Streetwise Professor

The CFTC has released its new position limits proposed rule.  It is an improvement on the earlier version, but still lacks a serious logical and empirical basis, try as the agency might to muster up a justification.

It is an improvement primarily for two reasons.  First, it has more sensible aggregation standards.  Whereas in the 2011 proposed rule, an entity would have to aggregate positions in every entity of which it had a 10 percent or greater stake in order to determine its overall position for the purpose of determining compliance with the limit, now that threshold has been increased to a more reasonable 50 percent.

Second, the new proposal does not include “class limits”.  Under the 2011 rule, swaps and futures were treated as different classes, and long positions in one class were not offset against economically equivalent short positions in the other.  Thus, a firm could have a zero economic exposure because a swap position was offset by an equivalent futures position, but it could be in violation of the position limit.  This made no economic sense, and was likely a surreptitious way of hamstringing swap dealers’ ability to enter into transactions with the massive passives who bother Chilton (and Gensler) so much.  Along with many others, I submitted comments criticizing this approach, and lo and behold, it has disappeared.  Now position limits are based on net exposures, meaning that a swap dealer can hedge a swap entered into with a customer using futures, in any quantity, without falling afoul of the position limit rule.

Unfortunately, not all nonsensical features of the 2011 proposal have vanished along with the class limits.  Most notably, the 2013 proposal not only includes, but extends the scope of, the “conditional limit” on positions held during the last 5 days of the a contract month.  Under this provision, the limit on delivery-settled contracts during the last 5 days is 25 percent of the deliverable supply, but the limit on otherwise identical cash-settled contracts is 5 times larger (i.e., 125 percent of deliverable supply).

As I commented in 2011-based on a paper I published in the Journal of Business in 2000-this makes no economic sense.  A trader that is long a delivery settled contract can manipulate by standing on excessive deliveries, thereby effectively buying up too much of the deliverable supply.  But a trader that is long a cash-settled contract can have the same price impact by buying the same quantity in the cash market.  Under the conditional limit rule, the holder of the cash-settled contract can get 5 times the benefit from this price impact as the holder of a delivery-settled one. The logic of the 25 percent of deliverable supply limit implies that the CFTC believes that taking delivery of something less than 25 percent of deliverable supply permits the long with a futures position of 25 percent of deliverable supply to manipulate profitably.  This means that the holder of a cash-settled position equal to 125 percent of deliverable supply can manipulate far more profitably.

This rule is passing strange especially considering that the CFTC has filed a manipulation claim against a trading firm-Parnon-that allegedly used cash market purchases to distort futures prices.  The strategy that the CFTC finds illegal in Parnon would benefit both cash-settled or delivery-settled contracts.  Under the conditional limit rule, the agency provides an incentive for the holders of cash-settled contracts to engage in such strategies.

What’s more, whereas the 2011 rule would have potentially constrained such strategies by limiting ownership of physical supplies by the holder of a cash-settled derivatives position to 25 percent of deliverable stocks, the new rule imposes no such constraint.  Instead, it imposes a requirement to report cash market holdings, and hopes that market oversight officials at exchanges will intervene if it looks like a manipulation is in progress.

None of this makes economic sense, and is in fact logically contradictory.  What makes it worse is that whereas in the 2011 proposal the conditional limit applied only to natural gas futures, it now applies to all contracts subject to position limits.

A big chunk of the proposal is a long-winded justification of the rule, in an effort to overcome the legal challenges that saw a federal court reject the 2011 proposal.  It seems to me that the commission is merely restating the arguments that failed in court, so I don’t really see how this helps.

A couple of things struck me as quite interesting.  In both the 2011 and 2013 proposals, the CFTC utilized the Hunt silver case and the Amaranth case as examples of the kind of destabilizing conduct that the rule would prevent. But whereas the 2011 rule argued that large leveraged positions (like those held by the Hunts) posed a threat to market stability, the word “levered” does not appear in the 2013 proposal’s discussion of the kinds of positions that are particularly worrisome.

This is interesting to me, in part, because my criticism of the 2011 rule as over-inclusive focused on the leverage issue.  If leverage is the problem, I argued, why impose the rule on unlevered positions, like those held by ETFs (which are fully collateralized) or real money investors? If leveraged positions were the real problem, the rule was over inclusive because it would apply to unlevered positions too.  Arguably, this argument had some impact, as all reference to the unique dangers posed by leveraged positions disappeared between 2011 and 2013.

But dropping the argument doesn’t eliminate the problem.  The CFTC has not shown how large, unlevered positions with trading decisions made by many individuals (as is the case with ETFs like USO or USNG) pose a threat to market stability in the way the Hunts did, or can cause unwarranted fluctuations in commodity prices.

Relatedly, the 2011 rule argued that position limits would reduce systemic risk.  I commented that it is wildly implausible that even a disorderly liquidation of a large position in a small market could destabilize the financial system.  Would a disorderly liquidation in the milk futures market really pose a threat to world financial stability?  Seriously?

And wouldn’t you know, the 2013 justification does not mention systemic risk.

More generally, the two-two, mind you-cases that the CFTC puts forth to justify its imposition of limits is highly unpersuasive.  I regularly use the Hunt case as an example of how speculation can distort prices.  Or, should I say, the example.  It is pretty much the exception that proves the rule. It occurred over 33 years ago.

Talk about ancient history.  When do we get to the part about the Trojan War?

The commission’s analysis, such as it is, of the Amaranth episode relies heavily on a report from the Senate Subcommittee on Investigations.  This report in no way demonstrates that Amaranth distorted prices, or that the liquidation of its position when it ran into financial trouble caused unwarranted price fluctuations.

A more plausible story is that Amaranth took a huge bet on natural gas spreads based in large part on a view that 2006 would be another big hurricane season.  When September came with no hurricanes, and none in prospect, spreads collapsed and Amaranth lost a lot of money.  The loss does not demonstrate that Amaranth distorted spreads, just that it took a big bet on these spreads, and bet wrong.

It’s not the job of the regulators to prevent market participants from losing big, if those big bets do not distort prices, either when they are initiated, or when they are liquidated.  (In the event, Amaranth’s positions were assumed-quite profitably-by JP Morgan and Citadel, with no notable dislocation in market prices.)

Moreover, even taking the commission’s view, the two episodes do not support the level of limits it proposes to impose.  The 2013 limits (like those proposed in 2013) would limit an individual firm to between 2.5 percent and 10 percent of open interest: the bigger the contract, the smaller the limit as a fraction of open interest.

But the Hunts and Amaranth had around 40-50 percent of the open interest in big contracts-at least 4 times, and arguably close to 20 times the limits the commission has proposed.  So even if you could argue that a 40 percent position could distort prices, or result in unwarranted price fluctuations when the position is liquidated, that doesn’t imply that a 10 percent or 5 percent or 2.5 percent of open interest position would.  There is thus a huge gap between the sizes of the positions that the CFTC claims, based on historical experience, distort markets, and the sizes of the limits it is proposing.

This is related, in a way, to cost-benefit analysis.  The agency is required to compare the costs and benefits of the regulation, but its analysis is perfunctory, at best. In particular, it does not provide a persuasive cost-benefit analysis of any major attribute of the rule, most notably of the size of the limits.  It basically adopts a precautionary principle approach: big positions could cause big problems, so they should be constrained as a precaution.  It asserts-but does not show-that liquidity will not be unduly restricted as a result.  This is insufficient.

Chilton-who has announced his departure-has claimed that the new proposal is immune to legal challenge.  I wouldn’t be so sure.  Even if the court accepts the verbose arguments relating to the commission’s obligation-or not-to make a finding that the limits are necessary, the agency is still vulnerable on the adequacy of its cost-benefit analysis.  Judge Wilkins never ruled on this issue in his 2012 decision, and in my opinion the CFTC is still vulnerable here.

It is not just the cost-benefit trade-off of the rule overall, but the specific choices made.  Most notably, the size of the limits needs to be justified better on a cost-benefit basis.  Similarly, the conditional limit needs to be so justified: and I’ll say that it is impossible-impossible-to do so, if one is constrained to using, you know, rigorous economics.

The rule is unbelievably long.  Five-hundred thirty three double spaced pages.  533.  (395 pages excluding appendices and attachments.) I have read most of it, but have to spend more time digesting the bona fide hedging portion of the rule.  More on that later.

Oh.  There are 846 footnotes: this is where the land mines lurk.  And there was much rejoicing.  By the lawyers, anyways.

There are few things more dangerous than a president in search of a legacy.  Especially those who are in political straits.

A besieged Obama is in search of a legacy in foreign policy by achieving a rapprochement with Iran.  No doubt he is being egged on in this by his Rasputin, Valerie Jarrett, who, you know, is an expert about Iran because she lived there until she was four.

Never mind that even the French think this is insane.  (This being the second time in the past 3 months that the French have made Obama look like the surrender monkey.  Quite an accomplishment.)

Never mind that this is disconcerting-no, infuriating-every traditional American ally in the Middle East, notably Israel and Saudi Arabia.  Quite an accomplishment to get those two singing from they same, um, hymnal.

Never mind that this could actually provoke the increased nuclearization of the Gulf, with the Saudis ordering nukes Prêt-à-Porter from Pakistan.

Never mind that the Iranians have taken president after president to the cleaners.  (And lest you think I am being partisan, the president who was dry cleaned most thoroughly was Reagan.  In attempting to bargain with the Iranians for the release of hostages, Reagan gave the Iranians incentives to take even more hostages, which they did.)

I just read the memoir of former CIA operative Bob Baer (“See No Evil.”)  Baer compellingly ties Iran to numerous major terror operations launched against the US for the last 30 years, including the bombing of the US embassy in Lebanon, the bombing of the Marine barracks in that city, and the Khobar Towers bombing in Saudi Arabia. He also plausibly argues that Osama and the Iranians worked together.

Note: the same people-notably the mullahs (especially Khamenei) and the pesdaren (i.e., the Revolutionary Guards)-who approved and/or carried out all of these operations are still the true powers in Iran today.  (Anyone gulled by the new, and supposedly moderate, Iranian president are truly fools.)

The only hope is that the true realists-like the French! (yes-SWP just wrote that)-will derail this insane train before it gets to the station.

And maybe the Russians will derail it (yes-SWP just wrote that too!)  The Russians are utterly cynical, and utterly self-interested. The Russian economic situation-by the admission of the Economics Ministry and the Russian Central Bank, not to mention the IMF and World Bank-is increasingly fraught.  A substantial decline in oil prices would put substantial stress on the Russian economy, the Russian budget-and the lifestyle of the rent seekers that rule the country.  A deal with Iran that relaxed sanctions would add approximately 1mm bbl of oil to world markets-around 1.1 percent of world liquids output.  Using a short run elasticity of 10, that translates into an 11 percent decline in world prices.  That would put Brent in the mid-90s. Russia needs a Brent price of approximately $117/bbl to balance its budget.  It is already on the edge with a current price of $105: $95 would be a major problem.  Major problem.

The Russians, in other words, want turmoil in the Middle East.  An American rapprochement with Iran that would reduce tensions in the Gulf-at least in the short run-and bring Iranian oil back onto market is the last thing that Russia needs right now.  Which could well lead the Russians to throw a spanner in any deal.

So this is what we’ve been reduced to.  To relying on French realism and stalwartness and Russian cynicism and cupidity to prevent Obama from making a blunder of historical proportions in his narcissistic search for a legacy.

If it works out this way I will never doubt Bismarck again.

For years-probably going on 7-I have argued that Russia was in for a long period of economic stagnation.  I referred to Putin’s Hamster Wheel From Hell, on which Russia would just continue spinning.

This prediction was based on my belief that Russia’s “natural state” politico-economic system was inimical to sustained growth.  Yes, the country could experience Cocaine Blues spurts of growth (“took another shot of cocaine and away I run”)-with the Russian economic cocaine being black and gooey instead of white and powdery-but the fundamental institutional deficits would continue to hold it back.  Indeed, the rent seeking and redistributionist policies that resource wealth sustain were-and are-a detriment to the country’s long term prospects.

I stopped writing about Russian stagnation so much, well, because I didn’t want the blog to stagnate along with them 😉  What new was there to say?

Today the Russian Economics Ministry released a forecast that echoes what I’ve been on about all these years:

Russia acknowledged for the first time on Thursday that its economy would lag global growth over the next two decades, setting the stage for an era of stagnation that could threaten President Vladimir Putin’s grip on power.

Economy Minister Alexei Ulyukayev forecast that Russia’s economy would grow at an average rate of 2.5 percent during that period – down from an earlier 4 percent and half the rate Putin targeted before his return to the Kremlin last year.

The downward revision casts Russia as the poor relation in the BRICS group of large emerging markets that includes Brazil, China, India and South Africa. The ministry expects the BRICS to grow at a 5.2 percent clip during that time.

With the ministry expecting global economic growth to average 3.4-3.5 percent, the outlook threatens to make a mockery of Putin’s oft-repeated pledge to lift Russia into the world’s top-five economies by the end of this decade.

And it is still based on an oil price forecast many analysts view as over-optimistic, showing just how much Putin’s Russia, the world’s largest oil producer, relies on not only high, but rising, oil prices to prosper.

Over-optimistic.  Too funny.

Note this isn’t a forecast about a year to two.  This is a forecast that extends to beyond Putin’s departure (likely, anyways, but not absolutely certain-which is symptomatic of the problems).  It is a damning verdict on Russia’s fundamental structural and institutional flaws.  From their own mouths.

One bank analyst sarcastically remarks: “Stagnation is starting to look like a policy goal in Russia.”  Actually, there is much truth in this remark, as I also noted in my writing on this subject going back to ’06-’07.  Autocratic systems like Russia’s that exist to redistribute rents in order to maintain political control and stability hate economic dynamism.  It creates new sources of wealth that can be used to challenge existing power structures.  It creates new groups of individuals, of middling means, who aspire for greater liberties and a political voice.

Meaning that given the choice between stagnation and control on the one hand, and dynamism and a lack of control on the other, Putin and the siloviki will choose stagnation in a heart beat.  Stagnation is a policy goal.  Stagnation means that those are on top stay on top, profiting wildly from their parasitism.  And that, ultimately, is the point.

Until it all falls apart.  Which it will.   The system is strong, in its way (note the utter demoralization of the opposition), but it is brittle.  Dynamic societies can adapt to big shocks.  Stagnant ones not so much.  They tend to shatter into little pieces instead of bending and adapting in response to big shocks.

I’ll sit here patiently waiting for all those soi-disant “Russophiles” who criticized, and at times ridiculed, my earlier prognostications as the product of a Russophobe mind to explain to me how the Economic Minister is similarly Russophobic.  Because he’s just saying what I’ve said for years. Some people are slow learners.  And some are no learners.  Which means I’ll probably be waiting a long time.

In September, the CFTC’s new SEF rule threw swap market participants into a panic when they realized that footnote 88 buried within the rule would require instruments that were thought to have been outside the scope of the rule to be traded on the new SEFs:

Further muddying the waters is a footnote that was written into the margins of the final rules that could end up having a major impact. Footnote 88 requires certain entities that offer trade execution of swaps on a multiple-to-multiple basis to register as SEFs, even if they only execute or trade swaps that are not subject to the trade execution mandates.

This could lead to a significantly expanded SEF universe, which is already expected to be crowded. Trading participants would have to code and test to these various SEFs, some of which will have hastily assembled their platforms in order to be compliant. The on-boarding process will be rushed for participants in order to generate needed liquidity at the Oct. 2 starting point.

“For some of our members who have decided that they’re going to connect to each one of the platforms that’s available, they’re going to need this unique coding and connectivity to these new platforms,” Nevins says. “That’s a lot of work in a very short period of time.”Those who don’t want to connect to each venue will have to decide quickly which SEFs they want to work with, and they still need to hurry the coding and connection of pipes to the SEFs.

But two can play the footnote game.  Today Bloomberg reports that the banks have found a footnote in the rule that allows them to shelter some trades from the SEF execution mandate.  Footnote 513.  (The number itself should give an indication of how bloated and complex the rule is.)

Wall Street, trying to preserve profits from swap trading in the face of tougher scrutiny from Washington, has found a new way to keep some of its overseas deals private. It’s called Footnote 513.

Banking lawyers have seized on the wording of the footnote, contained in an 84-page policy statement issued in July by the main U.S. regulator of derivatives. The largest banks told swap brokers in late September that the language means certain swaps still don’t fall under the agency’s new trading rules, according to three people briefed on the discussions.

London-based ICAP Plc (IAP), one of the largest swap brokers, told the banks it didn’t agree with their interpretation, said the people, who spoke on condition of anonymity because the discussions weren’t public. Other brokers accepted the banks’ position and have been trading billions of dollars in contracts outside the new regulatory system, the people said.

The deals in question include swaps for foreign clients that are arranged by U.S.-based traders or brokers and then booked through a U.S. bank’s overseas affiliate. Bank lawyers say that if the trade goes through an affiliate it can stay private and doesn’t need to be handled on one of the public electronic trading platforms approved by the Commodity Futures Trading Commission, two people said.

Other than lawyers, who thinks this Duel of Footnotes is anyway to run a railroad?  (I know, I know: most lawyers think this is stupid too.  It’s just that they’ll be about the only ones that profit from it.)

And remember it’s not just footnotes.  It’s commas too.  As I wrote about a year ago, the decision overturning the CFTC’s position limit rule hinged in part on the placement of commas.

The whole structure is still under construction, and it is already requiring a plethora of ad hoc fixes, in the form of exemptions and no action letters, which Commissioner Scott O’Malia trenchantly criticized.

And it’s not just in the US.  The rules and paperwork are metastasizing in Europe too.  As one commentator puts it, “Regulation descends into a Kafkaesque bureaucracy.”  Yeah.  This will work.  Especially when their Kafkaesque bureaucracy clashes with our Kafkaesque bureaucracy.  Kafka squared. Woot!

And it’s not just derivatives.  It’s hedge funds.  And I could go on.

The hedge fund article also points out something I’ve been hammering on for years now: perversely, since compliance costs have a huge fixed cost element, the regulatory onslaught creates scale economies that favor concentration and consolidation, and which can potentially reduce competition.  You are seeing it in hedge funds.  You are seeing it in banking.  You are seeing it in FCMs.

And I do mean perverse, because among the ostensible purposes of these regulations were mitigating the too big to fail problem, and promoting competition.  The dramatic increase in regulatory overhead that favors the big over the small is completely at odds with these purposes.

Moreover, don’t forget another point that I’ve made.  These rules are systemic in nature, in the sense that they affect myriad financial market participants, and in pretty much the same way.  Meaning that if one of the rules is fatally flawed, it could lead to a serious systemic problem.

Which raises the question: what footnote-or what comma-in what rule will create a future crisis?  Perhaps that’s a little hyperbolic, but not outrageously so.

In some earlier posts discussing the role of banks in commodity markets, I suggested that the decision should not be a binary one: banks in, or banks out.  Instead, the preferable approach would be to levy capital charges on bank commodity operations that reflected the risks of these operations, thereby attempting to ensure that banks internalize the TBTF costs associated with them and scale their commodity businesses accordingly.

The WSJ reports that the Fed is leaning towards this approach:

Federal Reserve officials are considering imposing a new capital surcharge on Wall Street banks that own oil pipelines, metals warehouses and other lucrative physical-commodities assets, according to people familiar with the matter.

Such an approach could encourage banks to pare back their involvement in physical commodities, which has increasingly raised concerns among regulators and lawmakers.

While no decision has been made, imposing a surcharge would allow the Fed to sidestep a legal jam caused by existing laws that set Goldman Sachs Group Inc. and Morgan Stanley apart from peers and give the former investment banks broad leeway to own commodities.

The devil, of course, is in the details.  The question is whether the surcharge will be set in a way that accurately reflects the relevant risks, or whether instead it will be set at punitive levels to achieve via misdirection what the Fed is apparently reluctant to do in a straightforward fashion (due to fears of legal challenge): i.e., precluding banks from participating in physical commodity markets.

In other words, this proposal is fine in principal, but could be a disaster in practice.  If the Fed really wants to drive banks out of commodity markets, I would much prefer it do so forthrightly, rather than by hiding behind capital surcharges that it chooses to achieve that outcome.

The EPA bowed to reality, and has admitted that the blend wall is real.  That is, (a) the vast bulk of autos in the US can only use gasoline with 10 percent of less ethanol, and (b) the mandated level of biofuel consumption exceeds 10 percent of US gasoline consumption.  The gap between the mandated use of biofuels and the actual use of biofuels had led refiners to scramble to by Renewable Identification Numbers (“RINs”) that they can substitute for actual biofuels to meet their mandate obligations.  But the supply of RINs is limited, and their price had skyrocketed started in the spring.  The available supply of RINs for 2014 would have been totally inadequate to cope with the increase in the mandated quantity for that year.  A quantity set by Congress in 2007 when it had no idea what market conditions would be it kicked in, and in defiance of technological realities.  Congress anticipated a steady increase in gasoline consumption, but stagnant economic growth and other factors have led to stagnant gasoline consumption, leading to the current yawning gap between the mandated quantity of biofuels and the quantity that can actually be utilized.

As a result, the EPA has decided to cut the mandated quantity for 2014 by nearly 1/6th, or 3 million gallons.

Economically this is the right result, but legally and procedurally it is a monstrosity.  Congress did give EPA the discretion to waive the mandate, but limited that discretion.  The agency can modify the mandate for two reasons.  Here’s how Reuters describes it:

This can be used to reduce the volumes in two cases: if enforcing the law were to cause economic hardship; or if it were simply not feasible due to “inadequate domestic supply”.

Making the “economic hardship” case is hard, so the EPA is using the second justification.  No.  Seriously.

The plain language of the law makes it clear that inadequate domestic supply of biofuels is the criterion for granting the waiver.  But we have a surfeit of biofuels, if anything: we can produce more of them than can be consumed.

Here’s the gobbledygook the agency uses to justify its decision:

“We interpret the term ‘inadequate domestic supply’ as it is used under the general waiver authority to include consideration of factors that affect consumption of renewable fuel,” the agency wrote in the proposed rules.

Uhm, “consumption” is related to demand, not supply.  But whatever.

The EPA seems inspired by this famous bit from Through the Looking Glass:

‘When I use a word,’ Humpty Dumpty said, in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’

‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’

‘The question is,’ said Humpty Dumpty, ‘which is to be master — that’s all.’

EPA is clearly determined to be master of the words in the Renewable Fuel Standard, and make them mean just it what it chooses them to mean.

The Reuters article states that the EPA’s action is sure to draw a legal challenge from the biofuels industry, and that’s no doubt true.

I yield to no one in my loathing for the Renewable Fuels Association, but they have the law on their side in this case, even if the law is indeed an ass. If the rule of law is to mean anything, laws must be enforced as written, not waived at will, especially when the justification for the waivers flies in the face of the black letter language of the statute.

If we really want a country of laws, the laws need to be enforced and followed, not waived.  We need to work to rule.  To bring home to Congress its folly, and to force it to change the law to bring it into conformity with economic reality, the RFS must be enforced, down to the last comma.

And the principle should be applied more broadly.  Obamacare is a prime example.  Ever G*d damned provision on every one of its 2000 plus pages should be enforced, no ifs, ands, buts or waivers, to make manifest its absurdity, thereby making possible a substantive change in the law-and perhaps scrapping it.

Maybe in the scheme of things RINsanity isn’t a big deal.  But it illustrates quite powerfully the degeneration of the rule of law in the US and the increasingly arbitrary nature of American government.

At the dedication of a new Rosneft refinery (for giggles imagine in your mind’s eye Obama doing something similar at an Exxon one), Putin made a strong statement regarding the compensation-or not-of the TNK-BP minorities.  In a nutshell: you’ll take the crumbs I give you and you’ll like it.

Rosneft should buy out the minority shareholders of TNK-BP Holding at the prevailing market price, not at the peak levels of the past, Russian President Vladimir Putin said on Friday, indicating there will be no increase for investors hoping for an improved payout.

“The valuation and payouts should be carried out for those who wish to sell not at peak levels but today’s market price,” said Putin, who was in Tuapse on the shore of the Black Sea for the opening of an oil refinery by Rosneft. “That should be the basis. No one should be deceived or robbed.”

Oh no one is being deceived here, but robbery is another matter: the minority holders know they are getting robbed.

Note that Putin doesn’t advocate the payment of a premium on the market price, or acknowledge that the market price was depressed as the result of legitimate fears-stoked by Sechin’s Rosneft-is-not-a-charity rhetoric-that the minorities would get a pittance.

This is everything that Sechin could ask for-and probably did.  But it is a huge dis of Medvedev.  Medvedev had publicly pressed Sechin (in a joint appearance) to up the compensation for the minority shareholders, by paying a premium over the average of the market price since the time of Rosneft’s acquisition.  Medvedev had said that this measure was an essential step in assuring foreign investors that they would be treated fairly, thereby making them more willing to invest.

Putin’s decisive rejection of Medvedev’s position tells you all you need to know about the prime minister’s influence in the country, and his ability to control Sechin and other silovki.  Perhaps more importantly, it tells you that Putin couldn’t care less about fixing the severe legal and institutional defects that make investment in Russia so fraught with risk, and which have brought on the stagnation that some have been predicting for some time (ahem) and which is now pretty much obvious to anyone who pays the slightest attention.  (The IMF’s recent appraisal of the Russian economy pretty much puts the seal on stagnation as the new conventional wisdom.  The few Russians of stature who can speak out-and by few, I mean like one, Kudrin-say the same.)

This may seem a small story, but it speaks volumes.  For those of you cock eyed optimists who had hope that Putin would feel compelled to reform in order to stave off stagnation and rejuvenate economic growth, now is time to face reality and abandon it.

I choose (d): All of the above.

Sechin held forth on the purchase of the TNK-BP minority shareholders.  The circumstances were rather extraordinary.  Late Friday night Rosneft’s PR people called a press conference to be held the next morning.  Obviously this was something that couldn’t wait

As for the “thief” part, Sechin gave no ground on piddling compensation to be offered the minority shareholders.  (I should note that BP is a beneficiary of this theft, and arguably an accessory after the fact to Rosneft’s theft of Yukos assets.)  He went with the “we’re paying the market price” line even though the market price of the minority shares had been hammered by realistic fears that Rosneft would not pay fair value.

But that wasn’t the main focus of his remarks.  That’s where the “thug” part comes in.  He was furious-furious-that an investor had the temerity to bring up the subject to Putin:

He seemed less concerned about the substance of the shareholder’s complaint–the fund manager voiced a concern widely held in the market that Rosneft’s offer to buy out minorities was unfairly low–than the fact that the investor had taken it directly to Mr. Putin during a public question-and-answer session at an investment conference.

“This was an attempt to apply pressure, maybe even to manipulate the market,” Mr. Sechin said of the fund manager’s question to the president.

“They should have said, ‘We thank Vladimir Vladimirovich (Putin) for the opportunity to work in Russia and please let us buy something else,’” he added, with only the faintest hint of a smile.

The concern was voiced by a representative of Franklin Templeton Investments, a veteran of emerging-markets investing. Templeton, the questioner said, had bought a stake in TNK-BP Holding, the traded unit of Anglo-Russian oil giant TNK-BP Ltd. in 2006. When Rosneft bought TNK-BP in March of this year, it bought out BP PLC and a group of Russian billionaires who were the British giant’s partners, paying a total of about $56 billion in cash and stock.

The Franklin Templeton representative said last week the stock had been trading at about 85 rubles ($2.10) a share before the Rosneft-TNK-BP deal was announced. The price Rosneft paid to BP and the Russian billionaires, he said, worked out to about 100 rubles a share. Then he added that Rosneft had just announced it planned to report a gain on the transaction because auditors had found the real value of TNK-BP was even higher than what Rosneft had paid–about 123 rubles a share.

His questions were simple: he asked the president if he thought Rosneft’s 67 rubles was a fair price and if such behavior would serve as a precedent for other state-controlled companies.

But here’s the good part.  And by “good” I mean “bad”:

“They’re a great fund, but no one should put pressure on us,” he added, referring to Franklin Templeton. Mr. Sechin said he’d had his staff identify the employee who asked the question, as well as to pull the records of the fund’s ownership, how much it had earned in dividends and how it had voted at annual meetings.

“Everything suited them,” he said, marveling that after such returns the fund would accuse Russia of “putting the squeeze on investors.”

Identify the employee who asked the question, etc.  No.  One would never construe that as a threat in Russia.  Never ever ever, right?

Reality: The message to Franklin Templeton is clear: we know who you are, and if you do that again, we will make you pay.  And for anyone else that has an idea of opening his pie hole, you might want to think about that again, fool. Ask Browder about that.

As for hallucinations, there were several.  For instance, Sechin lauded Russia’s investment climate.  No, really!  He did!

Mr. Sechin praised Russia’s investment climate, repeatedly crediting Mr. Putin for passing regulatory and other changes to stimulate oil production on the Arctic shelf and in other hard-to-produce fields.

“We have reinforced-concrete political stability led by Vladimir Vladimirovich,” Mr. Sechin added.

No further comment necessary.  Other than to say that Sechin’s nose will look tanned even in the middle of a sunless Arctic winter.

Another hallucination involved the shale revolution:

His brief tour of competing oil producers covered the Middle East and Venezuela, but didn’t include North America. [Talk about whistling past the graveyard!] When asked later about surging production of shale oil and gas that’s likely to help the U.S. overtake Russia as the largest producer of the fuels in the world this year, he acknowledged the boom but seemed dismissive. Echoing a view common among Russian officials but discounted in much of the rest of the oil world, he said the impact would be limited to the “local market.”

“We won’t be competing with them on global markets,” he said.

He brushed off a suggestion from a Russian journalist that Rosneft should focus on its own vast reserves of shale oil and gas and leave its current costly drive into the Arctic offshore for the future.

“There will be competition, but we have competitive advantages,” he said.

Um, the oil market is essentially a world market, and supply shocks in one “local market”-you know, like North fricking America-have world-wide implications.  A one percent change in world output emanating from North America has pretty much the same effect on price as a one percent change in world output emanating from Iraq or Nigeria or Russia or Libya: roughly speaking, about a 10 percent impact.  In the medium to long run, there is no “local” in the oil market.  This is Oil 101.  But apparently it’s lost on the CEO of the largest oil producer in the world.

Moreover, the technology of shale is mobile, and will be, after tweaks to accommodate disparate geologies in China and elsewhere, this technology will lead to increased world output, lower world prices-and lower profits for Rosneft.

But the hallucinations don’t end there:

Russian state oil giant Rosneft has plans to extract oil in the next 100 years and sees no significant threat from the increase in shale gas production in the United States, CEO Igor Sechin told journalists Sunday.

“We have a 100 year work prospect,” Sechin said. “As for the shelf, we have no other alternative. In general, oil needs to be extracted,” he said adding that the US shale production is high-cost, which makes it impossible for export.

So shale is expensive, but Arctic projects are cheap?  Seriously?  “Oil needs to be extracted”?  What, regardless of cost?

Yes, shale oil production is expensive compared to other, more traditional resources.  But Arctic projects are incredibly costly, especially for an inefficient, technologically lagging company like Rosneft, which needs western partners to develop these resources-but can’t find the way to play nice with its ostensible collaborators.  Hell, even Shell, which is a far more technologically sophisticated company than Rosneft, and which has a proven track record with technologically challenging projects, has been humbled by its recent failures in the Arctic:

Voser, who will be replaced next year, also said Shell’s failed Alaskan Arctic exploration, marred by technical and regulatory problems, is one of his biggest disappointments on the job, the FT said in a story published Sunday.

Shell RDSA still doesn’t know if it will return to the Arctic next year or in 2015, he said. The company spent $5 billion in the Arctic without being able to complete any wells.

If Shell finds the Arctic a perhaps insurmountable challenge, one can only laugh that Sechin thinks that Rosneft will be able to produce oil in the Arctic economically, even if that oil just needs-needs, I tells ya-to be produced.

One can only marvel at Sechin’s performance. It encapsulates myriad Russian dysfunctions.  A complete disregard for property rights.  Thuggish intimidation of those who question authority.  A complete denial of reality, with the only question being whether that denial is the product of delusion, or just plain dishonesty.

As a friend often reminds me.  Eta Rossiya.

In one of those episodes of Kabuki theater so common in Russian politics, Igor Sechin and Prime Minister Dmitri Medvedev discussed buying out minority shareholders in TNK-BP.  Medvedev expressed concerns about Russian corporate governance, and the nation’s bad reputation among international investors, and suggested to Sechin that a gesture by a state corporation could help improve this image:

Warning that Russia faced an economic “abyss” if it did not push through serious market reforms, Mr Medvedev urged Rosneft to improve corporate governance. “A state company can give an example of the right way to treat minorities. This will improve the investment climate,” he said

Sechin responded by saying that the company would consider voluntarily buying out minority shareholders in the TNK-BP holding company, despite the fact that it was under to legal obligation to do so.

My first reaction was one of surprise, and positive.  Then I saw the details.  Medvedev and Sechin agreed that the minority holders would be paid a 20 to 30 percent premium over the average price over the last several months.   A premium? Great, right?

Not really.  Sechin’s previous refusal to buy out the minority shareholders had crushed the share price.  He said they’d get squat, and the stock price fell to squat.  Now he’s generously offering to pay squat plus 20 percent.  Yes, this is better than nothing, but doesn’t really represent reasonable compensation.

In other words, the stock price was predicated on an estimate of what pittance Sechin might be persuaded to part with, rather than an objective appraisal of the value of the shares.  Offering to pay a small premium over the pittance price is hardly a great boon to the minority holders.

In terms of precedent, it also creates uncertainty due to the circularity of the process.  Think about a future episode.  The price of minority shares will depend on what shareholders and potential buyers think the acquirer can be persuaded to give up in compensation.  This compensation is not based on an independent appraisal of the value of the assets but the previous price, which is based on an estimate of the compensation; this is an infinite loop with no linkage to the value of the assets which the shares give a claim to.   This makes the price indeterminate.

The only thing that likely connects the price to value is the knowledge that someone in Sechin’s position would refuse to go along with the deal if the compensation paid represented a large fraction of value.  That is, in the present instance, Sechin may be willing to act all cooperative because the stock price has been so far below value that he’s not really giving up that much.   Here the fraction of value believed acceptable to the acquirer can anchor the stock price to value-or, more accurately, some fraction of value.

For instance, say the fair value of the shares is 100 Rubles, and that it is widely believed that an acquirer like Sechin will be willing to pay 15 percent of this value to make the minority shareholders go away, or to get political pressure off his back, or to make it look like he’s being all magnanimous.  So the shares sell for 15 Rubles.  If the conjecture is correct the future Sechin will be able to get the shares for 15 Rubles, which he’s willing to pay, but which is far below value.   So again, it’s what the acquirer is willing to pay-or believes he can get away with paying to avoid political flack-rather than value that determines price.  That doesn’t provide any real protection to minority shareholders.

This means that this apparent concession really doesn’t fix the fundamental problem that vexes Medvedev.  Only some independent appraisal mechanism and a legal obligation to treat minority shareholders fairly will do that.  Tying the buyout price to the previous market price doesn’t.

Speaking of Medvedev, this Kabuki play seems to be a part of a political campaign on his part.  In addition to the colloquy with Igor, he published a long article in Vedemosti raising an alarm that Russia faced a serious risk of prolonged economic stagnation.  The central part of his diagnosis is Russia’s institutional rot, the natural state that I’ve written about since the very early days of this blog:

I believe that the protection of private property and competition remains our unconditional political priority. The Russian economy still posts low investment levels, and this is not only caused by specific arithmetic calculations of potential capital-efficiency volumes. Investors still harbour irrational fears of working in an incomprehensible and sometimes unpredictable Russia. Add to this the absolutely explainable distrust of public institutions, including the judicial system and law-enforcement agencies. This is something which is very sad. As Fyodor Dostoyevsky wrote, capital likes external and domestic stability, otherwise it hides.

Among other things, this situation is caused by the fact that many officials, judges and police officers (although, of course, not all of them) still believe that state property, and therefore state companies, have the right to better protection, and that these rights are infinitely greater than those of individuals. They also believe that the latter pursue exclusively personal interests and are therefore suspicious and must be rigidly controlled.

The most frequently quoted phrase in this (“the irrational fears”) actually doesn’t make sense: in context, it is clear that Medvedev believes the fears are very rational.  Read that way, the diagnosis makes perfect sense: it’s not all that different from what I’ve written here for years.

But when it comes to recommending reforms, Medvedev shrinks from his diagnosis and advances technocratic proposals that will do nothing to correct the very real evils he identifies in the paragraphs quoted above.  The proposal that companies like Rosneft and Gazprom create and operate their own universities is particularly risible.  Russia’s problem is not a shortage of institutions of higher education, and the idea that corrupt and hidebound entities like Gazprom or Rosneft would be able to become world class educators is so bizarre that one wonders what Medvedev was thinking.

In other words, Medvedev is playing his by now familiar role of being one of the few in the elite that speaks frankly about Russia’s serious institutional weaknesses (Kudrin being another), but being completely unable to do anything about it.  The buyout of the minority shareholders in TNK-BP is just another one of those token efforts that betray an understanding of the Russia’s fundamental problems, and the complete lack of will to do anything serious about it.

My frequent sparring partner, John Kemp of Reuters, reads the IHS study justifying the benefits of bank involvement in commodity markets, and is not convinced. I agree that the report is rather lame, but am not convinced by Kemp’s critique, and the policy implications he draws.

One of Kemp’s points is that banks are not essential to the purchase, sale, transportation, storage, or processing of commodities.  Other entities, most notably commodity trading firms like Vitol or Glencore or Trafigura, can provide the same services as the banks.

This is true, but beside the point.  There are few types of firms that are utterly essential, with no substitutes.  Even banks are not irreplaceable in the functions that Kemp, and others, agree is appropriate for them.  Their core function of providing credit can be performed by the capital markets.  Or loan sharks.

The fact that banks can profit as a result of their activities in physical commodities should create a rebuttable presumption that they are providing economic value.  In a reasonably competitive market, where costs and benefits are internalized, firms that survive do so because they can provide a good or service of equal or better quality at equal or lower cost to other potential suppliers.  Indeed, in these circumstances, all active sellers have marginal costs that are approximately equal: cost functions determine the relative outputs of the active suppliers.   Driving out suppliers who can profitably service part of the market will drive up prices, reduce output, and reduce welfare: some of the output supplied by the eliminated firms will go unproduced, and the rest produced at higher cost.

Competition is not the issue. The market for commodity intermediation is highly competitive: even the big banks account for a relatively small share of activity, and the biggest players account for no more than 5-6 percent of trading activity in any major commodity market.  And even if banks accounted for a big share, that could be due to a cost advantage.

Which brings me to Kemp’s second objection, which potentially has more merit.  The above says “where costs and benefits are internalized.”  Kemp brings up, quite properly, the possibility that banks get a subsidy as a result of too big to fail, and hence the true costs of their activities are not internalized.

The immediate implication of this is that banks are too big, and that there market share in physical commodity activities is too big.  But “too big” does not mean that the right share is zero.  Banning bank participation in physical commodity markets, or excluding them from certain activities, is likely to be an overreaction, not a Goldilocks (“just right”) strategy.  They might be too big now, but zero is almost certainly too small.

Note too that eliminating banks from physical commodity markets, or restricting their participation, does not eliminate the TBTF subsidy.  Yes, they might not be able to exploit the subsidy by getting too big in commodities, but they are not going to let the subsidy money burn a hole in their collective pockets.  Won’t let them exploit the subsidy in commodities?  They’ll find someplace else to do it.  Restricting activity in one market segment will not appreciably reduce the TBTF subsidy that banks reap.

The right way to address this problem is to find ways to get banks to internalize the true costs.  This is best done by capital requirements that reflect the risks of the activities banks engage in, and the costs associated with bail outs.  Restrictions on permissible activities are a meat cleaver approach that will not mitigate the TBTF subsidy.

Kemp also goes on about the metals warehouse games.  As I’ve said repeatedly, both here and in media interviews, banks are not uniquely positioned to engage in such sorts of shenanigans.  If the conditions are right, whoever owns the warehouses will play the games. The best way to deal with this problem is ex post deterrence, either through private action (e.g., the numerous class action lawsuits against Goldman for its alleged warehouse manipulations) or government enforcement actions.

The role of banks in physical commodity markets will remain under scrutiny-and attack-for the foreseeable future. Many of these attacks are predicated on ignorance, not to say stupidity.  Kemp isn’t guilty of those things, but his analysis is nonetheless misguided.  Even when he identifies a real potential problem-the TBTF subsidy-eliminating banks from the physical commodity market is not the appropriate way to address it.

This illustrates a general point I’ve mentioned in many forums.  Attempting to address TBTF problems, and systemic risk problems, through structural interventions such as clearing mandates, SEF mandates, Glass-Steagall, or preventing banks from participating in commodity markets, is inefficient and likely ineffectual.  It is better to operate at the level of fundamental incentives, by getting banks and other financial intermediaries to internalize the costs and benefits of their activities. This is an easy principle to state in the abstract, though hard to implement in practice: just what is the right capital charge overall, and how should different bank activities contribute to this charge?  Not an easy question to answer.  Although imperfect, that’s still a better way of addressing these problems than mandating market structures.