Streetwise Professor

June 9, 2021

GiGi’s Back!: plus ça change, plus c’est la même chose

Filed under: Clearing,Economics,Exchanges,HFT,Regulation — cpirrong @ 2:45 pm

One of the few compensations I get from a Biden administration is that I have an opportunity to kick around Gary Gensler–“GiGi” to those in the know–again. Apparently feeling his way in his first few months as Chairman of the SEC, Gensler has been relatively quiet, but today he unburdened himself with deep thoughts about stock market structure. If you didn’t notice, “deep” was sarcasm. His opinions are actually trite and shallow, and betray a failure to ask penetrating questions. Plus ça change, plus c’est la même chose.

Not that he doesn’t have questions. About payment for order flow (“PFOF”) for instance:

Payment for order flow raises a number of important questions. Do broker-dealers have inherent conflicts of interest? If so, are customers getting best execution in the context of that conflict? Are broker-dealers incentivized to encourage customers to trade more frequently than is in those customers’ best interest?

But he misses the big question: why is payment for order flow such a big deal in the first place?

Relatedly, Gensler expresses concern about what traders do in the dark:

First, as evidenced in January, nearly half of the trading interest in the equity market either is in dark pools or is internalized by wholesalers. Dark pools and wholesalers are not reflected in the NBBO. Moreover, the NBBO is also only as good as the market itself. Thus, under the segmentation of the current market, nearly half of trading along with a significant portion of retail market orders happens away from the lit markets. I believe this may affect the width of the bid-ask spread.

Which begs the question: why is “nearly half of the trading interest in the equity market either is in dark pools or is internalized by wholesalers”?

Until you answer these big questions, studying the ancillary ones like his regarding PFOF an NBBO is a waste of time.

The economics are actually very straightforward. In competitive markets, customers who impose different costs on suppliers will pay different prices. This is “price discrimination” of a sort, but not price discrimination based on an exploitation of market power and differences in customer demand elasticities: it is price differentiation based on differences is cost.

Retail order flow is cheaper to intermediate than institutional order flow. Some institutional order flow is cheaper to intermediate than other such flows. Competitive pressures will find ways to ensure flows that are cheaper to intermediate pay lower prices. PFOF, dark pools, etc., are all means of segmenting order flow based on cost.

Trying to restrict cost-based price differences by banning or restricting certain practices will lead clever intermediaries to find other ways to differentiate based on cost. This has always been so, since time immemorial.

In essence, Gensler and many other critics of US market structure want to impose uniform pricing that doesn’t reflect cost differences. This would be, in essence, a massive scheme of cross subsidies. Ironically, the retail traders for whom Gensler exhibits such touching concern would actually be the losers here.

Cross subsidy schemes are inherently unstable. There are tremendous competitive pressures to circumvent them. As the history of virtually every regulated sector (e.g., transportation, communications) has demonstrated for decades, and even centuries.

From a positive political economy perspective, the appeal of such cross subsidy schemes to regulators is great. As Sam Peltzman pointed out in his amazing 1976 JLE piece “Toward a More General Theory of Regulation,” regulators systematically attempt to suppress cost-based price differences in order to redistribute rents to gain political support. The main impetus for deregulation is innovation that exploits gains from trade from circumventing cross subsidy schemes–deregulation in banking (Regulation Q) and telecoms are great examples of this.

So who would the beneficiaries of this cross-subsidization scheme be? Two major SEC constituencies–exchanges, and large institutional traders.

In other words, all this chin pulling about PFOF and dark markets is politics as usual. Furthermore, it is politics as usual in the cynical sense that the supposed beneficiaries of regulatory concern (retail traders) are the ones who will be shtupped.

Gensler also expressed dismay at the concentration in the PFOF market: yeah, he’s looking at you, Kenneth. Getting the frequency?

Although Gensler’s systemic risk concern might have some justification, he still fails to ask the foundational question: why is it concentrated? He doesn’t ask, so he doesn’t answer, instead saying: “Market concentration can deter healthy competition and limit innovation.”

Well, concentration can also be the result of healthy competition and innovation (h/t the great Harold Demsetz). Until we understand the existing concentration we can’t understand whether it’s a bug or feature, and hence what the appropriate policy response is.

Gensler implicitly analogizes say Citadel to Facebook or Google, which harvest customer data and can exploit network effects which drives concentration. The analogy seems very strained here. Retail order flow is cheap to service because it is uninformed. Citadel (or other purchasers of order flow) isn’t learning something about consumers that it can use to target ads at them or the like. The main thing it is learning is what sources of order flow are uninformed, and which are informed–so it can avoid paying to service the latter.

Again, before plunging ahead, it’s best to understand what are the potential agglomeration economies of servicing order flow.

Gensler returns to one of his favorite subjects–clearing–at the end of his talk. He advocates reducing settlement time from T+2: “I believe shortening the standard settlement cycle could reduce costs and risks in our markets.”

This is a conventional–and superficial–view that suggests that when it comes to clearing, Gensler is like the Bourbons: he’s learned nothing, and forgotten nothing.

As I wrote at the peak of the GameStop frenzy (which may repeat with AMC or some other meme stock), shortening the settlement cycle involves serious trade-offs. Moreover, it is by no means clear that it would reduce costs or reduce risks. The main impact would be to shift costs, and transform risks in ways that are not necessarily beneficial. Again, shortening the settlement cycle involves a substitution of liquidity risk for credit risk–just as central clearing does generally, a point which Gensler was clueless about in 2010 and is evidently equally clueless about a decade later.

So GiGi hasn’t really changed. He is sill offering nostrums based on superficial diagnoses. He fails to ask the most fundamental questions–the Chesterton’s Fence questions. That is, understand why things are they way they are before proposing to change them.

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March 15, 2021

Deliver Me From Evil: Platts’ Brent Travails

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — cpirrong @ 6:41 pm

In its decision to change speedily the Dated “Brent” crude oil assessment to include US crude and to a CIF basis, Platts hit a hornets’ nest with a stick and now is running away from the angry hive.

Platts’ attempt to change the contract makes sense. Dated “Brent” is an increasingly, well, dated benchmark due to the inexorable decline in North Sea production volumes, something I’ve written about periodically for the last 10 years or so. At present, only about one cargo per day is eligible, and this is insufficient to prevent squeezes (some of which have apparently occurred in recent months). The only real solution is to add more supply. But what supply?

Two realistic alternatives were on offer: to add oil from Norway’s Johan Sverdrup field, or to add non-North Sea oil (such as West African or US). Each presents difficulties. The Sverdrup field’s production is in the North Sea, but it is heavier and more sour than other oil currently in the eligible basket. West African or US oil is comparable in quality to the current Brent basket, but it is far from the North Sea.

Since derivatives prices converge to the cheapest-to-deliver, just adding either Sverdrup or US oil on a free on board basis to the basket would effectively turn Dated Brent into Dated Sverdrup or Dated US: Svedrup oil would be cheaper than other Brent-eligible production because of its lower quality, and US oil would be cheaper due to its greater distance from consumption locations. So to avoid creating a US oil or Sverdrup oil contract masquerading as a Brent contract, Platts needs to establish pricing differentials to put these on an even footing with legacy North Sea grades.

In the event, Platts decided to add US oil. In order to address the price differential issue, it decided to move the pricing basis from free on board (FOB) North Sea, to a cost, insurance, and freight (CIF) Rotterdam basis. It also announced that it would continue to assess Brent FOB, but this would be done on a netback basis by subtracting shipping costs from the CIF Rotterdam price.

The proposal makes good economic sense. And I surmise that’s exactly why it is so controversial.

This cynical assessment is based on a near decade of experience (from 1989 to 1997) in redesigning legacy futures contracts. From ’89-’91, in the aftermath of the Ferruzzi soybean corner, I researched and authored a report (published here–cheap! only one left in stock!) commissioned by the CBOT that recommended adding St. Louis as a corn and soybean delivery point at a premium to Chicago; in ’95-’96, in the aftermath of a corner of canola, I advised the Winnipeg Commodity Exchange about a redesign of its contract; in ’97, I was on the Grain Delivery Task Force at the CBOT which radically redesigned the corn and beans contracts–a design that remains in use today.

What did I learn from these experiences? Well, a WCE board member put it best: “Why would I want a more efficient contract? I make lots of money exploiting the inefficiencies in the contract we have.”

In more academic terms: rent seeking generates opposition to changes that make contracts more efficient, and in particular, more resistant to market power (squeezes, corners and the like).

Some anecdotes. In the first experience, many members of the committee assigned to consider contract changes–including the chairman (I can name names, but I won’t!)–were not pleased with my proposal to expand the “economic par” delivery playground beyond Chicago. During the meeting where I presented my results, the committee chairman and I literally almost came to blows–the reps from Cargill and ADM bodily removed the chairman from the room. (True!)

The GDTF was formed only because a previous committee formed to address the continued decline of the Chicago market was deadlocked on a solution. The CBOT had followed the tried-and-true method of getting all the big players into the room, but their interests were so opposed that they could not come to agreement. Eventually the committee proposed some Frankenstein’s monster that attempted to stitch together pieces from all of the proposals of the members, which nobody liked. (It was the classic example of a giraffe being a horse designed by committee.). It was not approved by the CBOT, and when the last Chicago delivery elevator closed shortly thereafter, the CFTC ordered the exchange to change the contract design, or risk losing its contract market designation.

Faced with this dire prospect, CBOT chairman Pat Arbor (a colorful figure!) decided to form a committee that included none of the major players like Cargill or ADM. Instead, it consisted of Bill Evans from Iowa Grain, Neal Kottke of Kottke Associates (an independent FCM), independent grain trader Tom Neal, and some outsider named Craig Pirrong. (They were clearly desperate.)

In relatively short order we hashed out a proposal for delivery on the Illinois River, at price differentials reflecting transportation costs, and a shipping certificate (as opposed to warehouse receipt) delivery instrument. After a few changes demanded by the CFTC (namely extending soybean delivery all the way down the River to St. Louis, rather than stopping at Peoria–or was it Pekin?), the design was approved by the CBOT membership and went into effect in 1998.

One thing that we did that caused a lot of problems–including in Congress, where the representative from Toledo (Marcy Kaptor) raised hell–was to drop Toledo as a delivery point. This made economic sense, but it did not go over well with certain entities on the shores of Lake Erie. Again–the distributive effects raised their ugly heads.

The change in the WCE contract–which was also eminently sensible (of course, since it was largely my idea!) also generated a lot of heat within the exchange, and politically within Alberta, Manitoba, and Saskatchewan.

So what did I learn? In exchange politics, as in politics politics, efficiency takes a back seat to distributive considerations. This insight inspired and informed a couple of academic papers.

I would bet dimes to donuts that’s exactly what is going on with Platts and Brent. Platts’ proposal for a more efficient pricing mechanism gores some very powerful interests’ oxen.

Indeed, the rents at stake in Brent are far larger than those even in CBOT corn and beans, let alone tiny canola. The Brent market is vastly bigger. The players are bigger–Shell or BP or Glencore make even 1997 era Cargill look like a piker. Crucially, open interest in Brent-based instruments extends out until 2029: open interest in the ags went out only a couple of years.

My surmise is that the addition of a big new source of deliverable supply (the US) would undercut the potential for delivery games exploiting “technical factors” as they are sometimes euphemistically called in the North Sea. This would tend to reduce the rents of those who have a comparative advantage in playing these games.

Moreover, adding more deliverable supply than people had anticipated would be available when they entered into contracts last year or the year before or the year before . . . and which extend out for years would tend to cause the prices for these longer dated contracts to fall. This would transfer wealth from the longs to the shorts, and there is no compensation mechanism. There would be big winners and losers from this.

It is these things that stirred up the hornets, I am almost sure. I don’t envy Platts, because Dated Brent clearly needs to be fixed, and fast (which no doubt is why Platts acted so precipitously). But any alternative that fixes the problems will redistribute rents and stir up the hornets again.

In 1997 the CBOT got off its keister because the CFTC ordered it to do so, and had the cudgel (revoking contract designation) to back up its demand. There’s no comparable agency with respect to Brent, and in any event, any such agency would be pitted against international behemoths, making it doubtful it could prevail.

As a result, I expect this to be an extended saga. Big incumbent players lose too much from a meaningful change, so change will be slow in coming, if it comes at all.

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February 1, 2021

Battle of the Borgs

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Regulation — cpirrong @ 6:39 pm

One metaphor that might shed some light on how seemingly small events can have cascading–and destructive–effects in financial markets is to think of the financial system as consisting of borgs programmed to ensure their survival at all costs.

One type of borg is the clearinghouses/CCP borg. The threat to them is the default of their counterparties. They use margins to protect against these defaults (thereby creating a loser pays/no credit system). When volatility increases, or gap risk increases, or counterparty concentration risk increases–or all three increase–the CCP Borg responds to this greater risk of credit loss by raising margins–sometimes by a lot–in order to protect itself.

This puts other borgs (e.g., Hedge Fund Borgs) under threat. They try to borrow money to pay the CCP Borg’s margin demands. Or they sell liquid assets to raise the cash.

These actions can move prices more–including the prices of things that are totally different from what caused the CCP Borg to raise margins on. This can cause increases in volatility that triggers reactions by other Managed Money Borgs. For example, these Borgs may utilize a Value-at-Risk system to detect threats, and which is programmed to cause the MM Borg to reduce positions (i.e., try to buy and sell stuff) in order to reduce VaR, which can move prices further, triggering more volatility. Moreover, the simultaneous buying and selling of a lot of various things by myriad parties can affect correlations between prices of these various things. And correlation is an input into the borgs’ model, so this can lead to more borg buying and selling.

All of these price changes and volatility changes can impact other borgs. For example, increases in volatilities and correlations in many assets that results from Managed Money Borgs’ buying and selling will feed back to the CCP Borgs, whose self-defense models are likely to require them to increase their margins on many more instruments than they increased margins on in the first place.

This is how seemingly random, isolated shocks like retail trader bros piling into heavily shorted, but seemingly trivial, stocks can spill over into the broader financial system. Borgs programmed to survive, acting in self-defense, take actions that benefit themselves but have detrimental effects on other borgs, who act in self-defense, which can have detrimental effects on other borgs, and . . . you get the picture.

This is a quintessential example of “normal accidents” in a complex system with tightly coupled components. Other examples include reactor failures and plane crashes.

I note–again, reprising a theme of the Frankendodd Years of this blog–that clearing and margins are a major reason for tight coupling, and hence greater risk of normal accidents.

I note further that it is precisely the self-preservation instincts of the borgs that makes it utterly foolish and clueless to say that creating stronger borgs with more powerful tools of self-preservation, and which interact with other borgs, will reduce systemic risk. This is foolish and clueless precisely because it is profoundly unsystemic thinking because it views the borgs in isolation and ignores how the borgs all interact in a tightly coupled system. Making borgs stronger can actually make things worse when their self-preservation programs kick in, and the self-preservation of one borg causes it to attack other borgs.

Why do teenagers in slasher flicks always go down into the dark basement after five of their friends have been horribly mutilated? Well, that makes about as much sense as a lot of financial regulators have in the past decades. Despite literally centuries of bad historical experiences, they have continued to try to make stronger, mutually interacting, borgs. Like Becky’s trip down the dark basement stairs, it never ends up well.

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January 29, 2021

GameStop-ped Up Robinhood’s Plumbing

The vertigo inducing story of GameStop ramped it up to 11 yesterday, with a furore over Robinhood’s restriction of trading in GME to liquidation only, and the news that it had sold out of its customers’ positions without the customers’ permission. These actions are widely perceived as an anti-populist capitulation to Big Finance.

Well, they are in a way–but NOT the way that is being widely portrayed. What is going on is an illustration of the old adage that clearing and settlement in securities markets (like the derivatives markets) is like the plumbing–you take it for granted until the toilet backs up.

You can piece together that Robinhood was dealing with a plumbing problem from a couple of stories. Most notably, it drew down on credit lines and tapped some of its big executing firms (e.g., Citadel) for cash. Why would it need cash? Because it needs to post margin to the Depositary Trust Clearing Corporation (DTCC) on its open positions. Other firms are in similar situations, and directly or indirectly GME positions give rise to margin obligations to the DTCC.

The rise in price alone increased margin requirements because given volatility, the higher the price of a stock, the larger the dollar amount of potential loss (e.g., the VaR) that can occur prior to settlement. This alone jacks up margins. Moreover, the increase in GME volatility, and various adders to margin requirements–most notably for gap risk and portfolio concentration–ramp up margins even more. So the action in GME has led to a big increase in margin requirements, and a commensurate need for cash. Robinhood, as the primary venue for GME buyers, had/has a particularly severe position concentration/gap problem. Hence Robinhood’s scramble for liquidity.

Given these circumstances, liquidity was obviously a constraint for Robinhood. Given this constraint, it could not handle additional positions, especially in GME or other names that create particularly acute margin/liquidity demands. It was already hitting a hard constraint. The only practical way that Robinhood (and perhaps other retail brokers, like TDAmeritrade) could respond in the short run was trading for liquidation only, i.e., allow customers to sell their existing GME positions, and not add to them.

By the way, trading for liquidation is a tool in the emergency action toolbook that futures exchanges have used from time-to-time to deal with similar situation.

To extend the plumbing analogy, Robinhood couldn’t add any new houses to its development because the sewer system couldn’t handle the load.

I remember some guy saying that clearing turns credit risk into liquidity risk. (Who was that guy? Pretty observant!) For that’s exactly what we are seeing here. In times of market dislocation in particular, clearing, which is intended to mitigate credit risk, creates big increases in demand for liquidity. Those increases can cause numerous knock on effects, including dislocations in markets totally unrelated to the original source of the dislocation, and financial distress at intermediaries. We are seeing both today.

It is particularly rich to see the outrage at Robinhood and other intermediaries expressed today by those who were ardent advocates of clearing as the key to restoring and preserving financial stability in the aftermath of the Financial Crisis. Er, I hate to say I told you so, but I told you so. It’s baked into the way clearing works, and in particular the way that clearing works in stressed market conditions. It doesn’t eliminate those stresses, but transfers them elsewhere in the financial system. Surprise!

The sick irony is that clearing was advocated as a means to tame big financial institutions, the banks in particular, and reduce the risks that they can impose on the financial system. So yes, in a very real sense in the GME drama we are seeing the system operate to protect Big Finance–but it’s doing so in exactly the way many of those screaming loudest today demanded 10 years ago. Exactly.

Another illustration of one of my adages to live by: be very careful what you ask for.

Margins are almost certainly behind Robinhood’s liquidating some customer accounts. If those accounts become undermargined, Robinhood (and indeed any broker) has the right to liquidate positions. It’s not even in the fine print. It’s on the website:

If you get a margin call, you need to bring your portfolio value (minus any cryptocurrency positions) back up to your minimum margin maintenance requirement, or you risk Robinhood having to liquidate your position(s) to bring your portfolio value (minus any cryptocurrency positions) back above your margin maintenance requirement.

Another Upside Down World aspect of the outrage we are seeing is the stirring defenses of speculation (some kinds of speculation by some people, anyways) by those in politics and on opinion pages who usually decry speculation as a great evil. Those who once bewailed bubbles now cheer for them. It’s also interesting to see the demonization of short sellers–whom those with average memories will remember were lionized (e.g., “The Big Short”) for blowing the whistle on the housing boom and the bank-created and -marketed derivative products that it spawned.

There are a lot of economic issues to sort through in the midst of the GME frenzy. There will be in the aftermath. Unfortunately, and perhaps not surprisingly given the times, virtually everything in the debate has been framed in political terms. Politics is all about distributive effects–helping my friends and hurting my enemies. It’s hard, but as an economist I try to focus on the efficiency effects first, and lay out the distributive consequences of various actions that improve efficiency.

What are the costs and benefits of short selling? Should the legal and regulatory system take a totally hands off approach even when prices are manifestly distorted? What are the costs and benefits of various responses to such manifest price distortions? What are the potential unintended consequences of various policy responses (clearing being a great example)? These are hard questions to answer, and answering them is even harder in the midst of a white-hot us vs. them political debate. And I can say with metaphysical certainty that 99 percent of the opinions I have seen expressed about these issues in recent days are steeped in ignorance and fueled by emotion.

There are definitely major problems–efficiency problems–with Big Finance and the regulation thereof. Ironically, many of these efficiency problems are the result of previous attempts to “solve” perceived problems. But that does not imply that every action taken to epater les banquiers (or frapper les financiers) will result in efficiency gains, or even benefit those (often with justification) aggrieved at the bankers. I thus fear that the policy response to GameStop will make things worse, not better.

It’s not as if this is new territory. I am reminded of 19th century farmers’ discontent with banks, railroads, and futures trading. There was a lot of merit in some of these criticisms, but all too often the proposed policies were directed at chimerical wrongs, and missed altogether the real problems. The post-1929 Crash/Great Depression regulatory surge was similarly flawed.

And alas, I think that we are doomed to repeat this learning the wrong lessons in the aftermath of GameStop and the attendant plumbing problems. Virtually everything I see in the public debate today reinforces that conviction.

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January 28, 2021

Let the GameStop Games Begin!

Filed under: Economics,Exchanges,History,Politics,Regulation — cpirrong @ 9:33 am

Short sellers have been hate objects since the earliest days of the U.S. stock market–witness the checkered lives of the likes of Daniel Drew or Jacob Little. It is therefore no surprise that the travails of their latter day descendants–hedge funds like Melvin Capital–that have resulted from the huge runups in the prices of stocks like GameStop ($GME) have been the source of considerable schadenfreude. I would suggest, however, that this will end in tears not just for the hedgies, but for those who contributed to their massive losses.

Long story short (no pun intended).  Small investors pile in a stock (GME, and some others like Blackberry), driving up its price.  Hedge funds think the stock is overpriced, so they go short.  A group of small investors thinks that this is an opportunity to punish the short sellers (a lot of mutual disdain/hate here), so via the reddit group WallStreetBets they coordinate to buy more, driving up the price further.  This imposes big losses on the shorts, who buy to cover, driving up the price further, imposing more losses on the remaining shorts, driving them to cover, etc., etc. 

It brings to mind an old doggerel poem from the Chicago Board of Trade in the 19th century:

He who buys what isn’t his’n, Must buy it back or go to prison.

In the case of GameStop, the price action went hyperbolic:

That chart ends at yesterday’s close. Things have been even more crazy overnight, with the price hitting $500/share. There have been gyrations caused by the shutdown of the chatrooms and some retail platforms stopping trading in this and other heavily shorted stocks. But the fundamental dynamic in play now–shorts slitting their own throats in panicked buying to cover–means that attempts to constrain the long herd will not have a lasting impact.

The short interest that had to (and has to) be covered is huge–short interest in GME was 140 percent of outstanding shares–and a larger share of the float. (How can there be more shorts than shares? The same share can be borrowed and lent multiple times!) The effects of the short covering are seen not only in the price, but in the stratospheric cost of borrowing shares. Earlier this week it was about 30 percent–juice loan territory. Now it is at 100 percent.

In many respects, this is reminiscent of some of the more storied episodes in Wall Street history, or more recently the 2008 VW corner which punished shorts severely. But there is a major difference. In some of the earlier episodes (including major corners of shorts in railroad stocks in the 19th century, or battles between shorts and stock pools in the 1920s, or the VW case), there was a single dominant long squeezing the overextended shorts. Here, it seems that the driving force is a relatively large group of small longs, acting with a common purpose.

How will it end? Well, the stock is obviously overvalued, and driven by “technical factors” (as is sometimes said euphemistically). It will crash to earth. When? Well, when the shorts get out. Who will lose? Well, the shorts are likely a big portion of the purchasers at these nosebleed levels, so they will be the biggest losers. But there will be some latecomers and trend followers who will have followed the Pied Piper of rising price, and will lose in the inevitable crash.

Should we really care? There is some possibility that the disruption in GME and other heavily shorted stocks could have knock-on effects. Hedge funds suffering large losses may have to dump other positions, causing those prices to decline. (The events surrounding the Northern Pacific corner, for example, sparked the Panic of 1901.)

One fascinating aspect of this is how it demonstrates the deep populist discontent that is in abroad in the land. The hedge fund laments have been met with a barrage of scorn and ridicule, with a major theme being “you a$$h0les got bailed out in 2008 while the little guy got hammered–how you likin’ it now?” Completely understandable. Revenge of the nerds, as it were.

But, alas, I do not think the visceral satisfaction will last. Things like this inevitably result in litigation. The WallStreetBets lot are in for major lawsuits filed by the losing hedge funds, and perhaps others (e.g., investors who had sold call options).

Following the trend and herd trading is not manipulation–as long as the herd doesn’t explicitly coordinate with the intent to move the price to uneconomic levels. However, many on WallStreetBets expressed an intent to drive up the price in order to impose losses on their bêtes noires, and apparently coordinated their buying activity to achieve this result. Intent and cooperation make the manipulation. Note that the explicit communication and coordination could also transform this into a Section 1 Sherman Act claim–with the attendant triple damages.

Now the hedge funds will never collect even a fraction of their losses. But for them, the process will be the punishment inflicted on their foes. Pour encourager les autres.

The SEC is not committing to any action right now. It merely says it is “monitoring” the situation. The DOJ has also been silent.

However, they will be under tremendous pressure to act. Ultimately, the decision will be political–precisely because of the political nature of the populist resentment. The hedge funds and Wall Street generally will be howling for the government to file cases. But if the government does so, there will be widespread popular outrage that the government is taking the side of the Wall Street elite. Again.

This will be the first thing on Gary Gensler’s plate at the SEC. He is in a no win situation. (Breaks me all up.)

In sum, the events of the past days have been fascinating from both an economic and a political perspective. They represent a back-to-the-future moment of colossal battles between longs and shorts, but with a major twist: whereas the historical battles tended to be between colossi, this one pits an army of Davids against a few colossal hedge funds. This in turn gives rise to a political narrative, which again has historic echoes–the little guy vs. Financial Capital. It’s like the 19th century, all over again.

The battle will play out for some time. For a few days or weeks in the markets, and in the courts for years after that.

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January 25, 2021

LNG Skyrockets: Is Excessive Reliance on Spot Markets to Blame, and Will This Cause Contracting Practices to Change?

Filed under: China,CoronaCrisis,Derivatives,Economics,Exchanges,LNG — cpirrong @ 8:26 pm

After languishing in the doldrums in the Covid era, and at times touching historic lows, the price of LNG delivered to Asia skyrocketed in recent weeks before plunging almost as precipitously:

As always happens with such big price moves, there has been an effort to round up suspects. Here, since the visible price increase occurred in the spot market, the leading culprit is the spot market–something that has been growing rapidly in recent years, after being largely non-existent prior to 2014 or so.

For example, Reuters’ Clyde Russell writes:

What is more likely is that some buyers misjudged the availability of spot cargoes, and when hit with a surge in demand found themselves unable to secure further supply, thus bidding up the prices massively for the few cargoes still available.

Frank Harris of Wood Mackenzie opines:

“Buyers are going to become aware that you may not always be physically able to source a cargo in the spot market regardless of price,” Mr Harris says. “The most likely outcome is it shatters some of the complacency that’s crept into the market over the last 12-18 months.”

It is incorrect to say that a shortage of spot cargoes per se is responsible for the price spike registered in the spot market. It is the supply of LNG in toto, relative to massive increase in demand due to frigid weather, that caused the price increase. How that supply was divided between spot and non-spot trades is a secondary issue, if that.

The total supply of LNG, and the spatial distribution of that supply, was largely fixed when the cold snap unexpectedly hit. So in the very short run relevant here (days or weeks), supply in Asia was extremely inelastic, and a demand increase would inevitably cause the value of the marginal molecule to rise dramatically. Price is determined at the margin, and the price of the marginal molecule would be determined in the spot market regardless of the fraction of supply traded in that market. Furthermore, the price of that marginal molecule would likely be the same regardless of whether 5 percent or 95 percent of volume traded spot.

If anything, the growing prevalence of spot contracting in recent years mitigated the magnitude of the price spike. Traditional long term contracts, especially those with destination clauses, limited the ability to reallocate supplies efficiently to meet regional demand shocks. The more LNG effectively unavailable to be reallocated to the buyers that experienced the biggest demand shocks, the less elastic supply in the spot market, and the bigger the price increase that occurs in response to a given demand shock. That is, having less gas contractually committed, especially under contracts that limited the ability of the buyers to sell on to those who value it more highly, mitigates price spikes.

That said, the fundamental factors that limit the total availability of physical gas, and constrain the ability to move it from low demand locations to high demand locations in the short time frames necessary to meet weather-driven demand changes (ships can’t magically and instantaneously move from the Atlantic Basin to the Far East), mean that regardless of the mix of spot vs. contract gas prices would have spiked.

Some have suggested that the price spike will lead to less spot contracting. Clyde Russell again:

The question is whether utilities, such as Japan’s JERA, continue with their long-term vision of moving more toward a spot and short-term market, or whether the old security blanket of oil-linked, but guaranteed, supplies regains some popularity.

It’s likely LNG buyers don’t want a repeat of the recent extreme volatility, but perhaps they also don’t want to return to the restrictive crude-linked contracts that largely favoured producers by guaranteeing volumes at relatively high prices.

The compromise may be the increasing popularity of short-term, flexible contracts, which can vary from a few months to a few years and be priced against different benchmarks.

Well, maybe, but color me skeptical. For one thing, contracts require a buyer and a seller. Yes, buyers who didn’t have long term contracts probably regretted paying high spot prices–but the sellers with uncommitted volumes really liked it. The spike may increase the appetite for buyers to enter long term contracts, but decrease the appetite of sellers to enter them. It’s not obvious how this will play out.

I note that the situation was reversed in 2020–buyers regretted long term contracts, but sellers were glad to have them. Ex post regret is likely to be experienced with equal frequency by buyers and sellers, so it’s hard to see how that tips contracting one way or the other.

This conjecture about the price spike leading to more long term contracting also presupposes that the only way of managing price risks is through fixed price contracts (or oil-indexed) contracts for physical supply. But that’s not true. Derivatives allow the separation of who bears price risk from the physical contracting decision. A firm buying spot (and who is hence short LNG) can hedge price risk by purchasing JKM swaps. This has the additional advantage of allowing the adjustment of the size of the hedge in response to more timely information regarding likely quantity requirements, price projections, and risk appetite than is possible with a long term contract. That is, derivatives permit unbundling of price risk from obtaining physical supplies, whereas long term contracts bundle those to a considerable degree. Moreover, derivatives plus short term/spot acquisition of physical supplies allows more flexible management of supply, and management of supply based on shorter term forecasts of need: these shorter term forecasts are inherently more accurate than forecasts over contracting horizons of years or even decades.

So rather than lead to more long term contracts, I predict that this recent price spike is more likely provide a fillip to the LNG derivatives market. Derivatives are a more flexible and cheaper way to manage price risk than long term contracts.

This is what happened in the pipe gas market in the US post-deregulation. Spot/short term volumes grew dramatically even though price spikes were a regular feature of the market: market participants used gas futures and swaps and options to manage these price risks, and benefited from the greater flexibility and precision of obtaining supplies on a shorter term basis. This shifted a lot of the price risk to the financial sector–which is the great benefit of the much bewailed “financialization” of commodity markets.

The same is likely to occur in LNG.

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October 22, 2020

VOLT Redux

Filed under: Clearing,Derivatives,Economics,Exchanges,Regulation — cpirrong @ 6:44 pm

The very first substantive post on this blog, almost 15 years ago, was about a failure of the electronic trading system at the Tokyo Stock Exchange.

Whoops, they did it again!

Apparently believing that misery loves company, Euronext has also experienced failures.

Euronext’s problems seem quite more frightening, because they involve the out-trade from hell: reversing the polarity on transactions:

“It has been identified that some of the 19/10 trades sent yesterday to the CCPs (central counterparty clearing house) had the wrong buy/sell direction”, Euronext said.

Thought you were long? Hahahahahaha. You’re short, sucker!

I hate it when that happens! (Yes, Euronext reversed the trades after it realized the problem.)

The lessons of my “Value of Lost Trade” (“VOLT”) piece still hold. It is inefficiently costly to drive the probability of a failure to zero. Whether exchanges have the efficient probability of failure (or really, the efficient vector of failure probabilities, because there are multiply types of failure) depends on the value of foregone trades when a system is down (or the cost of other types of errors, such as reversing trade direction).

Meaning that system failures will continue to occur, and long after this blog fades away.

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October 11, 2020

Milton Friedman vs. 21st Century Lilliputians on Corporate Responsibility

Filed under: Economics,Exchanges,Politics,Regulation — cpirrong @ 3:57 pm

This year marks the 50th anniversary of Milton Friedman’s article on the “social responsibility of business,” in which he argued that business has one responsibility: to maximize profit. The anniversary has unleashed numerous retrospectives, most of them negative, and most of the negative treatments being given by people who have to crane their necks to see the soles of Friedman’s intellectual shoes.

The criticisms can be grouped into two basic categories: (a) the need for “stakeholder capitalism” as opposed to shareholder capitalism, and (b) the need for corporations to work to achieve social goals, such as environmental objectives or racial justice.

Both criticisms are unavailing and unpersuasive. The stakeholder capitalism critique founders on the is-ought fallacy. The social goals criticism founders on the Knowledge Problem.

Stakeholder capitalism advocates elide the “is” and jump right to “ought.” This is a fatal intellectual error, well described by Chesterton’s Fence.

Put differently, before advocating stakeholder capitalism as a superior substitute to shareholder capitalism, it is wise to ask: if stakeholder capitalism is so great, why doesn’t it already exist?

After all, there are numerous alternative ways of organizing and governing the cooperation between and coordination of suppliers of inputs (one subset of “the stakeholders”) to produce output that is sold to consumers (another subset of “the stakeholders”). There are many ways of allocating control rights and cash-flow rights. The corporate form, which makes the shareholders the residual claimants with residual control rights is just one. You can have sole proprieterships, partnerships, worker cooperatives, consumer cooperatives, mutual companies, and even anarcho-syndicalist worker communes:

Yet the corporate form that Friedman focuses on dominated then, and dominates today. It evidently conforms to the “survivorship principle” (a concept elucidated by Friedman’s partner in crime, George Stigler). That is, its dominance is consistent with its efficiency–its maximizing the size of the pie. (I recall a quote, which I thought was attributable to Bertrand Russell but which I cannot track down: “Efficiency is the highest form of altruism.”)

Moreover, this increasing the size of the pie effect must outweigh any distributive inequities “inherent in the system”: its survival means than no coalition of “stakeholders” (e.g., workers, or workers and customers, or workers and suppliers of capital) can make themselves better off by setting up an organization with different control and cash-flow rights than the shareholder corporation. Maybe the distribution of benefits within a corporation is inequitable, according to some theory of justice, but efficiency apparently trumps equity.

Henry Hansmann’s excellent book “The Organization of Enterprise” examines various alternative organizational forms, and finds that the efficiency of different forms of organization (e.g., producer cooperative, mutual) depends on the fine details of the nature of the production and marketing processes, and in particular the effects of these on the costs of contacting. My paper on the organization of financial exchanges provides a very interesting example. Exchanges organized as non-profit mutuals (pretty close to what Dennis advocated) were efficient under one set of technological conditions (floor trading) but not another (electronic trading): when technology changed, organization changed. Almost immediately. (Cf., the wave of exchange demutualizations in the early-2000s.)

Put differently, if “stakeholder capitalism” (or anarcho-syndicalist communes) were so great, either on efficiency or distributive grounds, we would see it in an even moderately competitive environment. Its absence makes it clear that it ain’t so great.

Sorry, Dennis. With the exception of the exchange thing. For a while, anyways.

So what about broader “social” goals? In this regard, it’s well to remember Hayek’s injunction that the addition of “social” as a prefix to any concept, e.g., social justice, usually renders the concept meaningless, or at best confuses rather than clarifies. Moreover, it’s imperative to remember another Hayekian concept: the Knowledge Problem.

The very existence of costs (e.g., pollution) that are not amenable to contract, and hence supposedly require unilateral corporate action to address, demonstrates the enduring legacy of one of Friedman’s colleagues, Coase. The transactions costs of some corporate activities are clearly too high to mitigate efficiently via contract. So, apparently, CEO’s are supposed to take an Olympian perspective and address these problems unilaterally.

That’s where the Knowledge Problem kicks in. Pray tell: where are CEOs supposed to get the information to lead them to make the appropriate trade-offs? The virtue of contract is that it provides a means of generating information about costs and benefits in order to make the altruistic–i.e., efficient–choice. But with “externalities,” contracting is a prohibitively expensive means of acquiring this information, and acting on it in an efficient eay. So where does this information come from?

CEOs–and heaven forfend, their HR departments–are usually sufficiently arrogant to believe they know.

They’re wrong: pride goeth before the fall.

Meaning that corporate decisions made pursuant to environmental or “social justice” goals are certain to be wrong. Very wrong.

Funny, isn’t it, that those who fault corporations for decisions that affect those with whom they have contractual privity blithely assert that they should make decisions with those with whom they do not? This is intellectual incoherence of the highest order.

There is another allegedly anti-Friedman argument, raised by the likes of the FT’s Martin Wolf: Friedman argued that corporations should maximize profits subject to the rules of the game, but since corporations make the rules of the game, this argument has no force and indeed cuts the other direction.

For one thing, Wolf’s argument is superficial and conclusory: “I also increasingly realize that I have changed my mind because I no longer believe in the contractarian view of the firm: that it is merely an aggregate of voluntary contracts which reflect the freedom of individuals to choose.” OK, Marty, I guess you are such an Olympian figure that your opinion, unsupported by argument or evidence, should suffice your disregarding the contractarian perspective and proceeding to other considerations.

But more importantly, one of Wolf’s more substantive arguments has, well, more substance: corporations have undue influence over the the political system, and therefore exert influence that results in the adoption of inefficient, and arguable inequitable, policies.

Well, yes. And Friedman would agree. Wolf’s criticism (and those of others making a similar point) of one Friedman article focused on one particular issue overlooks altogether other major–and indeed primary–streams of Friedman’s thought.

The precise reason that Friedman (and Stigler) opposed regulation and advocated small government was precisely because governments almost always advance special interests at the expense of efficiency and equity. Friedman always–always–asserted (justifiably) that he was NOT pro-big business. He was pro-market (which makes it particularly perverse that the Pro Market blog–which clearly steals from Friedman–repeatedly distributes garbage that traduces Friedman and others of his ilk, such as Aaron Director).

In this, Friedman was merely echoing Adam Smith–who never had a kind word to say about businessmen (a point that Stigler, the eminent Smith scholar of his era, made repeatedly).

Meaning that if your problem (and yeah, I’m looking at you Marty) is with undue corporate influence, rather than reshaping corporations in some way, maybe you should see that they are just responding rationally to the incentives inherent in a political system that gives the government almost unlimited authority to create rules that distribute rents.

That is, don’t limit corporations, limit governments. Corporations are just maze-bright rats. If you don’t want them gaming the maze, take away the cheese.

So to tar Friedman (and by extension other old-school Chicago types) with the brush of enabling corporations to write the rules of the game in their favor, is to ignore a major element of Friedman’s (and other old-school Chicago types’) worldview.

I’m also at a loss to figure out what particular changes to corporate organization and governance will miraculously transform them into more broad-minded entities that eschew exploiting the political system for their benefit. Look at Germany, or Japan, which have more “inclusive” models of governance, and which include other “stakeholders” in the formal governance process. Do you think they don’t influence the government to advance their interests? As. Fucking. If.

And if your response is: “give governments more power,” you are totally hopeless. Due to their comparative advantage in exercising influence over government–something that Wolf et al, in agreement with Friedman believe–that will just give corporations more power to do harm, not less.

In sum, Friedman’s latter-day critics, conveniently arguing when he is in the grave, and therefore unable to demolish them (as he surely would), totally fail to come to grips with his arguments, and in particular the arguments of his entire body of work, not just one article. “Stakeholder capitalism” is a vapid, vaporous concept that fails to address Deirdre McCloskey’s pithy phrase: “if you’re so smart, why aren’t you rich?” Claims that corporations should adopt a new objective function that encompasses “social” objectives, and not just profit, founder on the Knowledge Problem. Defensible criticisms that corporations exploit the political system are not arguing against Friedman–they are agreeing with him, yet arriving at wrongheaded conclusions.

We should all wish that our current thoughts, when evaluated from the perspective of 50 years, hold up so well as Milton Friedman’s. I guarantee that that will not be said of anyone carping on him today.

Friedman was small in stature, but a giant Gulliver in thought. His Lilliputian critics today prove the point.

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September 26, 2020

Water, Water, Not Everywhere and Still Not a Drop to Drink, Or, The Very Natural State

Filed under: Climate Change,Derivatives,Economics,Exchanges,Politics,Regulation — cpirrong @ 2:53 pm

The WSJ reports that the CME Group is launching a cash-settled futures contract on California water, with Nasdaq providing the cash price index. I predict, with a high degree of confidence, that this will not be a commercial success. That is, it will not generate substantial trading volume.

Why not? For the same reason that listed weather derivatives hardly ever trade. Information flow is a necessary (but not sufficient) condition to make people want to trade. For weather derivatives, there is very little information flow until shortly prior to the pricing month. For example, what information arrives between today and tomorrow that leads to updates in forecasts about what the weather in Chicago will be in December 2020, let alone December 2021? Virtually none. Given the nature of weather dynamics, information flow occurs almost exclusively quite close to the contract date (e.g., in late-November 2020 or 2021, if not in December itself). There is little information that arrives today that would motivate people to trade today contracts with payoffs contingent on future weather, even for a future only months away.

So they don’t.

I predict a similar phenomenon for water derivatives. Most of the fundamental shocks are weather-driven, and those will be concentrated close to the pricing month, leading to little demand to trade prior thereto.

Moreover, successful futures contracts rest on functional physical markets. As this recent article from The American Spectator summarizes, it is a travesty to characterize the means of allocating water in California as “a market.” Instead, it is an intensely politicized process.

If you don’t consider the AmSpec reliable, do a little digging into the scholarly literature about water allocation in the West, notably things written by my friend Gary Libecap. The conclusions are depressingly similar.

The politicization of water allocation is not new. It has existed since the beginning not just in California, but the West generally. Control of water confers enormous political power. You think politicians are going to give that up?

Again, this is not a new thing. Read up on the “California Water Wars.” Or, for a more entertaining take, watch Chinatown, which is a fictionalization/mythologization of the conflict of visions between William Mulholland and Frederick Eaton over water in Los Angeles. Spoiler: the romantic vision died (literally drowned), and the corrupt vision prevailed.

California politicians will become charismatic Catholics before they give up control over water. In a way, it reminds me of the effect of sanctions in say Saddam’s Iraq. Restrictions on supply resulting from sanctions empowered the regime. It could use its power to grant access to a vital resource in order to obtain obeisance. Similarly, California politicians can use their power to grant access to the vital resource of water to obtain political support, and exercise political power.

In a way, this is the quintessence of something I used to write about in regards to Russia: “the natural state.” Here, the analogy is even more trenchant, given that it relates to a natural resource.

The natural state operates by creating artificial scarcity, which in turn creates rents. The natural state allocates those rents in exchange for political patronage.

To do things that would undermine the rents–that is, to alleviate the scarcity–would undermine political power. That will NOT happen voluntarily. Markets for water would be a good thing–which is precisely why they don’t exist, and are unlikely to exist, especially in places like California where water is scarce and hence real markets would be most beneficial.

So CME/Nasdaq California water futures face two huge obstacles. First, even if even a simulacrum of a cash market for water existed, the nature of information flows is not conducive to active trading of water futures. Second, there is not even a simulacrum of a water market in California. What exists in place of a market is a political, and highly politicized, mechanism. That is also inimical to building a successful futures contract on top of it.

PS. Riffing of the Rime of the Ancient Mariner in the title provides an opportunity for another Python reference!

Albatross!

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May 20, 2020

Whoops! WTI Didn’t Do It Again, or, Lightning Strikes Once

The June 2020 WTI contract expired with a whimper rather than a bang yesterday, thereby not repeating the cluster of the May contract expiry. In contrast to the back-to-back 40 standard deviation moves in April, June prices exhibited little volatility Monday or Tuesday. Moreover, calendar spreads were in a modest contango–in contrast to the galactangos experienced in April, and prices never got within miles of negative territory.

Stronger fundamentals certainly played a role in this uneventful expiry. Glimmers of rebounding demand, and sharp supply reductions, both in the US and internationally, caused a substantial rally in flat prices and tightening of spreads in the first weeks of May. This alleviated fears about exhaustion of storage capacity. Indeed, the last EIA storage number for Cushing showed a draw, and today’s API number suggests an even bigger draw this week. (Though I must say I am skeptical about the forecast power of API numbers.). Also, the number of crude carriers chartered for storage has dropped. (H/T my daughter’s market commentary from yesterday). So the dire fundamental conditions that set the stage for that storm of negativity were not nearly so dire this week.

But remember that fundamentals only set the stage. As I pointed out in my posts in the immediate aftermath of the April chaos, technical factors related to the liquidation of the May contract, arguably manipulative in nature, the ultimate cause of the huge price drop on the penultimate trading day, and the almost equally large rebound on the expiry day.

The CFTC read the riot act in a letter to exchanges, clearinghouses, and FCMs last week. No doubt the CME, despite it’s Frank Drebin-like “move on, nothing to see here” response to the May expiry monitored the June expiration closely, and put a lot of pressure on those with open short positions to bid the market aggressively (e.g., bid at reasonable differentials to Brent futures and cash market prices). A combination of that pressure, plus the self-protective measures of market participants who didn’t want to get caught in another catastrophe, clearly led to earlier liquidations: open interest going into the last couple of days was well below the level at a comparable date in the May.

So fundamentals, plus everyone being on their best behavior, prevented a recurrence of the May fiasco.

It should be noted that as bad as April 20 was (and April 21, too), the carnage was not contained to those days, and the May contract alone. The negative price shock, and its potentially disastrous consequences for “fully collateralized” long-only funds, like the USO, led to a substantial early rolls of long positions in the June during the last days of April. Given the already thin liquidity in the market, these rolls caused big movements in calendar spreads–movements that have been completely reversed. On 27 April, the MN0 spread was -$14.45: it went off the board at a 54 cent backwardation. Yes, fundamentals were a major driver of that tightening, but the early roll in the US (and some other funds) triggered by the May expiration clearly exacerbated the contango. Collateral damage, as it were.

What is the takeaway from all this? Well, I think the major takeaway is not to overgeneralize from what happened on 20-21 April. The underlying fundamentals were truly exceptional (unprecedented, really)–and hopefully the likelihood of a repeat of those is vanishingly small. Moreover, the CME should be on alert for any future liquidation-related game playing, and market players will no doubt be more cautious in their approach to expiration. It would definitely be overlearning from the episode to draw expansive conclusions about the overall viability of the WTI contract, or its basic delivery mechanism.

That mechanism is supported by abundant physical supplies and connections to diverse production and consumption regions. Indeed, this was a situation where the problem was extremely abundant supply–which is an extreme rarity in physical commodity futures markets. Other contracts (Brent in particular) have chronic problems with inadequate and declining supply. As for WTI being “landlocked,” er, there are pipelines connecting Cushing to the Gulf, and WTI from Cushing has been exported around the world in recent years. With the marginal barrel going for export, seaborne crude prices drive WTI. With a better-monitored and managed liquidation process, especially in extraordinary circumstances, the WTI delivery mechanism is pretty good. And I say that as someone who has studied delivery mechanisms for around 30 years, and has designed or consulted on the design of these contracts.

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