration–notably Lina Khan’s FTC–think is a great evil. Ironic, that. Ironic, but not humorously so.
Moving right along, the trendy Gary has targeted the New Thing, Artificial Intelligence. In public statements Gensler has made the at least somewhat plausible argument that interactions between very similar AIs can produce destabilizing positive feedback mechanisms. But the SEC’s proposed AI regulation instead focuses on potential agency problems:
Today’s predictive data analytics models provide an increasing ability to make predictions about each of us as individuals. This raises possibilities that conflicts may arise to the extent that advisers or brokers are optimizing to place their interests ahead of their investors’ interests. When offering advice or recommendations, firms are obligated to eliminate or otherwise address any conflicts of interest and not put their own interests ahead of their investors’ interests. I believe that, if adopted, these rules would help protect investors from conflicts of interest — and require that, regardless of the technology used, firms meet their obligations not to place their own interests ahead of investors’ interests.”
But under the guise of minimizing conflicts of interest, the SEC now proposes requiring advisers and broker-dealers to write new internal procedures and to log all uses of technologies relating to predictive data analytics for agency review. If left unchallenged, the new rules would hamper the American financial industry’s world-beating innovation.
The definition of what must be disclosed is comprehensive:
“an analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes in an investor interaction.”
This would basically encompass EVERY analytical function performed by covered entities, including e.g., quant traders’ algorithms, portfolio optimizers, and on and on and on. Basically any use of statistical methods is implicated (note the reference to “correlation matrix”).
Perhaps the “investor interaction” language will limit this to principle-agent applications (as bad as that would be), but it is so broad that it is highly likely that the SEC will interpret it to cover, say, an HFT firms algorithms to predict and analyze order flows. That involves “an investor interaction.”
This all brings to mind previous regulatory initiatives to require disclosure of all trading algorithms–something that was mercifully killed.
And what will the SEC do with this information? This would represent a massive amount of highly technical information that the SEC would not have the capacity or expertise to analyze proactively, and information that would metastasize inexorably. Hell, even storing the information would be a challenge.
Again, like the climate reg, this seems all pain no gain. This disclosure would entail massive cost. And for what? To find an agency violation needle in a massive informational haystack? Agency violations (such as trading ahead) that could not be detected using existing methods?
“Currently, the playing field upon which broker-dealers compete is unlevel,” said SEC Chair Gary Gensler. “Through volume-based transaction pricing, mid-sized and smaller broker-dealers effectively pay higher fees than larger brokers to trade on most exchanges. We have heard from a number of market participants that volume-based transaction pricing along with related market practices raise concerns about competition in the markets. I am pleased to support this proposal because it will elicit important public feedback on how the Commission can best promote competition amongst equity market participants.”
Volume discounts are obviously pervasive throughout the economy in the US and indeed the world. So why should these be somehow so nefarious in stock trading as to require their elimination?
Let’s apply some economics–which alas is an alien concept to Gensler. There are two basic reasons for volume discounts.
One is that it is cheaper to service bigger customers. In which case volume discounts are efficient, and banning them would be unambiguously bad.
Another is that it is a form of price discrimination. For example, big intermediaries may find it easier/cheaper to shift business between exchanges than smaller intermediaries, in which case their demand for the services of a particular exchange would be more elastic than the demand of the smaller firms. Exchanges would then rationally charge lower prices to the more elastic demanders.
The welfare effects of this type of price discrimination are ambiguous, making the case for banning it–even if it can be established that the volume discounts are demand-elasticity-driven discrimination vs. cost-based discrimination–ambiguous as well.
With respect to “concerns about competition,” well, elasticity-based discrimination requires that inter-exchange competition not be perfect in the textbook sense. But if that is what is driving the volume discounts, outlawing them treats a symptom of market power rather than market power itself, and how “imperfectly competing” exchanges will price when they can’t price discriminate is very much an open question–and exactly why the welfare effects of price discrimination are ambiguous.
Gensler seems to be channeling discredited Robinson-Patman like logic that protected the high cost against competition from the low cost. That is anti-competitive, not pro-competitive.
These are only some of the monsters the Frankensteinian Gensler is assembling in his DC laboratory. I could go on, but you get the idea.
There is hope, however. Whereas Gensler’s CFTC actions were largely rooted directly in very specific statutory directives, his work as Dr. Frankenstein is based on extremely expansive interpretations of the SEC’s statutory authority dating back to the 1930s. Such expansive interpretations–not just by the SEC, but many other agencies–are currently being challenged in the courts, including cases pending before the Supreme Court.
It is possible therefore, and indeed to be fervently hoped, that the Supreme Court will hand down decisions that demote Gensler back to Igor implementing very specific Congressional mandates, and end his career as regulatory Frankenstein.
And the benefits of such decisions would extend beyond reining in the SEC, for as bad as it is that agency is probably not the worst offender–the EPA probably is, but the competition for this dubious honor is intense. The administrative state–the American Mandarinate, as I like to think about it–needs to be culled. And with extreme prejudice, and as soon as possible.
Regardless, one question that hasn’t been asked in all the to-ing and fro-ing about Treasury basis trades is why they exist at all, let alone why they get so big. This graph (courtesy of FTAlphaville, based on CFTC data) provides a major clue:
Note the mirror image between leveraged funds (mainly hedged funds) and asset managers (ostensibly non-leveraged funds–the reason for the “ostensibly” will become clear shortly).
To the extent that hedge funds’ short positioning reflects basis trades, the graph suggests the following. Hedge funds take a leveraged market neutral position, buying bonds, funding them via repo, and selling futures. Futures are in zero net supply: the graph shows that the longs on the other side of the hedge funds’ futures short are asset managers.
Most asset managers do not, and in some cases even cannot, take leverage directly. So for example they are constrained in their ability to just buy Treasuries with borrowed money (e.g., via repo). But the basis trade allows them to lever up via futures. So in some sense, the basis trade is just an additional link in a chain of intermediation. Laundering leverage, if you will.
(A more complete picture might add swap dealers to the picture. Some managed money, such as leveraged ETFs, enter into swaps with dealer banks. The dealer banks in turn can hedge by taking offsetting futures positions.)
The hedge funds expect to earn a small margin on the trade–on average, though there is risk. The market is pretty competitive, so to a first approximation that margin (the difference between the actual futures price and the theoretical futures price derived from bond prices, bond vols and correlations, and repo rates) equals hedge funds’ marginal cost of supplying this intermediation. The asset managers on the long side of the futures trade are willing to pay “too high” a futures price (relative to bond prices) because this is a cheaper way of achieving a leverage target than via the available alternatives.
The March 2020 experience shows that the basis trade can be a fragile one that creates some systemic risk: this is why regulators are concerned about basis trades now, to Ken Griffin’s chagrin. Providing this leverage intermediation/laundering creates tail risks for the hedge funds that do so. This raises the question of whether there are regulatory constraints that inefficiently constrain the ability of asset managers to take leverage more directly, rather than via a longer dealer (or money market) to hedge fund to asset manager chain. If so, such constraints could give rise to unnecessary (systemic) risks.
If regulators are concerned about the systemic risks in basis trades, they should take a systemic approach–and understand more fully why basis trades exist in the first place, and why they have periodically become so large. Looking at individual links in the chain (hedge funds, or by Griffin’s lights, banks) can be misleading because it begs the question of why the chain exists in the first place. The link that is driving the process is likely the one that has escaped discussion so far–the asset managers at the end of the chain. Why do they want leverage and why is the basis trade the most cost effective way of supplying a lot of it? Could it be the most cost effective because other, more directly intermediated sources of leverage are unduly expensive because of regulatory or institutional constraints? Definitely worth regulators’ attention.
The market for United States Treasury securities (notes and bonds) has been a source of concern for some years, dating back to the Treasury “flash” event of 15 October 2014, but especially in the aftermath of the “dash for cash” during the March 2020 Covid scare. The relentless selloff of Treasuries in the past year plus has contributed to the angst.
This has led the SEC to propose various changes to the structure of the Treasury market. The most important of these is mandated central clearing of most Treasury cash trades and repos. Well, since Gigi is back in the clearing saddle, I guess I have to mount up too.
Just as with the Frankendodd clearing mandates, the case for Treasury clearing is very weak.
The basic argument is that Treasury market liquidity has eroded, and that clearing will enhance market liquidity. The supposed main cause of the decline in liquidity is that primary dealers face balance sheet constraints that limit their ability to intermediate the Treasury market.
In the Duffie paper and the Duffie, Fleming et al paper he cites, the main evidence of the deleterious effects of balance sheet constraints comes from the “dash for cash” in March 2020. Summarizing a variety of measures of market liquidity using principal components analysis, they show that liquidity usually varies inversely with market volatility, but liquidity declined far more than predicted by volatility alone in 2020. This was due, it is claimed, to the fact that dealers were not able to increase their holdings of Treasuries due to balance sheet constraints. Their ability to make markets was therefore constrained.
There is a big problem with this analysis. Dealers ended up holding far more Treasuries because Covidmania caused a sharp drop in the demand to hold Treasuries by hedge funds and others–they wanted to substitute cash for Treasuries. Part of the demand drop was accommodated by a price decline, but evidently dealers’ demands did not drop as much as the demands of non-dealers: thus, there was a major portfolio adjustment, with hedge funds etc. reducing their holdings and dealers absorbing as much of these sales as their balance sheets allowed.
Thus, this was a structural change in demand that led to major portfolio adjustments. Yes, the portfolio adjustments were accompanied by a decline in conventional measures of liquidity (bid-ask spreads, depth, etc.) but this decline in liquidity was a consequence of the underlying shock, and clearing of cash Treasuries or repos would have had little, if any, impact on this decline. Even if clearing increased dealers’ balance sheet capacity (something I discuss further below), given the underlying Covid-driven (and Covid policy-driven) demand shock it is highly likely that this incremental capacity would have been fully utilized as well and liquidity would have been about as bad.
This extraordinary shock that led to strained dealer intermediation capacity is different than the types of shocks that dealers typically intermediate. The role of Treasury liquidity suppliers–be they dealers or prop trading firms–is the same as the role of liquidity suppliers in any other market, be it stocks or currencies or commodities: to utilize inventory adjustments (balance sheet) to absorb temporary, temporally uncorrelated, and largely cross-sectionally uncorrelated investor (buy side) demand shocks. The dash for cash was a long-lasting shock highly correlated across major investors in Treasuries. It was a systematic shock that led to a long lasting adjustment in dealer portfolios, whereas market makers absorb idiosyncratic shocks that do not require long lasting adjustments to dealer portfolios.
That is, the kind of portfolio adjustments that occurred in response to Covid were fundamentally different in nature from the kind of portfolio adjustments that firms undertake to make markets. A long term transfer of risk rather than a short term transfer.
Therefore, using the dash for cash as the basis for policies intended to improve Treasury market liquidity is fundamentally misguided.
Be that as it may, it provides the underlying logic advanced for clearing mandates: improving liquidity requires increasing dealer balance sheet capacity, and clearing can supposedly do that.
How can clearing improve balance sheet capacity? The mandate defenders offer that hardy perennial as a justification: netting. For both cash Treasuries and repos, the argument goes, netting out offsetting exposures reduces the amount of capital and cash that dealers require to intermediate. For cash transactions, Duffie, Fleming et al estimate that netting would reduce daily settlement volumes substantially (70 percent in March 2020 according to their figures). This, and other factors, allegedly result in freeing up of dealer balance sheet capacity.
This analysis begs an important question: since dealers would internalize the benefits of more economical use of balance sheets that would result from clearing, why is it necessary to mandate it? Why don’t dealers and other market participants voluntarily utilize clearing more extensively in order to economize on the use of a scarce resource–balance sheet? After all, historically voluntary adoption of clearing in the stock market (e.g., NYSE clearing and CBOT clearing in the 19th century) was specifically intended to reduce settlement volumes by netting. In the case of the CBOT, the clearinghouse netted payment obligations but did not mutualize credit risk on derivatives transactions or impose margins (which were negotiated bilaterally).
The alleged failure of profit-motivated entities to reduce cost (from inefficient use of balance sheets) suggest that this does not come for free: at the margin there must be some cost for clearing that is greater than the putative benefit. That is, profit maximizers will balance marginal private benefits and marginal private costs. The benefits of netting from clearing are private, and thus the current degree of penetration in clearing likely reflects an efficient balancing of these marginal benefits and costs. The advocates of a mandate surely have not shown otherwise.
I further note that, as I wrote repeatedly during the Frankendodd era, netting redistributes default risk rather than reduces it. It is by no means clear that the distribution of default risk under central clearing/netting is more efficient than that under bilateral clearing.
Put differently, the advocates of clearing (both cash and repo) have not identified a “market failure”, e.g., a benefit from clearing that market participants do not internalize. Such a failure is a necessary (but not sufficient) condition for regulatory intervention such as a clearing mandate.
With respect to repo clearing, another supposed benefit is the disparity of margins (“haircuts”) in the repo market. Haircuts for some counterparties are low, but for others they are higher. Central clearing would impose uniform, value-at-risk (“VaR”)-based margins.
The operative theory behind central clearing is that the “loser pays”, namely the resources (margin, default fund contribution) posted by a counterparty is sufficient to cover any losses in the event of that counterparty’s default. Ideally, counterparty credit risk in central clearing is zero, though in reality some always remains.
Well, this begs another question: is the optimal amount of counterparty credit risk/default risk zero (or close to zero) in all transactions? Relatedly, is it optimal not to permit the pricing of counterparty credit risk, where the price varies by the creditworthiness of counterparties, with high credit quality entities paying smaller haircuts than lower quality credits? Central clearing makes pricing independent of creditworthiness, whereas bilateral arrangements that advocates of clearing dislike allow pricing of credit risk that reflects assessments of creditworthiness of counterparties.
Since credit risk mitigants (including margins/haircuts) are costly, and since market participants trade-off the costs and benefits of credit risk and its mitigants, allowing choice and competition on this dimension has strong justifications. Certainly the advocates of mandatory Treasury clearing have not identified a “failure” in this market that justifies regulatory intervention in the form of clearing mandates.
Put differently, clearing mandates force market participants to a corner solution–clear everything, and impose margins that make counterparty credit risk de minimis. The existing state of the market, where market participants can choose to clear with a CCP or not, reveals that they strongly do not prefer the corner solution. Furthermore, the advocates of clearing have failed to identify any market failure that implies that the interior solution/equilibrium is inefficient and can be improved by mandating the corner solution.
And the advocates have yet again failed to recognize the trade-off inherent in clearing: that is, the trade-off between counterparty credit risk and liquidity risk. This despite the fact that the reality of this trade-off has been made abundantly clear (no pun intended) repeatedly in the past–and including in particular the Treasury market basis trade turmoil during the dash for cash.
The real issue in Treasury markets right now, and the real threat to their stability, is the massive deficits in the United States, and the resultant increase in Treasury security issuance and Treasury securities outstanding. It is deficits and issuance that are driving the massive increase in the size of Treasury markets, and the consequent strains on the ability of dealers and others to intermediate the swollen market.
This is a challenge that no rearranging the market structure furniture on the deck of SS Treasury Titanic will fix. Furthermore, the economic case for mandating clearing of Treasury cash and repo transactions is laughably weak even if one overlooks that fact that clearing does not get at the real problem. But it appears that Gigi (cheered on by the Fed) will mandate a corner solution that makes the market less efficient, not more.
