Streetwise Professor

If you want an illustration of the primitiveness of the Russian economic and political system, and that of the systems in the Former Soviet Union generally, look no further than this story.

In terms of economic primitiveness, the fact that a dispute over potash (potash! FFS)  is elevated to a matter of state requiring the direct involvement of heads of state illustrates perfectly the dependence of FSU countries on the production and export of basic materials.  For all the yammering about economic transition, all the FSU economies, including notably Russia’s, remain dominated by the production of basic materials.  As witnessed by evidence accumulating day-by-day that the FSU countries are becoming economic satrapies of China, as demonstrated by the Chinese acquisition of a large stake in Uralkali, the mooted Chinese acquisition of huge tracts of land in Ukraine, and the plethora of Chinese energy deals in Kazakhstan and Turkmenistan.

But the episode is more interesting for its demonstration of the institutional primitiveness of Russia, and the other FSU countries.  In advanced countries, commercial disputes are adjudicated or arbitrated through institutional processes:  indeed, they would have never have progressed to the point at which Belarus and Russia now find themselves.  But the institutional underdevelopment in Russia and Belarus and other FSU states means that rule is personalized, and commercial disputes between large businesses must be resolved-or not-through the personal intervention of heads of state.

Could anything illustrate more tellingly the personalized, de-institutionalized nature of rule in Russia than Putin’s personal involvement in such a matter?  Could you hallucinate, even after a bender that would put the Hangover I, II, or III to shame, Obama or Bush or Clinton doing any such thing?  And this is not a one-off.  Putin is repeatedly involved in grubby commercial negotiations (usually over natural resources) within Russia, and between Russia and other FSU countries.

This is a perfect illustration of why I have long believed that Russia is doomed for perpetuity to exist in an economic limbo as a natural resource state falling further and further behind not just more advanced, institutionally developed nations like the US, but even other institutionally challenged countries like China.

In other words, the Former Soviet Union is Totally F’d Up.  And will remain so.

Going through my news clips this morning made me feel like I was in a video game fighting off hordes of zombies. Commodity market critic zombies.

Zombie #1: Gretchen Morgenson, with an article on RINs. It is a farrago of innuendo and idiocy.  Really, it is 9 pages long, and I could write 20 listing all the fundamental flaws.  I don’t have the energy for that (no pun intended), so I’ll limit myself to the greatest hits.  In a nutshell (emphasis on the nut), it is a typical Morgenson piece: if banks are involved it’s bad;  if people are speculating it’s bad; if there are unintended consequences of government policies, it’s not the fault of the stupid government, it’s the fault of those who have to deal with the stupidity, and who figure out ways to make money out of artificial bottlenecks created by the stupidity.

The article is an assemblage of assertions and allegations totally lacking in evidence.  Morgenson alleges JP Morgan has speculated in RINs.  Which it denies.  She insinuates that the market might be manipulated, but provides no evidence.  She mentions a “corner”, but obviously doesn’t understand how a corner works: that would require the accumulation of a long futures/forward position, but she provides no evidence that anyone has accumulated such a position. (CME shows a grand total of a whopping 558 RIN contracts outstanding.)

Morgenson is obviously very suspicious of speculation-kind of funny, since her entire article is completely speculative-and suggests that speculation distorts-i.e., manipulates-prices.

Assume arguendo that Morgan or some other evil bank did figure out that the blend wall would hit and that RINs would become more valuable as a result, and hence accumulated them.  If it is right, it will profit when prices rise.  That doesn’t mean it caused the prices to go up. Prescience isn’t the same as manipulation.

Morgenson should be forced to write on the blackboard, Bart Simpson-like:

Speculation≠Manipulation

Speculation≠Manipulation

Speculation≠Manipulation

Speculation≠Manipulation

Speculation≠Manipulation

. . . .

The real problem here is something that makes only a cameo appearance in Morgenson’s story: the artificial RIN bottleneck created by an idiotic government policy that was adopted based on a forecast of future gasoline consumption (‘cuz yeah, we’re so good about making energy forecasts) and an ignorance of the technological realities of ethanol.  It is inevitable that someone would figure that out, and make money off it.  Inevitable.

Quite honestly, you’ll learn more about the reality of RINs from one of those ubiquitous Hitler videos than the New York Times (h/t @izakaminska):

Speaking of tow-headed troublemakers named Bart . . . that brings us to Zombie #2. Taking a break from edifying us all about the evils of HFT, polymath Bart Chilton went off on the evils of banks in commodities:

Mr. Chilton, in prepared remarks viewed by The Wall Street Journal, said it’s “nearly impossible to figure out exactly what banks own.” He said the CFTC can see what banks are trading in derivatives markets tied to commodities, but doesn’t know what physical assets like oil tankers and aluminum they hold.

“Unless we can see that, we can’t reasonably and responsibly protect against market manipulations,” Mr. Chilton, a Democrat, plans to say in speech to a business association in Michigan Saturday.

The CFTC has been investigating firms that store and deliver aluminum, including Goldman Sachs and J.P. Morgan, after complaints from companies that use the metal. Beer and soda companies, can makers and other end users said firms that warehouse aluminum inflate prices by holding onto it for longer than necessary.

Banks that trade commodities have come under fire from government officials, companies and consumer groups who say they exert too much influence over markets for some raw materials.

Mr. Chilton plans to raise that concern in the speech, saying banks that own commodities and trade in derivatives based on the prices of those commodities have a potential conflict of interest.

“The prices of commodities are supposed to be based upon supply and demand,” Mr. Chilton plans to say. “However, what if you control, or have significant influence upon, the supply or the demand?”

Mr. Chilton also is expected to say the public should be able to “easily locate and click on a link to find out” what physical commodities banks own. He will also call on lawmakers to rein in banks’ role in the buying and selling of physical commodities and not leave the decision to the Federal Reserve.

Click on a link to find out physical positions.  Right, Bart.  Uhm, you can’t even do that for futures positions.  And care to share any evidence demonstrating that any banks exert a “significant influence” on supply and demand in any energy commodity?  Their market shares in physical tend to be very small.  Check out the stat on Morgan Stanley in the Morgenson article-Montaigne markets 2.5 percent of gasoline in the US. Big freaking whoop. JP Morgan serves one piddling refinery on the East Coast.  Sheesh.

Conflict of interest: the classic problem raised by people who don’t have a real argument. Speaking of real arguments, how’s this for a doozy:

“Maybe it’s just me, but I don’t think the American public wants banks owning grain elevators, electric companies, large warehouses or shipping and distribution interests,” Chilton said in the speech.

Wow.  Let no one ever question Bart’s ability to make a substantive economic argument, backed with empirical evidence.

Zombie #3: Lina Khan, in The New Republic. Again, far too much idiocy to deconstruct in detail.  One illustrative example: the insinuations about “inside trading.”  Trading on private information is quite different than inside trading.  The later involves the violation of fiduciary duty or the theft of corporate information that belongs to shareholders.  Trading on private information is the lifeblood of virtually all markets.  It’s called “price discovery.”

The huffing and puffing about Cargill and Trafigura operating hedge funds is another faux controversy.  These funds are regulated just like funds operated by other entities.  Moreover, there are Chinese walls restricting the flow of information between the company-managed funds, and other trading operations.

Furthermore, Khan makes broad allegations of manipulation.  I assure you that yes, manipulation does occur in commodities markets, and that trading firms sometimes execute these manipulations.  But manipulation is subject to regulation (contrary to the statements that these markets are unregulated).  Moreover, the allegations of manipulation in the article are amazingly vague, and unsupported by any evidence.  The article is a classic illustration of the Clayton Definition of Manipulation: Any Practice That Doesn’t Suit the Person Speaking at the Moment.

For instance:

Experts warn that this degree of involvement across the entire production cycle gives a handful of sizable firms even greater unchecked power over our most basic goods. “Clearly if you control the physical stock and stand to gain from managing the release of that stock, it would be foolish to expect companies not to take advantage of that,” said Sophia Murphy, senior adviser at the Institute for Agriculture and Trade Policy and author of “Cereal Secrets,” a report on the major grain traders.

Part of the trouble is that no public body oversees global physical stocks. Andres Missbach, co-author of Commodities: Switzerland’s Most Dangerous Business, said the vast storage capacity these companies have amassed equips them to create artificial shortages in the short-term if they wish. “We have no idea if they are manipulating,” he said. “We can only say they have the capacity to, and that there is no regulator ensuring that they are not.”’

Unchecked power? Seriously?  What fraction of global physical stocks does any firm own?  The article says that Glencore “controls” 50 percent of the trade in some commodities.  If you read Glencore’s statements, they refer to “freely traded” supplies, which are a fraction-and often a small fraction-of total supplies.  For commodities like oil, the biggest trading firms account for 5 percent or less of total supply.

“We have no idea if they are manipulating.”  LOL.  Remember what Judge Easterbrook wrote: “The undetected manipulation is the unsuccessful manipulation.”

I am quoted in the article, but my quotes are rather innocuous. Khan tried to get me to support her trading-firms-are-evil line, which I obviously declined to do: in fact, I disagreed strongly. Those quotes didn’t make the story, naturally. Yeah. No agenda there.

One last thing. All three are rather strange zombies, because they are apparently afraid of the dark.  Each mutters ominously about dark markets, trading in the dark, blah blah blah.

News flash: the “lit” transparent futures markets are the exception that proves the rule.  Virtually all commodity markets are bilateral search markets with little pre- or post-trade transparency.  This makes good economic sense given the heterogeneity of commodities, the idiosyncrasies of and variability in supply and demand for specific varieties, the desire to customize terms, and the low rate of transaction flow in any particular variety or at any particular location.  Commodity trading firms essentially customize commodities by transporting, refining, blending, storing them, etc.  The one size fits all standardization that is necessary to support continuous, centralized markets (like futures markets) is completely maladapted to the trade of actual physical commodities.  Physical markets and futures markets serve vastly different functions, and accordingly operate on vastly different lines.

Zombies that are afraid of the dark.  Too funny. Get a frickin’ night light, Gretchen, Bart, and Lina.

It never ceases to amaze me how commodities bring out the loons, and cause people to lose all ability to reason.  Like zombies.  Like Gretchen, Bart, and Lina.

Greenwald’s latest story is that the NSA spied on Brazil’s national oil company, Petrobras.  A long day of intense meetings in Geneva, so  I’ll be brief in my analysis.

Typical BS Greenwald story.  Starts out with an alleged fact based on a Snowden document.  (No one ever mentions that one can deceive by telling only part of the truth, but I’ll pass over that.)  Then proceeds with paragraph after paragraph of speculation of what the NSA could be doing.  In this case, the speculation is that NSA is engaged in commercial espionage for the benefit of US corporations.

Evidence for this? Bupkus.

Then, at the very end, Greenwald quotes a US denial, in this case by Clapper.  Clapper says that, duh, the US has an interest in economic matters, and that NSA does not engage in commercial espionage.

Does Greenwald have any evidence to dispute NSA does not engage in commercial espionage?  No.  But on his Twitter tl, he says that Clapper is lying.  Because, of course, the only reason that the US could be interested in Petrobras is for commercial purposes.  That is, he asserts and assumes that spying on a national oil company is for the purpose of benefitting US companies.

Um, not really.  Note two other very salient reasons.  First, the US Export-Import Bank lent Petrobras $2 billion.  Second, Petrobras has been the frequent subject of corruption allegations, including an accusation of money laundering made by a . . . wait for it . . . whistleblower.  Some allegations involve Dilma herself.

Gee, I thought Glenn was all about lionizing whistleblowers.

I guess that’s selective.  Go figure.

But enough expecting some sort of intellectual consistency.  Let’s just recognize that (a) the US government, and most governments, take an interest in major economic developments, especially in energy, and employ all elements of their national power to obtain information on this, (b) this does not imply that the governments use this information to advantage their domestic companies, though many do-notably China and France, (perhaps the US is an exception that proves the rule) (c) Greenwald provides no evidence, but merely asserts, that the NSA used information on Petrobras to advantage US companies, in one of his by now tiresome “can therefore does” exercises in illogic, and (d) most importantly, the US had a direct economic stake in Petrobras, and a strong reason to know whether the company was corrupt, and whether government officials involved with the company were corrupt.

Funny that Greenwald never mentions the ExIm Bank deal or the corruption allegations involving Petrobras and Brazilian public officials.  After all, that might provide some context, and we can have THAT interfering with our narrative, can we?

The latest conspiracy theory regarding Syria is that this is all a Qatari plot designed to open up a route for a natural gas pipeline.  (Google Qatar Syria Gas Pipeline and you get about 1.3 million hits, virtually all of the first several hundred are about this theory.)

Several comments.

First, consider the source.  This is has been a Syrian propaganda line since very early on.

Second, consider who is flogging this theory, notably Alex Jones and Zerohedge, both of whom are reliable Putin pilot fish, with the former being a notorious propagator of outlandish conspiracy theories involving the US government, including 911 Truther type conspiracies.

Third, and by far most importantly, the theory doesn’t explain one crucial fact: Saudi support for Assad’s overthrow.  Indeed, if this reductionist conspiracy theory were correct, the Saudis would be throwing everything behind Assad, not trying to oust him.

Saudi Arabia and Qatar have had a testy relationship for decades, and since the Arab Spring and the ascent of the new Emir of Qatar, Sheikh Tamim bin Hamid Al-Thani especially, that relationship has degenerated into a shadow war fought through proxies throughout the Middle East.  This is most evident in Egypt, where Qatar backed the Muslim Brotherhood Morsi government, and the Saudis backed the military, and bankrolled its overthrow of that government.

The KSA-Qatar battle centers on the latter’s support of the Muslim Brotherhood, and the former’s hatred of that organization.  (H/T @libertylynx)

With respect to gas specifically, Saudi Arabia has consistently blocked, or attempted to block, Qatari pipeline plans.  KSA scuppered a Qatar-Kuwait pipeline and vetoed another pipeline that would have traversed Saudi Arabia.  It tried and failed to stop a Qatar-UAE pipeline.

Saudi Arabia does everything it can to stop Qatari pipelines.  It doesn’t bankroll rebellions or importune the US to facilitate them.

It should also be noted that the main discussion of a pipeline from Qatar that would traverse Syria dates from 2009, when Turkey and Qatar announced that they would study the idea.  The concept at the time was that this pipeline would supply gas for the Nabucco pipeline into Europe.  But Nabucco’s prospects were never good, and it was formally killed earlier this year.  Remember that there are far more pipeline ideas announced, often to much fanfare, than actual pipelines actually built.  Spending billions to fund a war to build a pipeline with bleak economic prospects doesn’t seem like all that great a project for cagey investors like the Qataris.

For religious, political, and economic reasons, Saudi Arabia and Qatar are foes not friends.  So if it was all about gas, perhaps Qatar would be trying to overthrow Assad, but Saudi Arabia would be trying to stymie Qatar.  Perhaps if it was all about gas, a bloody stalemate would be in the KSA’s best interest.  Or perhaps, KSA would even support Assad.  But if it’s all about gas, there is no way the KSA would be backing Assad’s overthrow, funding rebels, and lobbying the US to intervene.  It is even rumored that the Saudis would participate in an air campaign against Assad.  They wouldn’t do that if the ultimate outcome would be to empower the Qataris and allow them to achieve objectives the Saudis have tried to stymie for years.  The KSA isn’t going to fight Qatar’s wars.

So the conspiracy story doesn’t explain a vital fact: if you squint really hard it might-might-explain what Qatar is doing, but it doesn’t explain what Saudi Arabia is doing. And it’s even worse than that: the explanation of the Qatari action would lead you to predict the Saudis would do the exact opposite of what they are doing.  That’s a pretty big fail.

Truth be told, I have no idea what is really motivating the Saudis and the Qataris.  In the murky world of the Middle East, it is an act of extreme confidence to predict what these countries are really up to.  There are circles within circles, personal feuds, dynastic and family dynamics, and on and on.

Which means that the US should look to its interests, and to its ability to mitigate humanitarian catastrophe, when contemplating intervention.  Trying to unravel the games the Saudis and Qataris are playing is a mug’s game.  Define an objective, determine what means are necessary to achieve that objective, and determine whether the cost of achieving it is worthwhile.  Don’t get distracted by conspiracy theories, especially those that don’t fit a very important fact.

I’ve written about Germany’s bizarre Energiewende program before.  It massively subsidizes renewables, and pays for the subsidy with a huge premium slapped onto electricity rates, although some big industrial consumers are immune.  The most wasteful part of the program is the huge subsidies for wind, especially offshore wind.  Now Der Spiegel chimes in with a very, very long article savaging the program. (Complete with a bonus snark at greens posing as “saviors of the world.”)

I agree with most of what’s in the article, though I am hardly a big fan of the Swedish approach that Der Spiegel touts as an alternative: it’s just a less bad, and less expensive, than the German way.  If anthropogenic CO2 is a problem, slap a tax on it and let people figure out how to respond efficiently, rather than subsidizing specific technologies and suppliers.  The regressivity of the scheme is also not the worst thing about it, though it’s hardly a feature.  What is interesting is that the allegedly “social” Germans, who carp about American inequality, would implement such a regressive scheme.

One other thing to note, which might lead me to discount the brutal nature of the article if I didn’t know about Energiewende from other sources.  The article is clearly aimed at Merkel and her government: the program is laid entirely at her feet.  Thus, the article is a part of Der Spiegel’s unremitting attacks on Frau Merkel in the lead up to the election that will be held in a couple of weeks.  The most prominent part of those attacks is, of course, the Snowden coverage.

Ironically, the Der Spiegel site appears to be down now.  No doubt part of a US operation to silence the brave Laura.

But maybe it’s German intelligence.  For today Reuters reveals that-brace yourselves-Germany has an intelligence service.  And an intelligence service that collects electronic intelligence on foreigners no less!  Who knew? It even has at least one “naval reconnaissance vessel” that plies international waters scooping up information from the international ether.  (“Reconnaissance”, of course, being a fancy name for “spy”.)

Syrian brigade and division commanders had been asking the Presidential Palace to allow them to use chemical weapons for the last four-and-a-half months, according to radio messages intercepted by German spies, but permission had always been denied, the paper said.

This could mean Assad may not have personally approved the attack close to Damascus on August 21 in which more than 1,400 are estimated to have been killed, intelligence officers suggested.

Germany’s foreign intelligence agency (BND) could not be reached for comment.

Bild said the radio traffic was intercepted by a German naval reconnaissance vessel, the Oker, sailing close to the Syrian coast.

The BND couldn’t be reached? What, are they secretive or something?

And they also intercept phone calls!  I think I’m going to faint:

Members of the foreign affairs committee present at the briefing told Reuters Schindler had said that although the BND did not have absolute proof Assad’s government was responsible, it had much evidence to suggest it was.

This included a phone call German spies intercepted between a Hezbollah official and the Iranian Embassy in Damascus in which the official said Assad had ordered the attack.

But I’m sure Germany would never intercept anything on the Internet, so Laura and Jake can continue to take refuge in Berlin in good conscience.  I’m also sure that it knows exactly who the bad guys are so it only intercepts their communications, and only when they’re plotting bad things.  No NSA needle in a haystack programs for Fritz.

In further irony, Der Spiegel originally posted a story about the interception of the phone call . . . in a brief web posting without a byline.  (I’d link that, but like I say, Der Spiegel’s website is down now.)

Update: The Der Spiegel site is back up now.

I’m supposed to be in Geneva right now, but United Airlines decided that what I really wanted to do was to sit around Dulles for 5 hours waiting for them to figure out they couldn’t fix a mechanical problem, and then to sit around a hotel for a day waiting for today’s flight.  Luckily I was able to get the last seat on that plane, so I don’t have to do something like Dulles-Newark-Frankfort-Geneva like some of the other folks on the canceled flight.

So that gives me some time to catch up on reading (and blogging).  And it takes some time to read this loooonnnnggggg Bloomberg encomium to Gary Gensler, which describes his valiant St. George-like battles against the big, bad banking dragons.

The basic theme is that anything the banks don’t like must be good, and anything the banks do like must be bad. The profile confirms that’s Gensler’s view of the world, and Silla Brush and Robert Schmidt pretty much adopt that template.

If only the world were that simple.  Yes, regulatory capture by major financial institutions is a major danger, and happens.  Freddie and Fannie illustrate that in spades, for sure.  So one should always approach the lobbying efforts of large incumbent players, especially large financial institutions, with incredible skepticism.

But at the same time, one has to remember that regulators do stupid things, and adopt regulations that are grossly counterproductive and impose costs far in excess of any conceivable benefits.  Banks potentially subject to such regulations reasonably fight against those, which means that bank opposition to a regulation is not a sufficient statistic to determine whether it is a good or bad policy.

The two regulations that Gensler fought for that are covered extensively in the Bloomberg piece are definitely examples of bad regulations.  The article devotes the largest share of pixels to the battle over the request for quote battle.  You may recall that I named Gensler’s RFQ proposal as the Worst of the Worst of Frankendodd.  The SEF mandate itself is seriously misguided, and mandating how many quotes those wanting to buy or sell a swap must obtain is totally cracked: it is predicated on the paternalistic belief that those who are doing the trading don’t have the ability to make the appropriate trade-offs between information leakage and greater competition to get their business.

The article also details the battle over the de minimis level of trading activity that would determine who has to register as a swap dealer, and thereby incur the additional compliance, collateral, and capital burdens.  Gensler wanted the level set at a piddling $100 million, which would catch pretty much everyone of even modest size in the CFTC’s swap dealer web.

If the purpose of the swap dealer designation is to reduce systemic risk, the level of trading activity is a very poor means of determining which entities should be subject to the higher level of regulation and scrutiny.  And seriously, many firms that must register as swap dealers under the $3 billion level eventually settled upon-against Gensler’s furious opposition-are not systemically risky, either.

Relatedly, the article identifies futurization as an end run around regulation.  As I’ve written before, futurization is a predictable response to regulations that treat economically identical instruments differently.  Swaps are treated more punitively, due to more onerous collateral standards, and because swap trades count towards the de minimis swap dealer trading level but identical futures don’t.  So, duh, people will choose futures over swaps that are otherwise economically equivalent.  If this also allows firms that aren’t systemically important to escape the burdens of swap dealer registration, that’s all for the better.

Moreover, it should be noted that futurization has been over-hyped.  Its main effect has been in energy.  There is no way that the real swap dealers who are systemically important-the JP Morgans, Citis, etc.-are going to be able to avoid being designated as swap dealers by switching their business to futures.  (Don’t interpret that to mean that I believe that swap dealer designation will materially reduce systemic risk.)  A lot of their business is in instruments for which futures are not a viable substitute.  In contrast, in energy (and commodities generally) for the bulk of the business futures and swaps are close substitutes.

Indeed, there is an irony here.  Large quantities of energy swaps were “NYMEX lookalikes” virtually equivalent to futures traded on NYMEX (and then the CME after it acquired NYMEX): firms traded the swaps because under the CFMA, they were subject to a lighter regulatory touch than futures.  So the energy swaps business was largely a product of regulation, and when the regulation changed, the business changed.  The business went to where the regulatory burden was lowest.  Go figure.  Given that part of the premise of Frankendodd is that the futures regulatory structure was the right model that made an appropriate trade off between costs and benefits, the migration to futures should be considered an improvement even by Frankendodd supporters.  It brought the business back to where it should have been all along, according to the advocates of Frankendodd.

The article also writes a lot about extraterritoriality, a subject that makes my eyes glaze over.  The most revealing aspect of this battle is Gensler’s regulatory imperialism, and his stubborn resistance to near universal opposition.  In Gensler’s view-and in the article-everybody was out of step but Gary.

One interesting omission (as if you think anything could be omitted in a 20 page article) is anything related to position limits, another Gensler hobby horse.  Perhaps this is because he eventually prevailed in the Commission, and got it to pass a rule to his liking, so it doesn’t fall into the category of where Gensler’s views lost out to intense political opposition.  But it does fall into the category of a regulation that was opposed vigorously by the banks, who prevailed-at least for now-in getting the regulation stopped.  The difference is that they fought and won that battle in court (though appeals are ongoing).

The article does devote some coverage to the systemic risk of clearinghouses.  Ironically, it indicates that Gensler is aware that CCPs concentrate counterparty risk, which can be problematic.  This is quite contrary to many of his public statements on the issue, including in an FT oped mentioned in the Bloomberg piece, in which Gensler suggests that CCPs are a magic box that makes risk disappear.  So was he misinformed before, and has he come to a better understanding of the way things really work?  Or was he deceptive in his earlier advocacy?

It’s good to know that there is some recognition of this issue, but sadly, the diagnosis of how CCPs contribute to systemic risk is cramped and simplistic.  Yes, the failure of a CCP is a major worry, but as I point out in the paper I will present in Paris next week (assuming UA cooperates!) measures to keep CCPs immune from failure can create systemic risks too.  There is too little systematic thinking about systemic risk.

In politics and journalism, good versus evil narratives are easy and comforting.  The problem with that is that when you are talking about something as complicated as derivatives regulation, the world isn’t that simple.  Rent seeking and capture happen, resulting in industry-friendly regulations that may create or perpetuate systemic risks, or fail to mitigate real problems.  But regulatory stupidity happens too.  This is especially likely when you have a regulatory crusader who believes that he is on the side of good fighting evil, and who approaches complicated markets with a very narrow set of simple beliefs, rigidly held: Transparency good! More transparency better! (Ironic, given that SEFs reduce transparency about the identity of counterparties, even if they increase pre- and post-trade price transparency).  Clearing good!  Banks bad and anti-competitive!

As you know, I believe that the intellectual assumptions underlying Frankendodd are fundamentally flawed.  The adverse consequences of those fundamental bugs are only exacerbated when the individual with the primary responsibility for implementing the law believes the bugs are actually features, and approaches his task with a Jesuitical zeal that treats any opposition as the result of malign and self-interested motivations.  Gensler’s rigidity and self-righteousness, and apparent unwillingness to contemplate the possibility that people were opposing him because, he was, you know, actually wrong, have made the process costlier and more contentious, and made the resulting regulations more costly and less beneficial.  Consequently, Gensler’s defeats on these issues-which are minor in the scheme of things, really-are to be welcomed, not lamented.

The CME has seen increased volumes in its cash settled Brent contract in the aftermath of its launch of a program that pays rewards to those who trade the contract.  This is a standard way to attract volume to a contract competing against an incumbent/dominant contract.  Indeed, it’s probably the only way to do it.

Eurex tipped the Bund market away from LIFFE in 1998 after implementing a fee holiday, which LIFFE smugly refused to match, so confident was it of its liquidity advantage.  But Eurex had enough organic order flow that it was fairly liquid already, and the fee cut made it cheaper to trade Eurex Bunds, as I document in my paper “Bund for Glory: Or, It’s a Long Way to Tip a Market” (which will be a chapter in a book I’m currently writing).  The market tipped within a period of mere months.

Other exchanges didn’t repeat LIFFE’s near fatal mistake, and responded to fee cutting entrants by cutting their own fees to match.  This is how CBOT saw off Eurex’s attempt to enter the US Treasury futures market in 2003, and how CME torpedoed EuronextLIFFE’s attempt to enter into the Eurodollar futures market a few years later.

Here’s the deal: incumbents have a huge liquidity advantage that entrants must overcome.  How can this be done?  The only way, really, is to cut fees, or actively reward volume to attract enough liquidity to compete with the incumbent.  And the odds are still long, especially if the incumbent follows the CBOT script, and matches the reduced fees.

But if you want to encourage inter-exchange competition, you have to look favorably on entrants using strategies that reward volume as a way of building liquidity to make themselves into viable competitors.

This basic fact makes this FT article very disappointing.   It criticizes the CME initiative, and only quotes those who are critical or dismissive of the endeavor.  Yeah, it’s probably true that the only reason why those who participate in the incentive program trade is to collect the rewards.  But their order flow can attract order flow from others: other traders see that there is two-way activity, and can be more confident that if they establish a position, it won’t be a Hotel California that they can check into, but can’t leave.  Meaning that it’s BS to say, as one anonymous source to the story says, “there is no economic benefit to the trades whatsoever.”  The economic benefit is that it can make the entrant a more viable competitor to the incumbent.

And quoting Bart Chilton.  Please.

The quote that claims that spread trades-which dominate the activity in the CME Brent contract-“make no loss because they buy and sell at the same price” is just a crock.  Yes, spread trades are lower risk, but calendar spreads do move.

The CME is engaging in a penetration pricing strategy.  The only real strategy that permits competition against an incumbent.  If you like competition, you should like a strategy that harnesses the greed of trading firms to generate liquidity and volume.  Because, quite frankly, that’s the only way to compete.

But if you like monopoly, go ahead and denigrate what the CME is doing.

It would also be interesting to see how ICE built market share in its WTI cash settled contract that competes with the CME’s flagship oil contract.  It is my recollection that ICE rebated fees for firms that brought volume to the ICE contract.  (The structure of the ICE inducement, and Eurex’s in Bunds, were interesting.  They basically made it a tournament, with rebates/bonus payment being limited to the top three-if memory serves- order flow providers.  That provides a very high powered incentive while controlling the cost of the program.)  If my recollection is correct, doesn’t that mean that sauce for the goose is sauce for the gander?

Competition in futures markets, where order flow is not socialized, is highly imperfect.  Incumbents have huge advantages.  Aggressive price competition-pentration pricing, specifically-is about the only way that an entrant can hope to dent the incumbent monopolist’s huge liquidity advantage, and even that is a highly dicey proposition.  The FT story would have been much better had it recognized this reality rather than taking an all too critical view, and containing only quotes that were no doubt music to Jeff Sprecher’s ears.

Richard Epstein has written about “government by waiver,” and its pernicious effects.  We’ve had numerous examples of late, from the Obamacare waivers, to the suspension of the employer mandate, to yesterday’s decision to exempt Congressional staff from Obamacare.  Yesterday also brought news of another administrative version of Emily Litella’s (and Nirvana’s!) “Nevermind”: the EPA is easing renewable fuel standards that had wreaked havoc in the gasoline market, and driven prices for Renewable Information Numbers “RINs” from pennies to nearly a dollar per gallon:

The Environmental Protection Agency, which administers the mandate, has said it will reduce total required volumes in its forthcoming proposal for 2014. It also extended the compliance deadline for 2013 by four months to June 30 of next year.

We’ve seen this movie before.  Congress passes expansive feel-good legislation that is at complete odds with economic reality.  Those who have to deal with economic reality importune the executive branch and administrative agencies for relief, and some sort of relief is granted.  (As another example, CFTC has also granted various forms of relief for some of the Frankendodd craziness.)

In the case of RINs, Congress demanded that refiners utilize far more renewable fuels (such as ethanol) than is feasible, given the installed base of auto engines which can only utilize 10 percent ethanol fuels.  Refiners could purchase unused renewable fuel credits (RINs) accumulated in past years when renewables usage exceed the then-lower mandated levels, but these are running out, and the renewable requirement was increasing even more for 2014.  Thus, the price of RINs had rocketed higher and there was risk that there wouldn’t be near enough for 2014.  The regulations also favored exports of gasoline because exported gas does not count towards renewables requirements.

So EPA stepped in and gave relief.  Because Congress couldn’t be bothered to worry its little head about minor details like the ability of the engines in hundreds of millions of autos to use the amount of ethanol it, in its infinite wisdom, decreed.

This is perverse in many ways.  It encourages rent seeking, at times to the point of corruption, or at least highly dubious political favoritism and dealing.  It empowers unelected bureaucrats who are difficult enough to hold accountable as it is, and who are often pursuing ideological agendas, and who can use their leverage to advance those agendas.  It allows Congress to avoid being held responsible for, let alone accountable for, its careless legislating: why take care in attempting to anticipate perverse effects when there’s someone there to clean up your mess?  It creates substantial uncertainty that discourages investment and hiring.  We end up with a thicket of ad hoc responses to legislative pipe dreams that lead to further problems that lead to more ad hoc responses and on and on.

In some respects, the RIN fiasco is the least of the renewable mandate’s sins.  Ethanol is a disaster on many dimensions, economic and environmental.  These problems are bad enough, but the EPA’s action is emblematic of a broader problem with the mega-legislation of the Bush-Obama years.  The legislation is unworkable, and compels delegation of considerable discretion to largely unaccountable administrators.  It undermines the rule of law and makes the US more like a natural state-or banana republic.

It’s Friday, and so a funny is called for, and this article on Rosneft in Eurasia Review (“News and Analysis”!) fits the bill.  The Tiger Beat tone of Kerim Has’s article has to be read to be believed.  Yes, he does acknowledge Rosneft’s dependence on the Russian state, but he still gives the impression that Rosneft is a real commercial venture.

Rather, it is a corporate Frankenstein, stitched together from stolen body parts and vivified by jolts of state power.  Here’s how the article treats the most important such part:

At this time, Yukos, then the largest petroleum company in Russia was having its assets transferred to Rosneft, a process which continued until 2007. And Sechin was one of the main actors in the Kremlin’s energy policy in this process

“Having its assets transferred.”  How’s that for a euphemism?: that’s not funny, it’s sick.  Note the passive voice.  Just who did the transferring?  How did that “transfer” take place?  And-most importantly-was the transfer consensual?

My neighbor had his assets transferred once.  It was called a B&E by the police.

I actually agree with one part of the article:

To sum up, energy politics and “pipeline diplomacy” which aimed Russia to regain its “global power” position in international arena seem to keep their vital importance still for long as key instruments of Kremlin’s foreign policy. During 2000’s, Putin’s this state-centred energy strategy allowed Gazprom to become a giant company in both the domestic and international natural gas markets. And now, it is being reapplied to clinch Rosneft’s dominance over the petroleum production and exporting sector. Rosneft is taking on important duties for the Kremlin, and it looks as if it will be one of the vital pillars of Russia’s transformation into an energy superpower.

There is no doubt that Putin will succeed with Rosneft just like he “succeeded” with Gazprom.  He will succeed in creating a corrupt, bloated, inefficient, wasteful firm that is indeed a giant.  But the most gigantic thing about it will be its capacity for value destruction and peculation.  Indeed, he’s almost there.

It’s all so confusing.  During the last spasm of Congressional criticism of the “financialization” of commodity trading, mainly during the Frankendodd “debates” over position limits, the target of criticism was evil speculators who trade commodities for purely financial reasons, and who have no involvement in the physical markets.

In the latest incarnation, the alleged problem is that financial firms that trade commodities paper do have physical commodity operations:

What concerns Brown and Senator Jeff Merkley, Democrat-Oregon, is that banks have numerous physical commodity holdings as well as the means to deliver those commodities, including oil tankers, transmission rights and pipelines, while they at the same time trade on energy prices in futures and swaps markets.

Big banks can buy “vast quantities” of commodities and pipelines, tankers and warehouses, said Merkley. This gives them “a huge amount of market information that’s very advantageous in trading” and gives them a “thumb on the scale in the terms of supply and demand and being able to have some influence over the price,” he said.

“If you’re simultaneously allowed to bet on the price and you’re allowed to have your thumb on the scale in reflecting the price it’s a huge conflict of interest,” he said.

“Financial institutions own fleets of oil tankers and can withhold delivery, while wagering on the price of oil or they can speculate on the price of energy while controlling supply,” Brown said.

This, the senators said, is a clear conflict of interest that is driving up commodity prices.

Make up your minds, people (which generously assumes you have them).  Is the combination of physical and financial trading a good thing, or a bad thing?

As someone who has arguably written more about commodity market manipulation than anyone alive, I can say definitively that the most costly manipulative strategies-corners and squeezes-involve trading of “paper” (e.g., futures contracts) and the physical commodity.  These strategies involve either taking excessive deliveries, or buying in excessive quantities in the physical market.  Engaging in a market power manipulation requires some involvement in the physical market.

Historically, many of the biggest manipulations have been undertaken by hedgers.

And that’s the key point that escapes the Washington hand-wringers.  On one of their wringing hands, they lament the involvement of non-hedgers in markets (let’s leave aside how you can have hedgers without speculators to take the other side of trades).  On the other, they bemoan the fact that those involved in both the physical and financial commodity markets-who are often hedgers-can sometimes exploit market power to enhance profits.  But if you believe that a primary function of commodity derivatives markets is to facilitate risk management by those involved in the producing, marketing, storing, and processing of commodities, you have to permit the physical traders to trade derivatives.

One of the consequences of that is that there will be manipulations by physical players.  But severing physical and financial trading in order to prevent manipulation, which is what Brown and Merkley and others are suggesting, is crack-brained.  It throws the hedging baby out with the manipulative bath.

And it is particularly crack-brained to focus on just one category of market participants, like banks.  The potential for manipulation exists due to frictions in the physical market, and the ability of some market participants to trade both derivatives and the underlying commodities.  Someone will step into the banks’ role if they are precluded from the market, and the potential for manipulation will remain.  Taken to its logical conclusion, the Brown-Merkley “conflict of interest” standard would preclude any entity-not just banks-from trading both commodity derivatives and the underlying physicals.

So what’s the best way to attack manipulation?  Not by destroying the ability of the markets to perform their vital risk transfer function.  Instead, as I’ve argued for going on 20 years, the best way is to impose penalties after the fact for manipulative conduct.  Thus, at least conceptually, I support FERC and CFTC enforcement efforts.  The problem is that practically their efforts are often misdirected and intellectually confused.

Congress should economize on its limited comprehension of these issues by focusing on the key problems, rather than throw around vapid phrases like “conflict of interest” and recommend policies that undermine the ability of financial and physical commodity markets to function effectively.  Better anti-manipulation laws predicated on a clear understanding of how manipulation works would be the place to start.  And no, this does not involve the Xeroxing of 10(b)(5) of the Securities and Exchange Acts and inserting it into commodity trading laws, which has been Congress’s default response for about a decade.  There is a complete mis-match between the fraud-based thrust of 10(b)(5) and the market power problems that sometimes arise in commodity markets.  I’ve made recommendations over the years on the right regulatory/legislative approach that would target market power problems more precisely.  This approach would permit the markets to exploit the synergies between paper and physical trading while at the same time improving the efficiency of these markets.

But instead, we get Congressional schizophrenia and meat cleaver approaches that would, if taken to their logical conclusion, destroy the markets in order to save them.

A further thought.  Those who have the ability to trade the physical, and who have extensive information and developed logistical capabilities are usually the best positioned to break corners, and to mitigate the frictions that make corners possible.  They also have the strongest incentive when they have a derivatives position that would be hurt by a manipulation.

I’ll post a link when I have a chance, but P.D. Armor’s breaking of the Leiter wheat corner in 1898 is a great example of this.  There are many others.