Streetwise Professor

Russiablog is usually good for a few laughs, but Yuri Mamchur’s piece “Russia Who” had me doubled over in laughter when it referred to Dmitry Medvedev as “a 42 year old entrepreneur.” There are many words that come to mind in describing Medvedev’s career. Entrepreneur ain’t one of them. A board position in one of the most malign corporations in the world does not qualify one as an “entrepreneur,” Yuri, old buddy.

The Russia-BP/TNK episode has all of the suspense of an old Rockford Files re-run. The familiar plot devices–the tax investigation, the national security angle, the environmental theme. Cameos by the usual heavies, such as Oleg Mitvol. No need to wake me to see the outcome. I know how it will end.

What is illuminating about this affair is that it is playing out against the background of Dmitry Medvedev’s turn at the Debutante Ball. He is making public statements, meeting world leaders (though usually it seems with his chaperone), and giving interviews in western papers. And the contrast could not be more stunning. While Medvedev says soothing things about the rule of law, freedom, yada, yada, another lawless act is playing out in plain sight.

To those swooning over Medvedev–or who are at least willing to give him the benefit of the doubt when he says seemingly liberal things–I would suggest that deeds, not words, are all that should matter. And the deeds speak volumes. The farcical voting (as Edward Lucas calls it, refusing to dignify the process with the word “election”); the continued harassment–and worse–of those who dissent; the BP shakedown; the declaration of more and more industries as “strategic.” All these things–and many more–say loud and clear that Russia is continuing to move away from a rule of law and freedom, and that it is continuing its steady march to corrupt and corrupting authoritarianism.

The contrast between Medvedev’s words and the ongoing acts of the government that he will soon head suggest either (a) he has power, and his words mean nothing because he really does not believe them or intend to put them into practice, or (b) he believes what he says, but he has no power to put them into action, in which case his words are still meaningless. Perhaps one could argue that we should wait until his inauguration and he has the chance settle into his new position before judging him on the basis of what is going on in Russia today. Perhaps. Since he is so much a part of the system that has methodically progressed to this point I am deeply skeptical that things will change once he becomes president. Maybe I’m wrong. I hope so, but I doubt it.

According to the FT, the UK’s Office of Fair Trading (the British antitrust authority) has apparently caught a case of the stupids from the USDOJ:

In the row over the ICE, which is planning to move clearing in-house and away from LCH, the matter is under review by the UK Office of Fair Trading. There are signs that the OFT, which has long been troubled by the competition issues raised by exchanges owning clearers, is studying the application closely. Two weeks ago, it sent out questionnaires to market participants querying the level of competition for the mostly widely traded ICE contracts in London.

If ICE forces customers to use only its own clearer, bankers say they will press the Commission to block the deal. Last week, in a separate initiative, Nymex launched a suite of products in direct competition with ICE that will clear through LCH.

Meanwhile, customers are also threatening to bring LCH to the attention of European authorities over a deal it tentatively struck with Liffe last week that would see the exchange take some of its clearing in-house but stop short of forming its own in-house operation and ending its relationship with LCH.

It would be nice, if just once, somebody, somewhere in some antitrust authority would actually step back and do a thorough analysis of economics of vertical integration in clearing and execution. The monomaniacal focus on (likely chimerical) anti-competitive effects, to the complete exclusion of any consideration of the possibility that vertical integration, might, just might, have some efficiency rationales will inevitably lead to bad policy. As I have said before, this is throwback antitrust analysis–BC, as in before Chicago.

One simple question for the OFT: if exchange control of clearing is the big obstacle to competition in execution, why hasn’t LIFFE faced competition in its products? And for that matter, why hasn’t LSE? (Okay, that’s two questions.) And who owns a big chunk of LCH? (Okay–three.) It wouldn’t happen to be the banks that are complaining about LIFFE moving clearing in-house, would it? (I know.)

On that last point, before one canonizes the poor, martyred banks who suffer at the hands of those cursed exchanges, consider the following story by the excellent Natasha (may I call you dahlink) de Terán:

LCH.Clearnet has operated SwapClear, a much used and admired swap clearing service, for nearly a decade. SwapClear has its critics and limitations but the one that could prove to be most damaging is its membership criterion.

A self-qualifying circle of dealers, OTCDerivNet, guard SwapClear’s gates. The buyside and other smaller dealer firms are kept outside. LCH.Clearnet might have wanted to roll out a similar service to that of the CME. But it has been hamstrung by OTCDerivNet.

Imagine that, a cooperative that restricts entry! Never heard of that before. (Yeah, well, except for the NYSE and pretty much every traditional US derivatives exchange and many overseas exchanges.) Think that such entry restrictions might well enhance the profitability of the members that are on the inside looking out? That certainly was the case with exchanges, as my 1999 J. Financial Markets paper showed.

Thus, perhaps the European Commission and OFT should take a break from obsessing about exchange vertical integration, and take a gander at some other possible competition issues in clearing. As I wrote in my clearing paper, disintegration combined with the formation of a cooperative clearing venture is no guarantee that a thousand competitive flowers will bloom. Execution venues that discover prices are likely to remain monopolies after disintegration; even cooperative clearers can exercise market power by restricting entry or supercompetitive pricing (and don’t be fooled by big rebates to members–that can be perfectly consistent with the exercise of market power); and the parallel operation of an exchange and a clearer both with market power can lead to inefficiencies in the form of double marginalization and higher transactions costs.

I am deeply ambivalent over Kosovo’s declaration of independence, and the support for this move from the EU and the US. Kosovars certainly suffered immensely at the hands of the Serbs, and Serb anger over independence does not move me at all. That said, Kosovo’s leadership hardly inspires confidence, and the very real possibility that Kosovo will serve (if it is already not serving) as a sanctuary for Islamist extremists in Europe is quite disturbing. Lastly–though you might be quite surprised to hear this coming from the likes of me–this seems a bad time to aggravate Russia, and a bad issue to aggravate it about. It is not a central strategic issue to the US, and hardly one for Europe. This plays into the hands of the worst elements in the Kremlin, and in Russia at large, and for what? Why put further strains on a strategically important relationship over what for the US should be a tertiary issue, and on behalf of one entity that is only slightly less unappealing than the other? We certainly will get no props from the Muslim world for rescuing an oppressed Muslim population–yet again. So, what’s the upside?

That said, I doubt that Russia will do anything precipitate in response. In particular, I doubt that it will carry through on its threats to support separatist movements in Ossetia and Abkhazia, and for the very reason that it is so exercised over the Kosovo “precedent.” Russia fears the precedent because it fears the centrifugal, separatist forces within the RF, most notably in the north Caucasus. Justified or no, Putin and others in the Kremlin are aghast at the prospect of a breakup of the RF, or at least the breakaway of certain parts of it. If Kosovo serves as a precedent for separatist movements that Russia fears could fracture Russia, Russia would only reinforce the precedent by supporting such movements in Georgia or Moldova. So, such support would be cutting off Russia’s nose to spite its face. This is not to say that Russia will refrain from stirring the pot in Georgia or Moldova or in the Ukraine (over Crimea, for instance), but they will stop short of supporting and recognizing independence movements.

Stratfor argues that Russia is retaliating by putting pressure on Georgia and Ukraine to “persuade” these nations not to join NATO–but Russia would do that regardless, independent Kosovo or no. At best, Kosovo gives Russia an issue that they can use to put the EU and the US on the defensive, but if the Kosovo argument wasn’t there, they’d just find another. With the Russians, like Roseanne Rosanadana used to say, “It’s always something.” Russia deems Georgian and/or Ukrainian accession to NATO a dire threat to its vital interests, and an intrusion on its sphere of influence, and will pull out the stops to prevent this.

At best–or worst–Kosovo gives Russia more influence over Serbia, and strengthens the pro-Russian nationalist elements in that country. But, the Russians have already demonstrated that their support comes at a huge price–witness what amounts to the theft of Serbia’s national oil company by Gazprom. Soon the Serbians will understand that Slavic/Orthodox solidarity is merely a front for Russian economic and geopolitical interests.

Showing some deference to Russia on the Kosovo issue would by no means assuage Russia. Putin et al have way too many issues, and are feeling their oats, and would take an inch on Kosovo and continue to demand miles on myriad other issues. But giving a bit on an issue of no pressing importance to the US would help to undercut the diplomatic and political influence of Russian complaints outside of Europe, especially as many nations (including European ones) have their own anxieties about separatist movements.

In sum, it is possible to protect the Kosovars from the Serbs without supporting full-blown independence. It raises an issue with Russia that Putin and his coterie can exploit, but does not provide any offsetting benefit to the US or Europe. So it would have been far preferable indeed to craft a third option that would have protected Kosovo; not presented such a stark challenge to the Westphalian system; and deprived the Russians of a hobby horse that they can ride to raise mischief.

In this last Presidential news conference, Vladimir Putin was in rare form. He was particularly outspoken on American efforts to encourage Europe to develop alternatives to Russian energy:

“We are aware of how the United States has been acting in Europe.”

“It puts pressures, it looks for new delivery routes, it urges others to refrain from buying fuels from Russia. This policy is wrong, and it is also silly,” Putin said, coupling this opinion with a warning against excessive politicization of the issue. As an example, he mentioned Turkey. When Iran slashed fuel export to that country, Russia compensated for the shortfall “without much a do.”

Putin voiced surprise why the West was so much afraid of Gazprom’s growing strength, a Russian monopoly that guarantees supplies to western consumers.

“The consumers should feel happy the economic potential of the Russian provider company is on the rise,” he said.

Yeah, I’m sure that the Europeans are just ecstatic over having Gazprom supplying a large percentage of their gas. Gee, ya think that Gazprom’s “economic potential” is in part built on rents extracted from Europeans by charging supercompetitive prices for gas?

Also note the divide-and-conquer rhetoric, another classic Putin touch; in Putin’s framing, the US is using the Europeans as a pawn against the poor, misunderstood Russians. But warning of the dangers of becoming overly dependent on Russian energy is not just an eeevil American plot to poison European minds against the innocent Russians–myriad thoughtful and farsighted Europeans, those that haven’t been bought off, anyways, recognize that it is very wise to develop alternative supply sources. (And maybe even more Germans will get a clue, after Lukoil cut off oil shipments today.)

Putin also framed things in terms of Russia always meeting its supply obligations. For one thing, that is debatable; consider, for instance, the Ukrainian gas shutoff in 2006 and the knock-on effects in Europe. For another thing, it misses a crucial point–price. Europeans should care not only about whether Russia delivers its contracted quantities at the contracted price–it should care deeply about what those quantities and prices are. A Europe that has numerous suppliers competing to serve it will be able to obtain more gas at better prices than if its supply alternatives are sharply limited, and overly dependent on Russia.

So, if the Europeans are smart they will see through Putin’s bluster and strive mightily to avoid becoming trapped in his–and Gazprom’s–web.

Catching up with several 2007 SWP posts, the G-7 finance ministers have called for China, Indonesia, and India to end price controls on oil (and the associated subsidies) because these encourage inefficiently high consumption. According to the linked Economic Times (India) article, Indonesia spends $11.5 billion to subsidize fuel; India $2.8 billion; and China $2 billion.

The article does not state whether the G-7 or any commentators have provided estimates on the additional consumption of oil that has resulted from these policies, or the impact on the world oil price. Nor have I been able to track down (via Google) any other articles or statements containing this information. Given the magnitude of the subsidies, and the inelasticity of oil supply, the quantity and price effects are unlikely to be trivial.

It’s good to see that this issue is finally getting some visibility, and that decision makers in the G-7 countries understand the world wide effects of these price controls. I wish I could be more sanguine that things will change, but I seriously doubt they will.

Or, if not God, Europe, the US, and China. Stephen Blank reports favorable developments from Turkmenistan. According to Blank, Turkmen President Berdymukhamedov is playin’ the Russians in the gas game. Realizing (it’s about time!) that he has tremendous leverage due to Gazprom’s junkie-like dependence on his country’s gas, Berdymukhamedov is playing hardball with the Russians, opening channels to China; Blank also suggests that this presents a major strategic opening for the EU and the US.

Importantly, Blank points out that Russia will face problems regardless of whether Turkmenistan has much gas or little. (The actual amount of gas there is a major mystery to outsiders.) If it has a lot, Turkmenistan will have the ability to deal with China and put gas in a Transcaspian pipeline that would undercut Russia’s dominance in European and Asian markets. If it has a little, Russia will be unable to meet its burgeoning domestic demand and its large export commitments.

This is good news, and helps ease some of the angst I felt after Putin’s apparent triumphs in the Caspian region last year. It all goes to show that unlike post-holiday sales, when it comes to this part of the world, No Deal is Final! Negotiations never end, and every announced contract is just another act in a drama with no end. Opportunism is the name of the game, and every shift of fortune leads to a new battle between contracting partners over how to divide the pie.

That said, it should also be recognized that the contrast between the despond of spring ’07 and the optimism of winter ’08 is a reminder that we understand very little of what goes on in that part of the world. We glimpse only the dimmest shadows cast by combatants in a dark and distant arena. We see the announcements–what we are supposed to see–but cannot discern most of what goes on. The bribes, the threats, the shifting alliances. This signal-to-noise ratio is low, so our mood should not shift too much in response to this announcement or that.

We should also put things into a broader context. I have often noted that Putin and the Russians are greatly, greatly exaggerating Russia’s military strength and prowess. Bob Amsterdam has repeatedly emphasized the Russian propensity for “premature contractualization”–the announcement of deals that never transpire, a practice that I have analogized to vaporware. In his piece, Blank notes that “Russia is very good at playing the bluffing game.”

That is, Russia’s talk far exceeds its capacity to walk. Through aggressiveness and bold talk Putin has achieved much more than the objective “correlation of forces” would suggest is possible. Calling some of these bluffs could very well demonstrate that the Tsar has no clothes. Inasmuch as the current Russian government depends crucially on maintaining an aura of strength and dominance, public rebuffs in the energy or geopolitical spheres would deeply shake it, and threaten Russia’s brittle stability.

I have no expectation whatsoever that Europe will call any bluffs anytime soon, and a lame duck administration in the midst of a contentious election season is unlikely to either. However, a year from now, things may be very different, especially if John McCain becomes US president.

One last thing. Stephen Blank is becoming one of my favorite commentators on Russia. He is a regular participant in the Russia Profile Weekly Expert Panel, and the one I am most likely to agree with.

Given that my views on Russia pundits seems to be nearly perfectly, negatively correlated with those of some of my doughty commentors, I suspect that my endorsement of Dr. Blank (a Chicago guy to boot!) will unleash a barrage of criticism–so, open fire, guys! And I mean that in all sincerity. Although, given the aforementioned negative correlation, it is unlikely that I will agree with your assessment of Dr. Blank, I do enjoy hearing all sides, and do learn things from your comments that help me calibrate my reading.

EU Energy Commissioner Andris Piebalgs channels Alfred E. Neuman in this RFE/RL interview. Although Piebalgs is only episodically coherent in this exchange, when he is comprehensible he downplays any concern about Gazprom’s strategy, its intent, or the necessity of a unified European response to the company’s ambitions. He does acknowledge a political element to Gazprom’s Serbian acquisition (what was his first clue?), but, he says, “I don’t see [that] with any other country.” There are none so blind, etc., etc.

Since Piebalgs, the EU’s leading energy official, is not exactly sounding the tocsin to raise the alarm against Gazprom’s predations, one wonders where leadership in Europe will come from. Not everybody is so Neumanesque as Piebalgs; the IEA has warned that Gazprom’s strategy needs watching. But as important as IEA is, more is needed from Europe’s political leaders. Alas, this does not seem in prospect. Europe seems all too willing to let the snake into the garden. They will be very, very sorry they did.

The New York Times reports that the Treasury and the SEC are contemplating requiring banks to disclose publicly quotes and trades in derivatives, such as CDOs. Where have I heard that idea before? Oh yeah, I came up with it 5 years ago to address problems in the energy market.

Now, of course, I shouldn’t take entire credit for the idea, as Mike Prokopp at Amerex, Ed Bell, then of PA Consulting, and Bob Anderson at the CCRO, and some folks at Reuters were thinking along similar lines. But I think it is fair to say that I contributed as much, and perhaps more, to the development and evangelization of the concept as anybody.

In energy, the issue was that many traders falsely reported the prices at which they bought and sold natural gas to trade publications such as Gas Daily and Inside Ferc. The price reporting was purely on an “honor system,” and like everything, honor has its price–and that was a price many traders weren’t willing to pay. So the basic idea I developed was that of a “data hub.” In a nutshell, traders would report prices of actual transactions to a central repository, that would validate the submissions by matching buys against sells. The data would then be disseminated to the marketplace.

The concept is pretty straightforward, but in the energy space it attracted a lot of flak, some of which I am still picking out of my backside. Transparency is not everybody’s friend; traders feel that they give up valuable information by publicly disclosing their prices. Moreover, the price reporting incumbents–notably Platts–had a vested interest in maintaining the old system. FERC and CFTC said nice things about the idea, but the political pressure from some industry groups, individual energy firms, and Platts overwhelmed the arguments that an academic and a few industry mavericks put forth. As a result, neither regulatory agency was willing to mandate that firms report prices to a particular entity. Absent a mandate, the collective action problems of creating a viable data hub were daunting.

In May, 2004 the idea was all but dead. As a last gasp effort to revive it, my then assistant Jeff Graefe had the idea to organize a roundtable on the idea at UH. Bob Anderson, who had formed a non-profit company called Energy Data Hub (imagine that) was there, as were several representatives of energy firms. Bob was about to give up on the idea when Jim Allison from Conoco-Phillips gave the idea his strong endorsement, and suggested that the concept be extended.

The original concept behind the hub was to collect and disseminate data on simple energy products, like day ahead and month ahead gas. Allison said that it would be much more useful to collect and disseminate information on more complicated products, including longer dated swaps and options. This would help firms get better estimates of the values of their outstanding contracts, and hence allow them to manage risk and determine profitability much more effectively.

With Allison’s strong endorsement, Anderson plugged ahead with the Data Hub. It is now collecting data from several companies, and should go live later this year. Although I take pride in pioneering the concept, Bob deserves credit in persevering to make the concept a reality, and Jim deserves credit for the vision to see how the concept could be used to solve problems other than the false-reporting issue that had been the reason for its development.

It is ironic, in light of the NYT article, that at a lunch with Anderson before Christmas I mentioned that the hub concept could–and should–be extended beyond energy to deal with other opaque markets, such as credit derivatives. The idea is, as they say, scalable, and numerous segments of the derivatives marketplace could do with greater transparency.

I am not a big fan of government mandates, but theory and practical experience tell me that (a) a mandate is the only way this can be done quickly, and (b) a mandate is economically efficient. As I noted before, trading firms don’t like transparency. They operate on the motto “The One Eyed Man is King in the Land of the Blind.” A individual firm that sees some deal flow–but not all the deals–likely has something of an information advantage over other firms. If all prices are revealed to everybody, the informational playing field is level–and who can make any money when that happens? So many firms–especially the big hitters that see a big chunk of the deal flow–would rather have a relatively opaque market. Sure, they don’t know values as accurately as if all prices were disseminated publicly, but trading profitability only requires that you have better information than others. So the biggest, most influential firms have a vested interest in opposing greater transparency.

Moreover, there is a positive externality from disclosure of value information; it helps other firms manage their risk better and mark their books more accurately. Firm A doesn’t benefit if firm B can manage risk better. Though Firm A could manage risk and mark books better if it also received information from firms B, C, etc., no individual firm captures all the benefits of its disclosures. Moreover, investors in the stock of the trading firms (and investors in hedge funds trading in these opaque markets) would benefit from having more accurate valuation information. But firm A gets all the trading benefits of keeping the information to itself, but none of the benefit that disclosure confers on other firms who can use the information to manage risk and mark more accurately. Collectively firms would benefit from disclosure (as the trading part of it is close to a zero sum game but the risk management part is positive sum), but individual firms can’t capture the collective benefit through unilateral disclosure.

Thus, there is a collective action problem, similar to the common pool problem in the oil business. It is well known (as documented by Gary Libecap and Steve Wiggins) that operators of common pools typically do not resolve that problem efficiently. On a priori grounds I would predict that collective action problems would make it very difficult for individual firms to come to an efficient agreement regarding mutual disclosures of price information. Indeed, the resistance of the “front offices” (i.e., the traders) to the idea would likely overcome the influence of the “middle offices” (i.e., the risk managers) who would otherwise favor the concept. (Traders usually swing much more stick than the green eyeshade types.) My experience in the energy data hub was strongly consistent with this conjecture.

So, despite my usually libertarian/Chicago instincts, here is a situation where I believe a mandate to be warranted, and I support the Treasury/SEC initiative. It is clearly most needed in the credit derivatives market, and in the market for various structured products, but it is also defensible in other parts of the derivatives market as well.

Perhaps the SEC/Treasury action will also galvanize FERC and CFTC to revisit the issue in energy markets too. Although the Energy Data Hub lives, it is still fighting the collective action problem.

When the subprime stuff hit the fan, it was clear that the market could use better price information. It was equally clear that due to the conflicting interests and the collective action problem, market participants were unlikely to provide it absent a nudge from the feds. That nudge has come, and none too soon.

Gazprom/Russia is/are playing smashmouth ball over Serbia’s national oil company. Don Miller and Don Medvedev have presented Serbia with an offer it can’t refuse: to sell Naftna industrija Srbije at a fraction of its true value–and one with an unbelievably short fuse, like, you know, Friday.

In exchange for control of SIJ’s hard assets and guarantees of a monopoly position in Serbia for some period (take that Serbian consumers, Gazprom doesn’t do competition), Gazprom Neft (Gazprom’s oil affiliate) is offering an amount that has been estimated to represent well less than one-half (and perhaps as little as one-quarter) of the Serbian company’s value. The tacit quid pro quo is that Russia will support Serbia on Kosovo–but, if Russian rhetoric is to be believed (yeah, I know) they would do that anyways.

To make the deal look a little less like an abject surrender, Gazprom has also dangled the prospect of giving Serbia a stake in a future gas venture. Word of advice, guys–DON’T BELIEVE IT, and DON’T TAKE IT. Gazprom is the master of what Bob Amsterdam calls “premature contractualization.” That is, announcing deals just in time to forestall projects that are adverse to Gazprom’s interest, and then fading the deal when the threatening competing projects are shelved in response to the Gazprom announcement. Gazprom will whisper sweet promises in anybody’s ear to get what they want, and then renege when it suits them. (Nigeria–you should take note of this, as Gazprom has been wooing you too.)

Gazprom’s stratagem is analogous to a common ploy in the software business. In the 80s and 90s “vaporware” was a commonly employed competitive strategy. A software company would announce a new, improved software product in order to forestall entry by a competitor. Once the potential entrant was scared away, the new software would just fade away into the mists, never to be seen. Gazprom is essentially following this playbook–constantly announcing vaporpipelines, vaporwells, vaporinvestments, vaporstorage, vapor-you-name-it whenever a threatening project is mooted.

So, what Gazprom is offering Serbia is: a pittance in cash plus a pig in a poke in exchange for hard assets right now. Given Gazprom’s record of delivering on its big talk, the Serbs would be well advised to take cash on the barrelhead and take the promises for what they are worth–a little more than nothing.