Streetwise Professor

A member of my vast, globe-straddling network of sources informs me that at this morning’s session of International Petroleum Week in London, John Kingston of Platts referred to my estimate of the economic surplus created by new pipeline investment.  That number is almost a year old, and Kingston’s mention prompts me to update that computation.

It is a basic welfare triangle calculation that depends on quantity-pipeline capacity-and price differences between LLS and WTI.  At present, the LLS-WTI spread is slightly north of $20/bbl.  The forward spread is above $7/bbl (and nearly $8/bbl) as far out as December 2015.  (These are based on settlement prices from CME Clearport.  There aren’t a lot of trades that far out, so those numbers have to be treated with some caution.  That they are in the ballpark of the forward Brent-WTI spread provides some confidence, but of course, CME might have used the Brent-WTI spread in calculating the settlement price for forward LLS-WTI spreads that didn’t trade.)

According to the EIA, there are 1.150 mm bpd of planned pipeline capacity additions from Cushing to the Gulf, and another 830 m bpd planned capacity additions from Permian to the Gulf (back in the day much Permian oil flowed into Cushing, so the Permian capacity additions are another way of easing the Cushing bottleneck)

Given the uncertainty about when that capacity will come on line, I will make a couple of calculations that will bound the value they create.

If all the capacity is expected to come online by December, 2015, the welfare gain is (.5)($20+$7)(1.98mm)-($2)(1.98mm)=$22.77mm/day.  (The $2 is an assumed marginal cost of transportation.)  Note that there is remaining value to adding even more capacity under these assumptions.  If Q additional bpd of capacity is required to drive the spread to marginal cost, the gain from adding this Q units of capacity is (.5)($7+$2)Q-($2)Q=$2.5Q.

If the capacity is expected to come on line sometime after December, 2015, and it is expected that the spread will go to marginal cost when it does, the value of the capacity is (.5)($20+2)(1.98mm)-($2)(1.98mm)=$17.82mm/day.

Big numbers.

It is possible to calculate a similar number for pipeline capacity going into the Midcontinent.  EIA reports that 1.19 mm bpd of capacity from Canada to Midcon is planned.   Western Canadian Select quotes are available via CME only through February, 2015, and are under -$20/bbl for the entire 2 year period: the nearby number is $-26/bbl.  I’ll make a WAG as to what the spread should be once the transport bottleneck is eliminated (because there are quality differences, and the distances are substantial, I don’t know off the top what that should be)-my WAG is $5/bbl.  That gives us (.5)($26+$5)(1.19mm)-($5)(1.19mm)=$12.5mm/day.  That number swings (.5)(1.19mm) for every dollar change in my WAG.

There has been a great deal of optimism regarding the future of oil and gas production in North America, and the US in particular.  Fracking has already turned the gas world upside down, and is starting to do the same in oil.  The IEA has made very optimistic forecasts, and the main cloud it sees on the horizon is that the US is not investing enough midstream and downstream to absorb the unexpected upstream bonanza.  Citigroup’s oil analysts just released a similarly sunny prognostication.  (I usually don’t see eye-to-eye with Ed Morse on the speculation issue, but he is very credible on the fundamentals of the physical market.)

OPEC is taking a contrarian view in its latest monthly report:

In its latest report, the group of major oil producers forecast the shale boom in the U.S. would help increase oil production by 520,000 barrels a day this year, giving the U.S. the highest production growth among the non-OPEC countries, but it also played down the positive side of these developments by warning of the challenges facing the industry.

“There are remaining risks associated with the growth forecast on the back of weather, technical, environmental and price factors,” the report said. It said that the heavy decline rate associated with the first year of shale oil production from individual wells in the first year was a major factor that could impact growth.

The decline rates are well-known, and E&P companies are basing their drilling investments based on the best available information.  Yes, decline rates could be faster than assumed, but they could be slower too.  Moreover, the technology here is extremely dynamic, and there is a substantial potential for advances in drilling and reservoir management that could make the forecasts of IEA and others appear unduly conservative.   Learning by doing and the accumulation of knowledge on how to exploit fracking technology, generated by the experiences of numerous companies, lay the foundation for positive productivity shocks.

OPEC’s sour attitude on unconventional oil bears an uncanny resemblance to Gazprom’s initial reactions to shale gas, reactions that were hardly persuasive early in the boom, and which look more pathetic by the day.

It seems that like Gazprom, OPEC is trying to spread Fear, Uncertainty, and Doubt about unconventional oil, in an attempt to try to scare off investment.  Their efforts are likely to be no more successful than Gazprom’s.  The people committing the capital know more about fracking and the formations where it can be used than OPEC, and are learning more every day.

And while we’re on the subject of OPEC and uncertainty, perhaps it could address things it might actually know a lot about, like the reliability of Saudi reserve estimates and the effects of political risk on production in places like Venezuela and Nigeria.

Sunshine: The New Subprime.

Spain can no longer afford greendoggles:

The Spanish government’s latest bid to cut its growing debts to the country’s energy sector is expected to slash profits at renewable energy companies as Madrid continues to grapple with a €28bn deficit built up through years of subsidies.

Spain’s most recent reform to the energy sector will force renewable energy operators to choose between a fixed price or market price for their power – and remove a previous subsidy – while renewables subsidies will also be delinked from consumer price inflation and instead aligned with Spain’s core inflation measure.

Shares in Acciona, Spain’s second largest wind power operator, have tumbled almost 20 per cent, with Abengoa, Spain’s largest solar thermal power plant developer, also falling sharply since the changes were announced at the end of last week.

This story about the travails of the Utility Formerly Known as TXU doesn’t mention renewables-notably wind-but it should:

Energy Future Holdings Corp., the struggling Texas power company involved in a record leveraged buyout, could end up splitting as it faces significant choke points on debt and seeks counsel from Wall Street restructuring advisers.

The former TXU Corp. has been getting advice from big-name law firms and investment banks ahead of May, when it must start making cash payments on certain debt. In addition, the company faces nearly $4 billion in debt maturing in October 2014. The Dallas-based company was purchased by the private-equity firms and others in 2007 for $32 billion plus about $13 billion of debt.

After a series of complicated transactions over the past several years that rearranged its finances, the company now appears poised to start contemplating a major debt restructuring, be it through a bankruptcy filing or another means, according to a person close to the situation.

The article rightly notes that the collapse in natural gas prices has cratered generating margins (spark and dark spreads, and especially the later).  This is the main reason for EFH’s problems, but not the only reason.  The large increase in wind generation-which benefits quite nicely from  federal subsidies-has put downward pressure on power prices in Texas, and has led to negative prices for power with some regularity.  This is particularly important because Texas operates an energy-only market, with no capacity market, meaning that capital costs must be recouped from energy prices.  With wind subsidy-supressed prices, traditional generation has a hard time paying for itself.  As PUC Commissioner Donna Nelson said:

Federal incentives for renewable energy… have distorted the competitive wholesale market in ERCOT. Wind has been supported by a federal production tax credit that provides $22 per MWh of energy generated by a wind resource. With this substantial incentive, wind resources can actually bid negative prices into the market and still make a profit.

We’ve seen a number of days with a negative clearing price in the west zone of ERCOT where most of the wind resources are installed…. The market distortions caused by renewable energy incentives are one of the primary causes I believe of our current resource adequacy issue… [T]his distortion makes it difficult for other generation types to recover their cost and discourages investment in new generation.

The impact is greatest in the western part of the state, but wind weighs on prices throughout the state.  Except when it’s hot, because that’s when the wind doesn’t blow-but the power is particularly needed.  And wind also imposes substantial reliability challenges, requiring backup generation resources-which find it difficult to recoup costs due to prices that are often artificially low due to the wind subsidy.

The subsidies completely distort price signals, which in turn distort investment incentives and raise the serious risk of shortages of reliable generation resources that can operate hot or cold, rain or shine.

Other than all that stuff, wind is great.

But regulators are hell-bent on tipping the scales in favor of wind:

It’s no secret why FERC is likely to rule against the homeowners in Iowa and Minnesota. The Obama Administration’s green vision is to make wind and solar an ever-larger share of U.S. electricity production, regardless of costs. Think high-speed rail for the electric power network. The only way to make that happen without a political backlash is to spread the costs far and wide.

Wind and solar power are too expensive to compete with natural gas, coal, nuclear and hydropower without government help. The wind lobby already won an extension of its $12 billion production tax credit as part of the recent tax increase. More than half the states also have renewable energy standards forcing residents to purchase wind power. And now the greens want another subsidy for transmission lines.

Because wind makes such economic sense.  The fact that subsidies (and, in some places, the indoctrination of children) are required to support wind development tells you just how much economic sense it makes.  It is a greendoggle of the first order, and one that you might want to think about when the lights or AC go out, especially in Texas on a hot summer’s day.

While I’m on the subject of commodity spreads and transformations, I’ll turn my attention to another spread story in the commodity news: cash premiums in aluminum.  This is a matter of great interest to people in the aluminum business, but even though I highly doubt such people make up a big fraction of my readers, it’s worth some analysis here because the broader and politically charged topic of the “financialization” of commodities has come to the fore in this debate.

In brief, there is a big differential between the price of aluminum “in store” in LME warehouses, and the price of newly produced aluminum at the factory gate.  Metal outside LME warehouses trades at a big premium to ingots inside them: the premium is about $300 on a price of around $2000.  The premium has become so wide and volatile that banks are offering swaps to hedge this risk.

So we have a spread.  Spreads price transformations.  What is the transformation at issue here?  Turning metal inside warehouses into metal outside of warehouses.  So if the spread is wide, that tells us that there must be a bottleneck in getting Al out of warehouses.  And indeed there is.  It can take more than a year (!) to get some metal out of LME warehouses.  Warehouse operators (including Goldman, JP Morgan, and Glencore) are the subject of bitter criticism from aluminum consumers (e.g,. Coca Cola) for what consumers claim are unnecessarily glacial load-out rates.  File this under There is Nothing New Under the Sun.  Warehousemen and consumers have fought over load-out rates forever in every commodity.  (Look at a history of the warehouse wars in Chicago stretching back to the mid-19th century.)

As a result of the load-out bottleneck, large quantities of aluminum inventory that built up during the financial crisis and period of extended economic weakness in the US and Europe, are trapped in warehouses.  The storage facilities have become the metallic equivalent of Roach Motels: aluminum checks in, but it can’t check out.  Or maybe the metallic Hotel California: aluminum can check in, but it can never leave.

The fact that large quantities of metal are trapped in warehouses means that there are large quantities of metal that have to be carried-and financed, primarily in cash-and-carry trades hedged by forward sales.  What other alternative is there?  It ain’t going anywhere, so it has to be held and financed by somebody.  Moreover, well-capitalized banks (Morgan, Goldman, etc.) can finance the inventory cheaper than anybody else.  So just surely as day follows night, given the fundamentals in the market, and crucially the load-out bottleneck, the well-capitalized banks end up holding, financing, and hedging a big chunk of the inventory.

Here’s where the financialization meme comes in.  Many people-including some who should know better-see the co-existence of financed inventory and premiums, and conclude that it is the participation of financial institutions that is causing the wide premiums.  See! they exclaim.  Look at how the participation of financial institutions in commodity markets is distorting things! Something must be done!

This is totally back-asswards, and confuses cause and effect.  The underlying problem here is the load-out constraint.  The cash premiums clearly signal that is the problem.  Banks are not holding back metal to create profitable financing deals: time spreads adjust so that financing deals break even.  The problem is that insufficient quantities of metal can get out of warehouses.  That’s what inquiries should focus on.  Is the rate too low?  Why?  Are warehousemen exercising market power by unduly constraining load-out?  If so, why isn’t there sufficient competition between them?  (It would also seem that this would have to be an ex post holdup problem: if those storing metal anticipated the exercise of market power via slow load-out, it would reduce their derived demand for storage, thereby reducing the amount of metal stored and the rate the warehouse could charge.  This would tend to attenuate and perhaps eliminate the ability and incentive to exercise market power.  An opportunistic response to an exceptional circumstance not anticipated when metal was put into store could be what is going on.  That is, this could be a time inconsistency problem combined with an unprecedented shock.)

In other words, large financing deals are a symptom of the load-out bottleneck, and the overhang of metal in store resulting from the financial crisis.  It is not the financing deals that are holding back metal.  It is the load-out bottleneck that is holding back the metal, and driving the need to finance the metal.

One last note.  One of the biggest complainers about the situation and the involvement of banks in the aluminum market is the living proof that Neanderthals still walk the earth: Oleg Deripaska.  Yes, Putin’s favorite pen catcher.  Word to the wise: Deripaska’s whines about the causes of the aluminum cash premiums should be heavily discounted, as should always be the case when a highly financially stressed individual loudly talks his book.  Especially when the book talker has, shall we say, a rather testy relationship with banks.

There has been a spate of world-turned-upside-down stories about the US as a potential exporter of oil and refined products.  The explanation is quite simple.  Supposedly menopausal North American geology has produced a surprise energy baby.  Or, I should say “babies”, for this is a multiple birth, in fact: oil and gas in different locations.

This has resulted in substantial changes in price relationships in oil and gas.  The most visible of these is the Brent-WTI spread, which blew out again to over $20/bbl (better than 20 percent of the WTI price).  But all sorts of spreads have reached record or near record wides.  Canadian oil sells at a deep discount to WTI at Cushing, which sells at a deep discount to the price in the Gulf.  Refining margins are wide.

Commodity trading is all about transformations in space, time, and form.  Spreads price transformations: they are the shadow prices of transformations.  Time spreads price the cost and benefit of transformations in time (through storage).  Locational spreads measure the marginal cost of transformations in space (through transportation).  Spreads between processed and raw materials price the costs of refining/processing.

The spread blowouts in energy  are highly visible evidence of how the spike in domestic energy production, and notably its location and quality, has been at odds with the energy transformation infrastructure that has developed in the US in the past decades.  That transformation infrastructure was-and crucially still is-configured to transform foreign and heavier/sour crudes into refined products for domestic production.  The main direction of movement of crude was south to north, from import points at the Gulf to refineries in the Gulf and Midcontinent.

The new production is in the north, or in Eagle Ford in Texas.  It is sweeter and lighter than the oil that most domestic refineries are configured to process.  Refineries in position (in the Midcon) to process this new output (especially the Bakken) are operating at capacity, giving them fat margins.  The transportation capacity to bring the oil to the Gulf (and to East Coast refineries, many of which have been shuttered in recent years) is highly limited because it was structured to bring oil inland, not ship it to the coast either for refining or (when the law permits), export.

Meaning that in the short run, quantities cannot adjust in response to the oil output shock: there are bottlenecks in transportation, storage, and refining.  Since quantities cannot adjust, prices bear the burden, leading to dramatic movements in spreads that price these transformations.

These spreads are signals about the locations of bottlenecks in the value chain, and the value of making investments in transportation, storage, and refining capacity to ameliorate them.  These investments are expensive, and take time.  Hence, historically anomalous spread levels are like to persist for some time.

Moreover, some investments can exacerbate other bottlenecks.  For instance, building Keystone XL (which will bring oil from Bakken and Canada to the Midcontinent) without adding more Midcon refining capacity and/or more capacity to move oil from Midcon to the Gulf (and perhaps the East Coast) would actually exacerbate the refining and outbound transportation bottlenecks in the Midcontinent.  This would, most notably, cause the Brent-WTI spread to widen further.  There is essentially a race between production capacity in the Midcontinent on the one hand, and the outbound transportation and refining capacity there.  Right now production is winning.  This will tend to cause spreads to change in ways that discourage too much output expansion, and encourage expansion in the ability to consume what is produced in the Midcon.  But there will be a minuet between production and consumption that will go on for years: prices/spreads will play conductor of the music that producers and consumers dance to.

There are economic considerations that limit the speed with which quantities will respond to these price signals.

For one, investment takes time.  You can’t snap your fingers to build a pipeline or add refining capacity, and have it arrive instantaneously in a puff of smoke.

Uncertainty is another.  The ability to invest in refining or pipeline or production capacity is a real option: in the face of uncertainty, it is often optimal to delay decisions to invest pending the arrival of new information about the economic value of those investments.

Sadly, politics is another.  Whether it is a politicized pipeline approval process, Byzantine environmental laws that give enviros and nimby-ists the ability to impede energy investments, or laws that restrict exports, the legal and regulatory systems in the US inflate the cost of investment in energy infrastructure, and crucially add an element of considerable uncertainty that also slows investment due to the real option considerations I just mentioned: the vagaries of politics and political influence are volatile, hard to predict, and can have first-order effects on the profitability (or not) of an investment.   It would have taken some time regardless to make the investments necessary to reconfigure America’s energy infrastructure to accommodate the huge shock to the location and quality of oil production.  Politics and regulation will only slow that response, and make it less efficient and complete than it should be.

And it should be noted that even though much of the law and legislation will be cloaked in the language of public interest, notably environmental paeans and invocations of “jobs, jobs, jobs”, it is largely the product of nakedly self-interested calculations.  This is most notable in the debate over natural gas exports, in which domestic petrochemical producers are trying to prevent-or at least sharply constrain-in order to reduce the cost of their feedstocks and thereby increase their margins.  Similar arguments are already starting to appear in oil just as the prospect of oil exports is being mooted.  It is also notable in transportation: is it any surprise that oil pipelines (notably Keystone) are the target of much opposition, given that Warren Buffett is making oodles of money transporting oil by rail, due to his ownership of the BNSF RR and a major manufacturer of rail tank cars.  (Sort of OT: speaking of Buffet, could the fact that the USDOJ is going after S&P but not Moody’s, despite the fact that their conduct during the pre-crisis period was almost identical, have anything to do with the fact that Saint Warren has a big stake in Moody’s?)

In other words, naked rent seeking is going to play a big role in the speed and efficiency with which firms make the investments necessary to respond to the unexpected domestic energy production shock.  Sadly, the intensely politicized nature of energy, and the swollen nature of the US government and regulatory apparatus (which deems that everything is its business) will dramatically impede this adjustment process.  Meaning that we are likely to be in a world of wide spreads for some time to come.

When the government is the bookie, it’s very hard to beat the spread.  Especially when that government is all too often indistinguishable from the mob.

Last year there were concerns about a “hard landing” in China.  Those fears have dissipated with 7.8 percent growth in the fourth quarter.  Now there is widespread optimism that China’s growth will continue inexorably: the recent spike in iron ore prices (which had plunged when concerns about the Chinese economy were most acute) is a very visible sign of that.

But . . .

It appears that this rebound is the result of another dose of stimulants, notably an injection of credit.  Which (a la Michael Jackson) gives less of a lift each time it is applied.  Now it takes about 3 RMB of credit to generate a RMB of GDP growth.  Moreover, this application of stimulus has deepened the investment-dependence of the Chinese economy, and delayed its transition to a more balanced, natural system.  Furthermore, to the extent that the projects funded by this debt don’t generate sufficient returns, the borrowers will not be able to repay; this risks a solvency crisis, and of course, a liquidity crisis that can break out when lenders are solvent, but at elevated risk of becoming insolvent.

A few articles in the last few days suggest that the optimistic turn may be quite overdone, and that there are dangers lurking beneath the sea of debt.  Chinese banks are rolling over local government debt that was used to fund stimulus spending.   Chinese heavy manufacturing enterprises are becoming increasingly indebted, and are staying afloat with borrowing.  The shadow banking system is growing and mutating.

The Chinese economy is still largely centrally planned.  Not directly, but through subsidies and especially through subsidized credit.  Admittedly, my priors are that centrally planned economies are doomed to difficulty, even though they can produce spurts of measured growth.  With sufficient coercive powers, such governments can keep things going for quite a while.  But there’s a point when they can’t.  I wouldn’t be surprised if China is approaching that point.  In other words, the further injection of credit may have just deferred the hard landing . . . and made it all the harder.

A tag-team of my favorite blogs-the wonderfully sardonic (and insightful) Rhymes With Cars and Girls and the less sardonic (but equally insightful) Deus ex Macchiato-discuss the fact that model-based risk-weighted capital calculations on the same assets differ substantially between models/banks.

From this, DEM concludes the need to centralize capital calculations:

he answer is clear. Centralize and standardise capital calculation. Throw all those internal models away, and use one common, regulator developed approach. Now that a lot of progress has been made on trade reporting, the data infrastructure exists to do this — or least it wouldn’t be too hard to extend what does exist to do it. Developing the models would be a huge undertaking, but compared to having each large bank do it individually, a central infrastructure would be cheaper and more reliable, and anyway you could pick the best of individual banks’ methodologies. You could even spin out the var teams from four or five leading banks into the new central body — just don’t pick the bank whose IRC is less than 10% of the average answer…

Crimson Reach at Rhymes is more cautious, repeating his theme that All Large Calculations are Wrong.  He concludes:

In other words, it’s a Large Calculation. But as RWCG readers know, all large calculations are wrong. So, I’m skeptical that the answer to this is to ‘centralise’ the calculation – i.e., make it even larger.

I’m on Crimson’s side on this one.  (Sorry, David.)

Centralize capital calculations?  No. No. No. No. No fucking no.

Crimson is right: all Large Calculations Are Wrong.  Including those-and I would suggest, especially those-undertaken by some Centralized Authority, e.g., The Wizard of Financial Oz.

What would you rather have?  Randomly distributed mistakes, or perfectly correlated ones?

The answer, it seems to me, is gob-smackingly obvious.  Randomly distributed.  Perfectly correlated errors are a recipe for systemic risk.  All banks will crowd the risks that the model underprices and avoid the risks that it overprices.  If an adverse shock hits the crowded investment, every bank is screwed simultaneously.  All will need to liquidate their positions in that asset, or in other assets.  Every bank will have fire sales at the same time.

That’s what we want to avoid.  That’s what creates a systemic risk.

We want to diversify model risk, not concentrate it.  Centralized calculation concentrates it.  I actually see an evolutionary benefit in the wide range of model risk weights that DEM bewails.  That represents a diverse ecosystem of entities with divergent views that is less vulnerable to a single shock.  Yeah, that shock will crater some banks, but not all of them. When I think of any-ANY-centralized calculation, I think of the Socialist Calculation Debate.  I also think of monocultures that are dangerously vulnerable-systemically vulnerable-to a single shock.  Think of the devastation that smallpox wreaked on native American populations.  A single shock can crater everybody all at once.

If that happens, who is the buyer in the fire sale?  If there are no buyers in the fire sale, how low can prices go? Pretty damn low.

Crimson is right.  All Large Calculations Are Wrong.  The answer to this problem is exactly the opposite that DEM suggests.  Diversify this risk.  Don’t concentrate it.  Don’t sort on it.

We need less centralized control-freakishness.  Not more.  A lot less.  Mistakes are inevitable.  Create a system that induces them to make uncorrelated mistakes (or at least, mistakes with low correlation).  Don’t induce perfect correlation in errors.  I say again: don’t induce perfect correlation in errors.  Create a diverse ecosystem, not a monoculture.   Imposing uniformity because disagreement is unseemly and reveals the fundamental uncertainty with assessing risk is exactly-exactly-the wrong answer.  It makes errors systematic.  Systematic errors create systematic risk.

Diversified, diverse populations are far more robust than uniform, monocultural ones.  Disagreement is a feature, not a bug.  Enforced agreement is the worst bug of all.  Sort of like smallpox.

This week’s big derivatives story was about a public workshop at the CFTC on the issue of futurization.  I was one of the first people to comment on this issue, last year when ICE announced it was converting all of its energy swaps into energy futures.

That was Futurization 1.0. The conversion merely consisted of renaming “swaps” “futures”.  In all economic dimensions (contract specs, execution, clearing) the contracts remained identical.  But the renaming allowed some energy swap users to escape the dreaded Swap Dealer designation.

Futurization 1.1 was the CME’s conversion.  This illustrates some of the silly impacts of Frankendodd.  The CME has cleared energy swaps for going on 10 years now.  The parties would execute a swap, and submit the swap for clearing through an Exchange of Futures for Swaps (EFS) trade.  So the originally executed swap existed only until it was submitted for clearing, when it was replaced with economically equivalent futures contracts.  But no matter how short the swap’s life, the fact that it was born a swap meant that it counted towards the volume of swaps activity used to determine whether someone was a swap dealer.  So the process has now changed, and market participants use (mainly) block trades of futures to create the positions they want, thereby cutting out the interim swap step.

The transformation of the energy derivatives landscape, and the launch of swap futures by CME and Eris are now raising the question of whether futurization will spread beyond energy.

One motive to eschew swaps in favor of futures is unlikely to exist in interest rates, credit and other financial derivatives: the biggest market participants are likely to trade enough bespoke swaps for which there are no futures equivalents, meaning that they will be treated as swap dealers regardless: this reduces their incentive to substitute futures for swaps.

The main driver of futurization outside of energy will be CFTC regulatory treatment of futures and swaps.  Differential treatment will affect the economics of futures vis a vis swaps, and the prospect of such differential treatment was the center of controversy at the CFTC meeting, and in the larger debate in the industry.

The main sources of differential treatment are execution and margining.  Swaps will have to be executed subject to (allegedly) soon-to-be announced SEF rules, and are subject to immediate reporting.  Most market participants who will substitute futures for swaps will execute these deals via privately negotiated block trades subject to exchange rules.  Crucially, reporting of block futures trades is delayed 15 minutes, a concession to fears that immediate reporting would impair liquidity because block positioners (those supplying liquidity to the block futures market) could find it difficult to lay off their risk if the fact they had just done a big trade was announced immediately.  This would induce them to require larger price concessions for doing block trades.

Which raises the question: why the difference between the futures goose and the swaps gander?  Similar considerations obtain for swaps.

Thus, this rule difference is likely to favor futures executed via block trades as opposed to swaps executed via traditional means (but with immediate post-trade transparency) or via SEFs.  (Economically material differences between the rules governing block trades and SEF trades could also affect the relative costs of trading in these disparate ways, and hence affect the choice between them.)

Margining will be different for swaps and futures.  Futures will be margined assuming a one- or two-day liquidation period (i.e., margins will be based on something analogous to a one- or two-day value at risk).  However, swaps-even cleared swaps-will require a minimum liquidation period of 5 days for calculating initial margin.

This substantially higher margin for swaps results in a substantial economic disadvantage to these contracts compared to futures contracts that generate the exact same cash flows (in the absence of default).   This will likely be another factor pushing the market towards futures-which is a major reason for the fury of swaps dealers.

This differential treatment of economically equivalent contracts just because one is called a “swap” (BAD!) and the other is called a “future” (GOOD!) makes little-or no-economic sense-and reflects the swap-o-phobia that pervades DC, and which was an animating principle behind Frankendodd.

The reason to set margins based on a liquidation period reflects the purchase of IM: it is intended to cover potential losses on a defaulted position before that position can be liquidated by the clearinghouse (i.e., the position can be assumed by another solvent market participant).  The less liquid an instrument,  the longer it takes the CCP to work out of the position, the more it is exposed to potential adverse price moves and hence the more margin cover it needs.

This liquidation period depends on the economic characteristics of the contract, how widely it is traded in the marketplace, the identity, number and capitalization of the firms that trade it, and market conditions at the time of liquidation. All of these conditions should be pretty much the same for two contracts that specify the same contingent cash flows, one of which is called a swap and the other a future.  Consider say a 10 year vanilla IRS and economically equivalent futures contracts that offer the same contingent cash flows.  Abstracting from margining differences, these contracts have identical price risks, and should attract the same kinds of users.  Why should liquidity of one differ from the liquidity of the other in the event of the default of the holder of a big position?

And don’t tell me that futures are traded in light markets and swaps are traded in dark ones.  As already noted, futures traded as substitutes for swaps are and will be typically traded in blocks outside the limit order book.

More importantly: in the event of the default of a big FCM or dealer that should be the reason to be concerned, the CCP is going to try to get rid of the defaulted portfolio in big chunks through some sort of auction process.  The firm winning the auction will then trade out of the position, likely using the central market and block trades.

This isn’t much different than how a swap CCP will handle the default process.  Indeed, LCH obligates its members to assume portions of a defaulted portfolio, and one reason for having stringent CCP membership requirements is to ensure that the members have the capital and trading expertise to manage big pieces of defaulted portfolios.

We actually have a case study of futures and swap default management processes.  When Lehman defaulted, CME auctioned off its interest rate, equity, currency, commodity, and energy positions.  These trades were done at differentials from market prices, to reflect the risk that those taking over the positions would assume and have to work off.  A couple of the positions were under-margined: the firms taking over the positions required the CME to provide more funds than the Lehman margin it had against those positions.  As it turned out, the other positions were over-margined, and across all positions the over-margining exceeded the under-margining, meaning that the CME clearinghouse did not suffer any loss as the result of the default.  But this illustrates the possibility that futures can be under-margined, and that even the putatively more liquid futures contracts can require substantial price concessions to get someone to assume them.

LCH.Clearnet handled the default of the Lehman IRS positions. These totaled $9 trillion in notional-bigger than the Lehman futures positions at CME, and arguably far larger in terms of risk.  ($1 trillion in notional of a 10 year IRS poses substantially more risk than $1 trillion in notional of Eurodollar futures.)  90 percent of the position was hedged within a week.  According to LCH.Clearnet, the costs of trading out of the defaulted position were “well within” the Lehman margins it held.

It’s hard to see much of an economic difference between the CME and LCH experiences.  It doesn’t appear that it was materially more difficult to manage the default of “swaps” than it was “futures.”   The Lehman default does not provide any evidence that swap-o-phobia is anything but a mental illness.

Further, this case study illustrates that there is no reason to believe that absent government regulation, swaps will be under-margined and futures will not.  Indeed, had the Lehman positions been held at 5 separate CCPs, two of them would have been under margined.

Indeed, there are serious reasons to be concerned that government regulations of the margining of economically similar (and in some respects identical) contracts will create systemic risks, rather than mitigate them.

The margin regulations-with larger IM imposed on swaps than futures-are a form of price control, in this case default risk price control.  And we know that price controls work out swell, especially when applied by regulators in a two-sizes-fits-all fashion across all different kinds of instruments posing different risks and cleared by CCPs with potentially disparate financial strength.

Moreover, this price control will tend to induce activity to move towards futures CCPs.  Whereas in the absence of the margin differential clearing activity in, say, interest rate derivatives would be split between futures CCPs and swap CCPs, under the differential regulation, business will tend to tip to the futures CCPs-most notably, CME.  This will tend to lead to greater concentration of credit risk.

Wasn’t the whole point of Frankendodd to reduce concentration? Just asking.

The whole conceit that regulators can set risk prices is quite dangerous, and is likely to be a source of systemic risk because these prices are set on the basis of highly limited information in a politicized process, and because mistakes in setting risk prices (especially price differences between similar products) tend to lead to crowded trades and risk concentration that is highly destabilizing during crisis periods (cf. Basel II).

The case for setting different margins (default risk prices) on very similar-and in some cases identical-derivatives contracts is particularly weak.  It is the characteristics of the products and those who trade them that will drive liquidity and liquidation periods: products called “futures” that share the same economic characteristics as products called “swaps” will pose virtually the same challenges to liquidate in the event of a large default.  Given this, the economics suggest that imposing differential margins based on a name difference-rather than economic differences-can’t make things better, and could well make them worse.

But the Sorcerer’s Apprentices know better. So futures are likely to get an artificial advantage, and swaps an artificial burden. Such distortions are quite dangerous.  My conclusion? Futurize in haste, repent at leisure.

Dmitri Medvedev-prime minister of Russia, at least until Putin needs a sacrificial victim to blame for some failure, that being the main role of a Russian PM-claims that Russian business has not been harmed by the Magnitsky controversy:

Medvedev said the whistleblower’s death in jail, for which no one has been brought to justice, was being used by Kremlin critics to score points but was of no import to business leaders.

. . . .

“It does not interest anyone, except maybe certain citizens who are trying to use it to accumulate political capital,” said Medvedev, who was president from 2008 until Vladimir Putin returned to the Kremlin last May.

“Not a single businessman raises this issue,” he told state television in an interview focusing on his role in the forum. “But unfortunately it has become a factor in political life.”

Biznessmen have a different story-off the record, which is part of the point:

With international concern spreading after the 2009 death of Sergei Magnitsky, some Russian tycoons are worried their legitimate cross-border money transfers involving anything from industrial investments to luxury properties will get hit by red tape.

And they complain that the Kremlin’s hard-line stance on Magnitsky is not doing them any favours.

“The Russian business (community) is absolutely united. The situation is more than bad and things may well spread to the EU and UK and God knows who could be sucked in,” said a Russian billionaire, speaking at the World Economic Forum in Davos.

. . . .

Economist Sergei Guriev said: “Russian business is very upset. The last development they want is to see the EU or UK joining those sanctions. Quite simply it is where the Russian business has huge assets and where their kids are studying.”

Russian officials and bankers say the impact on commerce is becoming far too negative.

“Of course I have concerns about a worsening in (Russian-U.S.) relations. It creates unease for business. And it is a question for both sides – what’s the point of continuing all this? I think it is very important to move on,” said German Gref, head of top Russian bank Sberbank.

And here’s why what Medvedev says doesn’t mean bupkis:

The billionaire asked not to be named as he said the Russian business establishment was still afraid of bringing up the matter with Russian President Vladimir Putin

(And maybe they don’t bring it up with Medvedev because, like it would matter.)

Politicians say things they know are untrue all the time.  Perhaps that’s what Medvedev is doing.  But perhaps it is a reflection of one of the Achilles’ heels of authoritarian systems: fear keeps people from revealing inconvenient facts to rulers. Relatedly: a captive and docile press that is used primarily to disseminate the official line to the populace and which does not serve as an independent check on the government deprives the rulers of vital feedback.  Surrounded by yes men and deprived of independent feedback, authoritarian leaders often live in a fool’s paradise.  Problems are suppressed, and metastasize.  (In another example of our convergence to Russia from above, similar things are happening here, but for somewhat different reasons and in a somewhat different way.)

It is particularly ironic that the supposed crusader against legal nihilism blows off concerns about Magnitsky, and its effect on the business climate in Russia.  Perhaps he knows, but he is also afraid to challenge Putin (and the siloviki) on this.  (I would not rule that out, by any means.)  Or perhaps he is living in the authoritarian leadership bubble, cut off from feedback from planet Earth.  This is one of the sources of brittleness in authoritarian systems generally, and Russian in particular.  Regardless of the cause, the disconnect between what Medvedev says and what the nervous oligarchs say suggests that Russia will continue to underperform due to the failure (or refusal) of the government to address the Magnitsky case, and what it signals about the myriad dangers of doing business in Russia.

More indications that Frankendodd, Basel III, and other measures intended to reduce the risk in the banking system, and to address the too big to fail problem, are leading to greater consolidation of the banking sector:

Investment banks must take further actions to improve returns and more will follow firms like UBS AG (UBSN) and Royal Bank of Scotland Plc  that have exited businesses, McKinsey & Co. said.

Only five or six companies will remain “bulge bracket” firms that offer all investment banking and trading products worldwide, the consulting firm said today in a report titled “After the Reckoning.” Others will step back from some businesses to focus on areas where they have a competitive advantage, according to the report.

. . . .

The top three firms in each asset class account for about two-thirds of trading volume in that product, according to the report. Banks that lack such scale or face higher funding costs will probably focus on businesses such as foreign exchange or structured rates and credit, McKinsey said.

So: increased concentration and reduced competition as some banks exit certain businesses.  The sector overall will almost certainly shrink, but the remaining bulge bracket firms will account for a greater fraction of business, and may grow absolutely.  It is also likely that these remaining firms will be as interconnected, or more interconnected, than was previously the case.