Streetwise Professor

Greg Meyer at the Financial Times wrote a piece covering a just-released study I did analyzing the performance of the CME-NYMEX WTI crude futures and ICE Brent crude futures during the financial crisis.

The full study is here: scroll down to the bottom for the PDF.

Cliff’s Note version: (a) the financial crisis was a period of unprecedented volatility in the oil markets, (b) the hedging performance of both pricing benchmarks declined during the crisis, (c) the crisis affected front month WTI more acutely than second month WTI or either front or second month Brent, (d) the performance of second month WTI was comparable to that of both Brent contracts, (e) the most likely cause of the observed price behavior was the major shock to demand, which resulted in a sharp increase in oil in store at Cushing, (f) spread behavior was not something peculiar to WTI, because the fundamental shock affected West Texas Sour crude (also tributary to Cushing) too, (g) oil stocks and WTI spreads continued to covary positively, as you’d expect, though the relationship was weaker during the period of the crisis, but (h) oil stocks and Brent spreads covaried negatively during the crisis.

Manufacturing output is rising around the world, with bullish reports from the United States, Europe and Asia.  The global purchasing managers index reached 55.9 in December: anything over 50 indicates an expansion in output.

But not Russia.  In fact, Russia’s PMI fell further in December, to 48.8 from 49.1 in November.  This indicates an accelerating decline in Russian industrial activity.  From Bloomberg:

The decline in new orders led to another round of inventories depletion that also contributed negatively to the PMI in December,” Dmitry Fedotkin, an economist at VTB Capital in Moscow, said in the statement.

Manufacturers including OAO Novolipetsk Steel are trying to adjust to smaller markets, with Deputy Industry Minister Andrei Dementiev projecting a 7 percent decline in the country’s steel industry in 2009, Interfax said on Nov. 10. Sluggish bank lending and gains in the ruble threaten to hamper a recovery led by last year’s 84 percent gain in Urals crude, Russia’s key export. The ruble gained 13 percent against the dollar in the last three quarters of last year, a trend the central bank has said it wants to curb.

The government has forecast a rebound from Russia’s 10.9 percent annual contraction in the second quarter, the steepest drop since at least 1995. Output fell a further 8.9 percent in the third quarter and will contract about 8.5 percent for all of 2009, Prime Minister Vladimir Putin said on Dec. 30.

. . . .

Exports “remained a key source of weakness” as new orders from abroad fell for a 15th month, VTB said. The work backlog contracted at the sharpest pace since April and inventories of finished goods continued to decrease “at a strong rate,” the bank said. Employment in manufacturing fell in December, extending a string of declines that started in May 2008, VTB’s gauge showed.

Earlier signs of recovery in manufacturing may have been caused by one-time effects. While industrial output expanded in November for the first time in more than a year, a six-fold jump in the production of hydraulic turbines accounted for much of the increase, Raiffeisen International Bank-Holding AG’s Russian unit said in a Dec. 22 research note. Chinese imports of raw materials failed to recover in November, “raising doubts that external demand will stimulate the growth of Russian industry,” according to the note.

Rising joblessness and a drop in retail sales in November indicate economic growth last quarter was close to zero, according to Raiffeisen. The unemployment rate jumped in November to a four-month high of 8.1 percent from 7.7 percent in October.

This contradicts Russian government happy talk:

The gloomier manufacturing outlook contrasts with a brighter picture presented by the government, which said on its Web site on Dec. 30 that the economy grew a seasonally adjusted 1.9 percent in the fourth quarter, citing preliminary figures. Putin predicted on Dec. 30 that the economy will expand about 3 percent in 2010.

Russia will post “steady” growth this year after domestic producers regained access to external financing and prices for oil, gas and metals picked up on improved prospects for a global economic recovery, central bank Chairman Sergey Ignatiev said on Dec. 22, forecasting an expansion of 5 percent or more.

The Bloomberg article mentions the unemployment rate.  Even the higher 8.1 percent rate seems very low, given the cratering of Russian manufacturing, and the lack of any appreciable rebound.  I’ve conjectured that most unemployment is masked, by companies either retaining and paying idle employees under pressure from the government, thereby weakening their financial condition and limiting their ability to expand later, or as a result of government support of some kind.

This article in SeekingAlpha (H/T LR) provides some color regarding how the government provides this support:

For those interested in where Russian deficit spending is going, much of it has been used to cushion the effect of what one former senior Putin advisor has called the most precipitous decline in Russian industrial output since the Axis invasion of 1941.

Furloughed Russian workers have been paid by regional authorities to re-paint and polish-up their inactive factories for limited periods of time. Government orders have been placed for unneeded equipment, just to keep people working. Make-work retraining and adult internship programs have been instituted. And last but not least, the automotive sector has been bailed out.

This deficit spending on bailouts and social programs is rapidly draining the country’s reserve funds:

Interfax reported Monday that in a meeting with President Medvedev, Finance Minister Kudrin claimed that the Reserve Fund of the Russian Federation—one of the two components of the Stabilization Fund set up in 2004 to serve as a rainy-day repository for oil superprofits—will be fully liquidated in 2010 in order to support government deficit spending.

The fund’s prognosis seems to be growing bleaker by the hour. In an interview earlier in the day with the news channel Vesti, Kudrin had said that total liquidation would only occur in the event that oil falls below $70 dollars per barrel for any substantial length of time, thereby depressing tax revenues and forcing Moscow to dip further into its reserves.

In that interview, the minister had also stated that Russia would start rebuilding the Reserve Fund no earlier than 2013.

The fund is currently invested in dollar-, euro-, and sterling-denominated sovereign debt. According to the Finance Ministry’s website, the fund’s value has dipped from $142.6 billion in September 2008 to $75 billion at present—a decline of over 47 percent, attributable largely to asset liquidation to cover Russian deficit spending of roughly 6.3 percent of GDP in 2009.

Putting this altogether provides some insight onto the mixed blessing that an increase in oil prices (courtesy of Helicopter Ben and his Chinese counterpart) is for Russia.  The higher price has eased somewhat the pressure on the reserve funds and helped the government’s fiscal situation, but at the same time it has provided support to the ruble.  This has harmed industrial exports (n.b., a “key source of weakness” per the Bloomberg article), and thus manufacturing.

Moreover, although Goldman Sachs continues to be bullish on Russia, and the Russian equity market has rebounded, foreign direct investment has not kept pace.  This reflects myriad factors, not the least of which is the growing realization (hey, it’s never to late to learn!) that investing in Russia under the shadow of expropriation is a mug’s game:

Foreign investors in Russia are playing a game that Nathan Detroit, the host in “Guys and Dolls” of “the oldest established permanent floating crap game in New York,” found unwinnable. On a losing streak, the gun-toting thug, Big Julie from Chicago, forced use of his own dice— which had no spots (“I know where they are,” Big Julie assured the players)—and proceeded to roll only winners.

The modern version of Lenin’s famous prediction that “the capitalists will sell us the rope with which to hang them,” might be that they will provide the capital to develop Russia’s natural resources so the regime can dominate its “near-abroad” and increase Western Europe’s dependence on it for supplies of natural gas. But investing in a nation in which there is no established rule of law is to shoot craps with Big Vladimir of Leningrad.

One reasonable conclusion to draw from all this is that Russia is likely to be a laggard, rather than a leader, in the world recovery.  Yes, a recovering world will boost oil prices and generate some tax revenues–but it will also boost the ruble, thereby impeding a recovery in manufacturing, which will be a drain on the fisc.  Investors are still relatively cautious around the world, and hot money aside, Russia offers a lot of dangers that they are quite happy to avoid, thank you.

The result?  A familiar one: purgatory.

In (somewhat) better news, Russia’s population didn’t decline in 2009:

Despite Russia’s natural population decline, immigrants ensure the country’s overall growth, the health and social development minister said on Thursday.

Tatyana Golikova said as of November 1, Russia’s population was 141.9 million and that by January 1, 2010, it would be 15,000 to 25,000 more than for the same period in 2009.

She said although natural decline continued, the birth rate was 3-3.5% higher than a year ago and that 1.76-1.78 million babies were expected to be born this year.

Mortality was also down 3.-3.5% on last year, but still rather high – a total of 1,985,000.

According to the Russian Federal Migration Service, 333,474 foreign nationals and stateless individuals received Russian citizenship in January through November 2009.

Something of a mixed bag: more immigration, a slight decline in mortality, a slight increase in the birth rate, but still a natural decline (a “symbolic” in the words of one official increase in total population of about 20K, with immigration of 333K implies a natural decline).

It would be interesting to know whether the increase in the birth rate is more than one would have expected, conditional on the fact that women born during the last Soviet baby boomlet are at their years of peak fertility.  I’m sure somebody will answer that question for me.

Which means that it must be time for another Russia-Ukraine gas row.

After months of happy talk in which both sides repeatedly claimed that there was no prospect of a repeat of the 2005-06 and 2008-09 imbroglios, a few days ago Gazprom CEO Alexei Miller raised the alarm:

However, despite the expected rise in cold weather demand, Russian gas export monopoly Gazprom (GAZP.MM) said on Friday Ukraine had cut gas purchases in recent days.

“We assess the situation with payments for Russian natural gas deliveries in December as very alarming,” Gazprom’s chief executive Alexei Miller told state television.

“In the middle of December, there was a trend of a reduction of gas off-take which confirms that Ukraine is facing serious difficulties with (future) gas payments,” Miller said.

A new wrinkle this year is Russia cutting off oil shipments through Ukraine for export:

Traders said on Friday Russia’s pipeline monopoly Transneft told oil firms to scrap oil export plans via Ukraine’s Black Sea port of Yuzhny and gave no reason for the move.

“All volumes have been taken away. There will be no supplies in January (from Yuzhny),” said one trader, who asked not to be named because he is not allowed to comment on the issue.

This cutoff is probably a combination of signal (we can do it with oil, need we remind you we can do it with gas?) and economic pressure (reducing Ukrainian transshipment revenues).  Maybe the signal will get through, and Ukraine will come up with the scratch.  But with the elections impending, and the usual chaos of Ukrainian politics, it very well may not.

So, in the midst of another brutal winter (AGW=anthropomorphic global what?), Europe could be facing yet another gas crisis.  How often does that have to happen for the Europeans to get their act together?

The French Vice Chairman of the UN’s Inter-governmental Panel on Climate Change (IPCC) has accused the FSB of causing Climategate by hacking into UEA CRU’s computers.  This presents ol’ SWP with something of a dilemma, with many of the targets of my ire–the French, the UN, the IPCC, and the FSB–arrayed against one another.  What a target rich environment.  On the one hand, I can’t miss.  On the other, it does make choice of target something of a challenge.  LOL.

And I’d be sitting down, ladies and gentlemen, because on this one I have to side with the FSB, at least on the basis of what we know so far.

Here’s what IPCC VC said:

“It’s very common for hackers in Russia to be paid for their services,” Professor Jean-Pascal van Ypersele, the vice chairman of the Inter-governmental Panel on Climate Change, said in Copenhagen at the weekend. “It’s a carefully made selection of emails and documents that’s not random. This is 13 years of data, and it’s not a job of amateurs.”

The leaked emails, Professor van Ypersele said, will fuel scepticism about climate change and may make agreement harder at Copenhagen. So the mutterings have prompted the question: why would Russia have an interest in scuppering the Copenhagen talks?

This time, if it was indeed the FSB behind the leak, it could be part of a ploy to delay negotiations or win further concessions for Moscow. Russia, along with the United States, was accused of delaying Kyoto, and the signals coming from Moscow recently have continued to dismay environmental activists.

When Ed Miliband, the Secreatary of State for Climate Change, visited Moscow this year, he had meetings with high-level Russian officials and pronounced them constructive. But others doubt that Russia has much desire to go green.

In brief, M. Van Ypersele rests his case on (a) opportunity, and (b) motive.  The notorious abilities of Russian hackers provided the opportunity.  This cannot be disputed.  The motive is much murkier, however, and very indirect.  First, Ypersele assumes that the motive of the leak was to derail Copenhagen.  Perhaps–or perhaps it could have been the result a fit of conscience by someone at CRU (or an affiliated institution) who was scandalized by the anti-scientific behavior of Jones et al.  That could explain the very specific documents targeted in the leak emphasized by Ypersele.

Second, Ypersele stretches to argue that Russia has an especially strong motive to derail the implementation of a global cap and trade system.  The reverse could be true, given that Russia owns the largest stock of Kyoto-created emissions credits: an aggressive climate change deal that required other nations to reduce sharply emissions would enhance the value of these credits.  Yes, Russia has other agendas, such as protecting inefficient polluting industries and encouraging demand for its energy.  Thus, it is hard to determine on net whether Russia’s interests lie with or against CO2 caps.  (And in saying “Russia” one always has to remember it is the Russian elite and power structures that matter.  The credits could create a very nice slush fund for these folks to skim.)

There are other interests–Saudi Arabia comes to mind–that does not have such conflicting interests.  And, as Ypersele notes, Russian hackers are paid for their services: I’m sure Saudi money spends just as well as Russian, and the Saudis are likely to have more at the moment.

So the motive angle is very weak, and does not put Russia at the top of the list of suspects.  (This is sounding like a game of Clue or something.)

Nor does the fact that the documents appeared on a server in Tomsk mean much of anything.  The hackers originally tried to put the stuff on the RealClimate website (and no, I won’t link to that) using a computer in Turkey.  Then, using a computer in Saudi Arabia, they put up a link to the Tomsk site.  Given the murky international connections in the hacker world, it’s impossible to make anything of this.  Moreover, these sorts of analyses inevitably get into the Holmes-and-Moriarty on the Train quagmire: the FSB wouldn’t have put the stuff on a Russian server because it would have drawn suspicion; because people would figure the FSB would never draw suspicion to itself by posting on a Russian server, they put it on a Russian server; because people would figure . . .

This isn’t like Georgia at the time of the invasion in 2008, or in Estonia on 2007.  In each of those cases the motive was clear, few others had the same ability or opportunity, and other circumstances made it clear that Russian interests, and likely the Russian state were involved.  Here, the circumstantial case that Ypersele advances is pathetically weak. Not to say that it’s impossible that the FSB was involved, just that it’s far from proven, or even the most likely scenario.

One final thing.  The NYT article linked above discussing Russia’s Kyoto credits has yet another example of the economic idiocy that characterizes its news pages:

That is because Russia, as a result of the collapse of much of its heavy industry in the 1990s, owns one of the largest stocks of credits to offset carbon emissions.

The unearned windfall, a legacy of the Kyoto agreement that tried to deal with the threat of  climate change, is worth several billion dollars. If abruptly sold abroad, those credits could send the price of carbon on the world’s fragile emissions markets plunging toward zero.

I see.  The credits are worth billions.  Unless they’re sold.  In which case they’re worthless.  Whatever.

This ranks with a story I read some time back in the NYT which expressed astonishment that the unemployment rate went up even though the rate of increase in layoffs had fallen.  First derivative.  Second derivative.  Again–whatever.

Anybody who gets economic analysis from the NYT is sadly misinformed, but probably considers him- or herself as one of America’s elite.  Which explains quite a lot of our current economic and political troubles.

Perhaps reporter James Kanter can hide behind the adverb “abruptly.”  But why would Russia dump them on the market if that would drive the price to zero?  And if the price doesn’t go to zero due to self-destructive behavior, the whole premise of the rest of Kanter’s article disappears.  Oy.

Update:  An interesting analysis by a systems administrator that casts serious doubt on the hacker story.  In brief: it is almost certain that all the documents had already been assembled, probably by a freedom of information act officer, in response to or anticipation of FOIA requests.  Now, it could have been the case that a hacker gained access to this and disseminated it, but since it was (per this analysis) assembled and ready to go out, it’s also quite possible that this was a leak.  And if it was already assembled for FOIA/FOI purposes, the reasonable inference is that it would have been released in time.  That said, the release weeks before Copenhagen–just enough time for the story to get traction, not enough time for it to die–is crucial.

Yes, Russia can breathe easy.  Even when it comes to corruption, it’s not the worst!  Bad–tied for 146th out of 180, according to an average of surveys assembled by Transparency International–but not the worst.  Indeed, not even the worst in the FSU–several ‘Stans are all well below Russia.

And I am sure that the “whatabout Ukraine” crowd is asking, well, “whatabout Ukraine.”  Well, amusingly, it is tied for 146th place, although since ties (based on rounding to 1/10th of a point) are arranged alphabetically, and the lowest and highest scores for Ukraine are both higher than Russia’s, my guess is that without rounding Ukraine edged out its former Gulag cellmate.

Speaking of ties, Zimbabwe joined Russia and Ukraine in 146th place.  Now that’s something to be proud of.

It should also be noted that Russia isn’t even close to being the least corrupt in the FSU. Indeed, one ‘Stan–Kazakhstan–came it at 120, and even Azerbaijan beat Russia’s 2.2 score (out of 10!) by a tenth of a point. The Baltic states aren’t even in sight, with Estonia at 27 and Lithuania and Latvia at 52 and 56, respectively.

But, according to accounting firm PWC, Russia IS the worst, when it comes to, er, agency problems:

Russia is the worst country in the world for companies in terms of employee theft and extortion by officials, a PricewaterhouseCoopers LLP survey showed.

Seventy-one percent of domestic and foreign companies in Russia were victims of fraud in the past year, double the rate reported in fellow BRIC countries Brazil, India and China, PwC said in a report released today. That’s a “shocking” increase of 12 percentage points from 2007, when the last survey was conducted, PwC said. In Japan, the figure is 9.6 percent.

Theft and bribery hit Russia’s financial, energy and mining industries the hardest, according to the survey of 3,000 executives from 55 countries, including 86 Russians. “The nature of these industries means that they are particularly exposed to both asset misappropriation and corruption, the two most prevalent types of economic crime,” PwC said.

. . . .

PwC said the prevalence of government graft in Russia is twice the global average, with 48 percent of all companies surveyed reporting an instance of bribery or corruption in the last 12 months.

The problem has been exacerbated by the country’s record economic contraction, which has lowered the “morale” of employees and made “asset misappropriation” more tempting, PwC said. The economy shrank 10.9 percent in the second quarter, the most on record, and 8.9 percent last quarter.

More people are feeling “real pressure to ‘cross the line’ or to look the other way,” PwC said.

The line about the special vulnerability of energy and mining is of particular interest.

One other Russia bit caught my eye today.  Russia’s industrial output contracted in October:

Russia’s  industrial slump deepened in October as companies failed to build up inventories and credit remained tight even after eight central bank interest rate cuts since April.

Output fell 11.2 percent from a year earlier after the decline eased to 9.5 percent in September, the  Federal Statistics Service in Moscow said via e-mail today. Production rose a non-seasonally adjusted 0.8 percent on the month. The medianestimate in a Bloomberg survey of 10 economists was for an annual decline of 8.1 percent.

. . . .

Manufacturing in October plummeted an annual 17.5 percent, the most since May, and dropped 4.3 percent compared with the previous month in the first monthly decline since August.

Output and generation of electricity, heat and water dropped 6 percent last month compared to the same period in 2008, the smallest annual decline since April.

Passenger car production in October plunged an annual 58 percent, while output of trucks declined 54 percent compared to last year, the statistics service said.

Wage arrears increased in October by 6.4 percent, to 5.4 billion rubles ($188.4 million) after declining 8.6 percent in September, the statistics service said in the report today.

This may be the case of every silver lining having its cloud.  The strengthening of commodity prices (thanks, Ben! thanks, China!) has bolstered the ruble, which adds another blow to an already devastated manufacturing sector.

The corruption news–with the energy and mineral industries at its heart–and the Dutch Disease effect, both demonstrate just how hard it will be to transform Russia’s economy.  The powerful won’t want to stop the gravy train, and as long as it is going it will be very difficult for non-resource industries to take hold.

Like I say.  Purgatory.

All of the legislative proposals relating to over-the-counter derivatives would impose seismic changes on the way that these instruments are traded, and the performance risks related to them are managed.  Indeed, it is fair to say that these proposals, if implemented would dramatically shrink the OTC market, and perhaps destroy it altogether. Under either the House (Frank) or Senate (Dodd) bills, most derivatives would have to be traded on exchanges, and be cleared.  (Clearing is a way of mutualizing default risks.  At present, default risks in a particular contract are directly limited to the buyer and seller.)  (BTW, when you hear “Frank and Dodd” do you think Fannie Mae and Freddie Mac?  I do.  Does this inspire confidence?  Self-answering question.)   These efforts are strongly supported by Treasury Secretary Timothy Geithner, CFTC head Gary Gensler, and SEC head Mary Shapiro.

These legislative proposals are clearly predicated on a very strong belief: participants in the derivatives markets routinely chose the wrong institutional arrangements.  That this immense market is and was in fact arguably the largest market failure in financial history.

And these markets are indeed immense.  According to Bank of International Settlements data, notional (“face”) values of these instruments totaled $683 trillion in June, 2008 (right before the onset of the financial crisis), and their market values totaled $20 trillion (ballooning to $34 trillion by the end of 2008).

Moreover, these markets had grown dramatically over the years–at a double digit annual pace.  They also dwarfed the market for exchange traded (and cleared) derivatives.  The BIS reports that at the end of 2007, total notional values of outstanding contracts traded on exchanges were $28 trillion, which had shrunk to less than a mere $20 trillion at the end of 2008.  (I won’t go into the quibbles over the interpretation of these numbers, which make true apples-to-apples comparisons impossible.  Suffice it to say, difficulties of interpretation duly considered, the exchange traded markets are huge, but the OTC markets are HUGE.)

But our betters on Capitol Hill think that these collective results of the individual decisions of thousands of informed participants with major skin in the game are wrong, wrong, wrong.  They know better.  EVERYTHING should be traded on exchanges.  EVERYTHING should be cleared.  The emergent order is fundamentally flawed; a constructed one must be substituted for it by legislative fiat.

This assertion of systematic, immense market failure demands a coherent explanation.  It is, to be honest, quite hard to find one.  In this post and some that follow, I’ll examine some of the attempts at explanation.

Cliffs’ Note version of my conclusion: I’m still searching for a coherent story.

One of the most commonly heard stories is that OTC derivatives are enormously profitable for big banks due to the lack of transparency in the market.  Exchange trading and clearing would shrink profit margins, costing the banks big money.  So they have deliberately kept the market dark in order to enhance their market power and their profits.

Of course, all dominant incumbents want to maintain market arrangements that protect their market power and monopoly profits.  This is why GM is enormously profitable due its continued dominance of the automobile market.

Back to our regularly scheduled reality.

To justify the profit protection story, it is necessary to demonstrate the existence of entry barriers.  It is possible for banks to charge their customers supercompetitive prices persistently only if there is no possibility for competitors to undercut these prices (where the idea of “price” should be interpreted broadly to incorporate all of the costs that customers pay to trade derivatives.)  There are, however, strong reasons to believe that such entry barriers don’t exist, or aren’t sufficiently strong to explain the dominance of the OTC markets.

Let’s consider for a minute the legislative proposals.  They want to force trading onto exchanges.  They believe that this trading will be cheaper and more efficient due to greater transparency and competition, and share default risks more efficiently, than the current OTC markets.  But exchanges already exist.  For years they have been striving mightily to make inroads into the OTC derivatives markets.  Futures brokerage firms have also been trying mightily to market their services to the customers of OTC dealers.  Exchanges have launched head-to-head competition in many areas–and failed miserably in most of them.

If exchanges are really cheaper, because OTC dealer banks exercise market power and charge supercompetitive prices, why haven’t the exchanges made greater penetration?  Why haven’t they drawn business from the OTC dealers?  Why has the market share of OTC derivatives grown?

I’ll wait.  Barney?  Chris?  Tim?  Gary?  Mary?  [Humming quietly to myself.]

Put differently: the alternative market arrangement that the DC crowd says is more efficient and cheaper has been available to the allegedly poor, exploited customers of dominant dealers for years, and they’ve chosen to trade with the dealers nonetheless.  How to explain this?  Battered spouse syndrome?  Masochism?  It is a puzzle, no?

But it gets better.  There are many markets in which virtually identical products trade OTC and on exchanges.  In many of these markets, consenting adults knowingly choose to trade the uncleared, bilateral OTC contracts.  Why would that be if OTC markets are beset by market power that inflates the costs that customers pay?

Moreover, there are cases where clearing has developed organically in an OTC market without the benefit of a government mandate.  Most notably, clearing has grown dramatically in OTC energy derivatives since 2003.  This demonstrates that clearing can succeed competitively where customers want it.  This undercuts the idea that clearing (or exchange trading) is at an inherent competitive disadvantage relative to OTC dealer.  Ironically, and tellingly, this development has occurred precisely when the firms that dominate the OTC financial markets–e.g., Goldman Sachs, J.P. Morgan, Morgan Stanley, and other big banks–began to dominate trading in OTC energy derivatives.  How come they didn’t strangle the clearing baby in the crib to create and protect a privileged position in the energy markets?

In sum: there have been vigorous attempts of the putatively cheaper, more efficient exchange trading platforms to enter the market, suggesting that entry barriers do not preclude such competition.  These competitive efforts have often failed, and have certainly failed to displace OTC trading.  Where given a choice, customers sometimes choose cleared or exchange traded products–and oftentimes don’t.

Which calls into serious, serious question the received story as to why the inefficient, opaque, market-power ridden OTC market has survived and thrived. Instead, this “explanation” appears to be yet another of the many Just So Stories that have proliferated in the aftermath of the financial crisis;  a superficially plausible explanation that does not withstand scrutiny.

But on the basis of such Just So Stories, we are supposed to countenance the complete re-engineering of the world’s financial markets.

[Cross posted at Organizations and Markets.]

They’re both virtually uninsurable:*

Political risk insurance premiums have risen across emerging markets in the last year, fueled by rising resource nationalism and unrest linked to the financial crisis as well as a renewed concern over risk amongst investors.

Foreign direct investors use the political risk insurance market to buy protection against nationalization, expropriation, political violence or capital controls preventing convertibility of earnings. It generates some $1.5 billion in premiums each year.

. . . .

RUSSIA ALMOST UNINSURABLE

Madagascar, Ecuador, Kyrgystan and others have also seen examples of expropriation or effectively forced renegotiation that have worried insurers. However, in some other countries — such as Brazil or South Africa — a slight rise in leftist rhetoric has had less impact on premiums.

The industry is particularly concerned over risks in Russia, where extractive projects have become almost uninsurable.

BP (BP.L) faced a difficult battle for control of its local joint-venture TNK-BP last year, but problems have not been limited to the oil sector and Norwegian telecom Telenor faced a similar battle this year over its stake in mobile operator Vimpelcom.

“The main difficulties seem to be in any sector you can describe as strategic,” said Elizabeth Stephens, head of credit and political risk analysis at London insurance broker Jardine Lloyd Thompson.

No doubt the “We’re Not the Worst!” crowd that routinely pipes up in response to any criticism of Russia and Putin will seize on the fact that another ex-Soviet basket case is in the same, uhm, basket:

Buying coverage for investment in Ukraine has also become almost impossible, she said, as the country struggles with both financial and economic crisis. Ukraine’s state gas firm Naftogaz defaulted on a $500 million Eurobond last month before restructuring.

Take your solace where you can get it, I guess.

Looking at the roster of other virtually uninsurable countries–Bolivia, Venezuela,  Madagascar, Ecuador, Guinea, and Kyrgystan–should be a source of deep shame for proud Russians.  But we are routinely bombarded with harangues about the restoration of Russia’s power and its assuming its proper place in the world, all led by that stalwart avenger of Russia’s humiliation, Vladimir Putin.

But what has he really accomplished?  To turn Russia into an economic pariah (to all except the Germans in their current at-your-feet mode) condemned to economic purgatory for the foreseeable future.  The radioactivity of Russian political risk is a striking testament to the true wages of Putinism.

But in this era of hyperactive, grasping government, America should take heed Russia’s lesson:

The huge increase in Western government intervention in financial markets following the global crash had also prompted some firms to worry about the risk of expropriation in developed economies, Zurich’s Roorden said.

“We’ve had some enquiries about the United States, mainly concern over the risk of nationalization as governments take extraordinary measures due to the crisis,” he said.

We’re nowhere near Russia on this score yet, but the journey to hell begins with the first step.  The actions of the US government with respect to major banks, the automakers, and perhaps, health care insurers and providers, raise questions about the vulnerability of property rights in this country too.

* And I bet you were thinking, “Uhm, drunk drivers?”

CFTC Chairman Gary Genlser continues to make concentration and diversity his primary justifications for expanding position limits:

I believe we should consider setting position limits to guard against excessive concentration in the energy futures market,’ said Gensler at a luncheon held by the Natural Gas Roundtable, a nonprofit organization.

The CFTC is weighing whether to set position limits — a maximum market share — for oil and other energy products. The agency already sets limits on agricultural contracts.

‘When the CFTC set position limits for certain agricultural commodities, the agency sought to ensure that the markets were made up of a broad group of market participants with a diversity of views,’ said Gensler.

This raises several questions.

First, what is the statutory basis for position limits designed to reduce concentration and increase diversity? I see none whatsoever.

The relevant statute–available right there on the CFTC’s website–makes it clear that position limits are for the purpose of reducing “excessive speculation” that causes unwarranted price changes:

Excessive speculation in any commodity under contracts of sale of  such commodity for future delivery made on or subject to the rules of  contract markets or derivatives transaction execution facilities causing  sudden or unreasonable fluctuations or unwarranted changes in the price  of such commodity, is an undue and unnecessary burden on interstate  commerce in such commodity. For the purpose of diminishing, eliminating,  or preventing such burden, the Commission shall, from time to time,  after due notice and opportunity for hearing, by rule, regulation, or  order, proclaim and fix such limits on the amounts of trading which may
be done or positions which may be held by any person under contracts of  sale of such commodity for future delivery on or subject to the rules of  any contract market or derivatives transaction execution facility as the  Commission finds are necessary to diminish, eliminate, or prevent such  burden.

It couldn’t be much clearer.  Congress has authorized the CFTC to fix trading limits “for the purpose  of diminishing, eliminating,  or preventing such burden [of “sudden or unreasonable fluctuations or unwarranted changes in the price  of such commodity”].”  Period.  Full stop.  Not a word about “concentration” or “diversity.”  Like Bart Chilton’s musing about “unintentional manipulations,” Gensler’s advocacy of position limits based on these concepts is completely unmoored from the law.

That is, “excessive speculation” that distorts prices can provide a legal basis for position limits; Gensler’s “excessive speculation” (with no attempt to connect such concentration to price distortions) cannot.

Second, what is the evidence that variations in concentration across markets affect market quality?  I am not aware of any.  That is, what constitutes “excessive” concentration?: how would we know when this level is reached?

Third, what does Gensler believe causes variations in concentration across markets?  Could there be fundamental economic considerations that affect the level of concentration?  Could it be that trying to micromanage concentration through position limits would impose costs because these limits conflict with these fundamental economic considerations.

Fourth, more generally, what are the costs of position limits (e.g., in terms of constraining risk transfer)?  Has Gensler made any effort to weigh the costs against his estimates of the benefits?

Fifth, what levels of concentration are problematic?  Under what theory?  What is the evidence that supports this contention?

Sixth, are there any markets that have reached this level of concentration?

Seventh, is there any evidence that position limits materially impact concentration?

In terms of what concerns concentration poses, concentration levels (per CFTC data) are not large as compared to, for instance, industrial concentration in most markets.  In crude and nat gas, 4 firm concentration ratios range between 25 and 40 percent, while 8 firm ratios are in the 30-50 percent range.

I think that Gensler’s clear desire to shift the grounds of the debate from the (legally required) “excessive speculation” issue to something else (the legally meaningless idea of “excessive concentration”) reflects the fact that there is clear lack of both logic and evidence to support any claim that “excessive speculation” has, in fact, caused “unwarranted” price fluctuations.  Lacking such evidence, Gensler is attempting to hitch a ride on the financial crisis.  As the article quoted above says,  “Chairman Gary Gensler of the Commodity Futures Trading Commission said the financial crisis last fall showed the risk posed by ‘large concentrated actors on the financial stage’.”  He provides no evidence that this concentration caused problems in the futures market even during the height of the crisis (which would, interestingly, undercut his argument that clearing is a panacea to systemic risk).  And even if it did, it still provides no legal basis for position limits, which must as noted above, can be imposed only “for the purpose  of diminishing, eliminating,  or preventing” undue price fluctuations caused by excessive speculation.

By repeatedly invoking “concentration” and almost completely ignoring the sole legal basis for position limits, Gensler may actually call into question the legitimacy of any position limit regulation the Commission does pass.  If Gensler really believes that concentration is a problem, he should advocate amendment of the Commodity Exchange Act to make concentration a justification for imposing limits.  By straying from statutory authority in his advocacy for position limits, Gensler risks becoming another out of control regulator attempting to ensure that no good crisis goes to waste.  He has a lot of company in that, but that’s no excuse.

The amendment that would have limited dealer ownership of clearinghouses to 20 percent  has been stripped from Barney Frank’s OTC derivatives bill:

In a bill passed last week by the House of Representatives’ financial services committee to reform the  over-the-counter derivatives markets, an amendment was inserted at the last minute by Massachusetts congressman Stephen Lynch that appeared to limit the stake banks could collectively own in a clearing house to 20 per cent.

. . .

Susan Milligan, special counsel at the OCC, said it was “purely anti-competitive” and would have favoured for-profit clearers compared with quasi-utility clearers like the OCC.

Steve Adamske, spokesman for the financial services committee, said on Thursday the 20 per cent limit had intended to limit dealer control of clearing houses but legal experts had decided it was invalid as it conflicted with another amendment.

The bill would, however, limit to 20 per cent the voting rights of dealers for “designated contract markets, exchanges and alternative swap execution facilities” – and not for clearing houses.

Wonderful, isn’t it, to observe the careful deliberation with which our Solons weigh decisions that affect trillions of dollars of risk exposures?  Just throw a bit of offal into the grinder–who’ll notice?  And at whose behest was this inserted?

Legislators react with high dudgeon to bankers’ cavalier attitudes towards risk and limited accountability, but they run far greater risks with other people’s money with virtually no accountability every day.  They have no room to talk.  Whatsoever.

The European Commission released its “Communication to a Cast of Thousands” on “Ensuring efficient, safe and sound derivatives markets: Future Policy Actions.”  It is, at best, a series of policy proposals based on nothing more than assertions delivered from on high.  These assertions are both logically dubious and completely empirically unsupported.

The main policy recommendations are to force the bulk of derivatives trades into centrally cleared platforms and exchange trading.  This will be accomplished by margin and capital requirements, and mandates.

At one level, the EC report identifies the appropriate objective: to encourage market structures that “allow markets to price risks properly” (p. 2).  However, it provides neither theoretical nor empirical support for its assertions that its policy actions will in fact improve risk pricing.  At root, its argument is that centralized price setting dominates decentralized price setting.

As has been known since Hayek and his peers, the relative efficiency of centralized vs. decentralized price setting depends crucially on the information available to those setting the prices.  Recognition of the crucial issue of information is completely lacking in the EC document.

The Olympian tone of the document is well summarized by the statement that it is adopting a new regulatory approach “where legislation allows markets to price risks properly” (p. 2).  In other words, it is legislation that is the essential determinant of whether markets price risks properly or not.  As if.

The document states “the proposed measures will shift derivative markets from predominantly OTC bilateral to more centralised clearing and trading.”  Putting all this together means that the EC is asserting that the existing market structure is history’s greatest market failure.   One would think that such a sweeping claim would require some supporting evidence and theory.  The EC document provides none whatsoever.

The assertion that markets have systematically failed to price risks occurs throughout the document.  For instance, it says: “the function of prices to allocate resources must be restored: derivatives should be appropriately priced in relation to the systemic risk they entail.”  The necessity of a “restoration” implies that: (a) the market has done a bad job in pricing these risks in the past, and (b) regulators can do better going forward.  Although one may agree with (a), it is essential to avoid the Nirvana fallacy: the crucial element of a policy recommendation is the comparative performance of imperfect markets and imperfect regulators.  Thus (b) is the crucial issue.  Sadly, the EC consistently falls prey to the Nirvana fallacy, and asserts without providing the least support that of course regulators will do it better than markets.

The document reeks of the Olympian disdain of Eurocrats in love with their own superiority.  It is the Nirvana fallacy distilled into 9 pages of text.

For instance, we get pearls like: “Such contracts will continue to be cleared bilaterally with counterparties exchanging collateral to cover their exposure.   However, current collateral levels are too low.”  What is the basis for such an assertion?  Who knows?  And, even granting the possibility that some collateral levels may be too low, there is also the possibility of setting them too high.

You’ll search in vain trying to find any reasoned discussion of (a) the relative costs of excessive or deficient collateralization, or (b) the information available to regulators and market participants that they can use to set these levels.

The document suggests that initial margin levels “will be specific to counterparty characteristics.”  This has to mean measurable characteristics.  But what information does a regulator have to measure the counterparty characteristics necessary to set initial margin levels?  Is that information better or worse than the kind of information that large dealers have?  I have very strong priors on the answer to that question: the dealers.

If you think differently, fine.  But before you decide, I suggest that you consider the entire credit rating agency fiasco, in which credit risk evaluations based on measurable characteristics were made by a small number of (centralized) entities.  Not only were these evaluations systematically flawed (thereby raising similar concerns that regulatory decisions regarding initial margin levels will be so too), crucially they were extremely brittle because of the lack of diversity in evaluations and the information on which they were based.  Thus, the errors the agencies made had broad systematic effects.  In contrast, a more diffuse mechanism for establishing initial margins, in which multiple agents possessing different information evaluate counterparty risk and price it appropriately is less susceptible to such systematic errors.  Since systematic errors can translate into systemic risk–as the AAA CDO disaster demonstrated–this is a very serious concern.

Bad pricing of relative counterparty risks across transactors will lead to a misallocation of trading activity and counterparty risk exposure across them.  Those whose counterparty risks are underestimated will trade too much; those whose risks are overestimated will trade too little.  These errors are inevitable, so the crucial question is what sort of market arrangement will minimize the costs of these errors.

This depends on the information available to those making the decisions.  In my view, major dealers will almost inevitably have more information individually than would a central regulator or clearinghouse.  Moreover, since in a market structure like that has evolved heretofore numerous entities are collecting information and making these judgments, there is the possibility of the aggregation of diffuse private information.  This possibility is absent in a highly centralized structure.

Put differently: the EC (and its American counterparts) are acting as if they had never heard of the socialist calculation controversy.  (Which is probably true–all the worse for them if so.)  Namely, how does a central agent set prices in a world with diffuse private information about costs and value?  Information about counterparty risk is highly diffuse, and largely private.  How can a central agent set the “right” prices in such an environment?  Can markets do it better (even if not perfectly)?

We have all too much experience with the defects of central price setting as compared to decentralized price setting in markets (cf. the USSR) to be at all confident with the relative superiority of centralized counterparty risk pricing.  At the very least it is incumbent on the advocates of such a centralized approach to address seriously the possibility (demonstrated by vast experience in many contexts) that centralized price setting in derivatives markets will founder on the same information problem that has wreaked havoc with other efforts to set prices centrally.  Tragically, they don’t even acknowledge the problem, let alone provide a convincing analysis supporting the contention that centralized pricing will dominate private, decentralized pricing.

Similar problems are inherent in the EC’s recommendation of differential capital charges for cleared and non-cleared derivatives contracts.  Again, what is the basis to believe that the regulators have the information to set this differential (or the levels) properly?  This ability is blithely assumed in the EC report; again this crucial issue is not even acknowledged.

It does not inspire confidence that the EC paper invokes the authority of the Basel Committee on Banking Supervision as the model for the setting of capital charges.  That would be the source of the same Basel rules that made it very attractive for systemically important financial institutions to load up on AAA CDOs.  We all know how that worked out.  Another illustration of the socialist calculation problem in action.

Beyond the complete failure to engage the fundamental informational questions, the paper says things that cast serious doubt on the competence of the EC to make such sweeping changes to financial markets.  For instance, there is a statement in the paper that strongly, strongly suggests that the EC does not understand the first thing it is talking about.

Specifically, on p. 6, it asserts, in a completely conclusory way, with no supporting evidence or argument whatsoever, that counterparty risks of “contracts that are cleared on a CCP” are lower than “the counterparty credit risks of those [contracts] where clearing is done bilaterally.”

If one defines counterparty credit risk as being the probability distribution of default losses, this statement is completely wrong.  Holding positions and the portfolios of the transacting parties constant, the probability distribution of default losses is the same between centrally cleared and bilateral contracts.  All central clearing does is change the allocation of those default losses across market participants.  That is, holding the market and credit risk exposures of market participants constant, the total dollar amounts of defaults is the same in every state in the world in cleared and bilateral markets.  Clearing changes the allocation of these given dollar losses across market participants, not their magnitude, or their probability distribution.

It is possible that this re-allocation of risk can be efficiency enhancing, but that is not a given.  Moreover, the fact that the EC apparently believes that CCPs somehow make counterparty risk magically disappear, it is almost certain that it has not thought seriously about the efficiency implications of this reallocation.  Why think about allocation of something that you believe won’t exist due to some form of financial alchemy?

This raises very serious concerns.  Read literally, the EC document implies that the Commission believes that clearing makes default risk disappear.  This is wrong, wrong, wrong.  It is understandable that someone operating under such a delusion would be very enthusiastic about clearing.  It should also be understood, however, that the enthusiasm of someone operating under a delusion is very, very dangerous.

The foregoing analysis assumed that positions would be the same in cleared and bilateral regimes.  However, the adoption of central clearing will almost certainly affect the sizes of positions that market participants take.  This, in turn, will affect overall default risks, and the allocation of these risks.  Indeed, given that clearing involves the mutualization (i.e., socialization) of risk, there is the distinct possibility that the effect of these changed positions will be to increase total default exposures; mutualization means moral hazard, and moral hazard tends to encourage risk taking.  Although CCPs can control this risk taking through margins, this is costly.  I have pointed out in my academic work that clearing can lead to increased overall risk exposures for other reasons as well.  Not that you would know this from reading what the EC–or any American official–has said on the subject.

Nor would you know that under certain types of structures, default losses borne by systemically important institutions can be higher under clearing because under these structures, CCP members guarantee customer trades, whereas in a bilateral market customer counterparties of a defaulting firm suffer default losses.  This is part of the allocational aspect of clearing, and means that systemically important institutions that backstop CCPs can actually suffer greater default losses in a cleared market than they would absent clearing.

I must say again: the case for forcing changes in market structure, most notably forcing adoption of clearing through either carrots (differential margin and capital charges) or sticks (mandates) has not been made.  Not in the least.  The key issues have not even been raised, let alone addressed.  The informational challenges that clearing poses have been assumed away.  Policies based on ignoring core issues do not inspire confidence, to say the least.

Sad to say, the Olympian, arrogant, government-knows-best attitude embodied in the EC paper is also manifest in the pronouncements of US regulators.  Most notably, Gary Gensler of the CFTC has come out in favor of trying to force virtually all trading onto exchanges and clearing.  And none of the arguments he makes in support of this view–none–grapple with the fundamental informational issues.

Unless and until those advocating a radical restructuring of the financial infrastructure, complete with implicit and explicit government pricing of counterparty risk, acknowledge and address the informational and incentive challenges associated with such a change, there can be no confidence that the change will be a beneficial one.  Indeed, given the sorry experience with centralized, hierarchical, regulatory price setting mechanisms in environments where information is private and diffuse, the odds favor the opposite result.

When make cartoon arguments for clearing (and for exchange trading), I have a sinking suspicion that the results will be anything but funny.

None.

By all appearances, both the US and Europe are on the fast track to a complete restructuring of the financial system based on a shockingly incomplete understanding of the true trade-offs.  In so doing, we are laying the groundwork for the next crisis, and a loss of efficiency until that crisis materializes.  Heaven help us.