Streetwise Professor

Texas governor Greg Abbot has extended an invitation to the CME Group to relocate from Chicago to Texas. The exchange group may well be moveable because the city’s new mayor, Let’s Go Brandon Johnson, has mooted a $1 or $2 per transaction tax on futures, options, and securities transactions in order to fill the city’s gaping fiscal hole–despite the fact that this is currently illegal under Illinois law.

Now you might not think that a buck is a big deal, given that a T-note or crude oil contract has a nominal value of around $100 grand. But it is a big increment to the cost of executing a contract. For example, the bid-ask on a crude oil futures trade is usually about $10, and the brokerage commission adds on only a few bucks. So the tax would increase transactions costs on the order of 5 or 10 percent.

I note that the industry fought for years at efforts to impose a 15 cent futures transaction tax. What Johnson is proposing is substantially greater than that.

Now, if Johnson’s objective was actually to raise revenue, this would be an incredibly stupid idea. Rule one of taxation: tax what can’t move. Although in the floor days uprooting the exchange and taking it outside the city or the state would have been very difficult, that’s not the case in the electronic era.

Have servers, will travel. Yes, CME Group (and CBOE–which given recent developments might end up in CME) has corporate employees there, but if any city should understand that is no impediment to relocation, Chicago should given the exodus of several major corporate HQs from the Chicago area in recent years–Caterpillar, Boeing, and Tyson Foods being prominent examples.

Moreover, even before the CME says hasta la vista motherfuckers, it faces competition in some of its products from ICE, and a tax would shift business there.

Numerous trading firms (notably Citadel) have fled Chicago for reasons–namely the marked decay of the city. (And I do mean marked: even in the last two years the decline has accelerated dramatically.) The CME has certainly already put those factors on the scale when making its decision, and a sizable transaction tax would almost certainly tip the balance heavily in favor of joining the exodus.

Notice that I framed my analysis as a conditional statement: if Johnson’s objective was actually to raise revenue. One cannot be too sure these days. Mayors of city after city have taken actions, or failed to take actions, that seem designed to drive out all but the underclass and turn the polities they govern (I use the term loosely) into crime-ridden, drug infested wastelands. In fact, it’s hard to name a big city whose elected officials haven’t done that or aren’t doing it.

American Spectator writer Scott McKay calls it “weaponized government failure:” “deliberate refusal to perform the basic tasks of urban governance for a specific political purpose.” The “specific political purpose” being to drive out middle class voters who pose the main political threat to the Brandon Johnsons and their ilk.

Framed as a hypothesis, I’m hard pressed to come up with contrary evidence.

Whether that’s the true purpose behind Johnson’s transaction tax brainwave, if he moves forward with it it’s a near lock that CME will hit the road. An electronic exchange is footloose and fancy free and not beholden to any place. Where once there were “locals” whose physical presence was necessary to operate an exchange, there are now what may be called “globals” who can and do supply liquidity from anywhere.

And if it moves, Texas is a good place. No income tax for one thing. Reasonable housing costs. And as for the weather, as I told my late mom when she fought coming here: “Look, you spent four months a years indoors in Chicago. You’ll spend four months a year indoors in Houston. Just different months.”

So come on down, Terry Duffy. I’ll be here to greet you. With bells on.

The Fed and the SEC have expressed concerns about Treasury “basis trades” wherein a firm purchases a cash Treasury security funded by repo-ing it out and sells Treasury futures. Their concern is somewhat justified. As mentioned in the linked article, and analyzed in detail in my paper in the Journal of Applied Corporate Finance (“Apocalypse Averted“) the spike in the cash-futures Treasury basis caused by COVID (or more accurately, the policy response to COVID) caused a liquidity crisis. The sharp basis change led to big margin calls (thereby creating a demand for liquidity) and also set off a feedback loop: the unwinding of positions exacerbated the basis shock, and thereby reinforced the liquidity shock.

This is just an example of the inherent systemic risk created by margining, collateralization, and leverage. The issue is not a particular trade per se–it is an inherent feature of a large swathe of trades and instruments. What made the basis trade a big issue in March 2020 was its magnitude. And per the article, it has become big again.

This is not a surprise. Treasuries are a big market, and leveraging a small arb pickup is what hedge funds and other speculators do. It is a picking-up-nickels-in-front-of-a-steamroller kind of trade. It’s usually modestly profitable, but when it goes bad, it goes really bad.

All that said, the article is full of typical harum-scarum. It says the trade is “opaque and risky.” I just discussed the risks, and its not particularly opaque. That is, the “shadowy” of the title is an exaggeration. It has been a well-known part of the Treasury market since Treasury futures were born. Hell, there’s a book about it: first edition in 1989.

Although GiGi is not wrong that basis trades can pose a systemic risk, he too engages in harum-scarum, and flogs his usual nostrums–which ironically could make the situation worse:

“There’s a risk in our capital markets today about the availability of relatively low margin — or even zero margin — funding to large, macro hedge funds,” said Gensler, in response to a Bloomberg News inquiry about the rise of the investing style.

Zero margin? Really? Is there anyone–especially a hedge fund–that can repo Treasuries with zero haircut? (A haircut–borrowing say $99 on $100 in collateral is effectively margin). And how exactly do you trade Treasury futures without a margin?

As for nostrums, “The SEC has been seeking to push more hedge-fund Treasury trades into central clearinghouses.” Er, that would exacerbate the problem, not mitigate it.

Recall that it was the increase in margins and variation margins on Treasury futures, and the increased haircuts on Treasuries, that generated the liquidity shock that the Fed addressed by a massive increase in liquidity supply–the overhang of which lasted beyond the immediate crisis and laid the groundwork for both the inflationary surge and the problems at banks like SVB.

Central clearing of cash Treasuries layers on another potential source of liquidity demand–and liquidity demand shocks. That increases the potential for systemic shocks, rather than reduces it.

In other words, even after all these years, GiGi hasn’t grasped the systemic risks inherent in clearing, and still sees it as a systemic risk panacea.

In other words, even though I agree with Gensler (and the Fed) that basis trades are a source of systemic risk that warrant watching, I disagree enough with GiGi on this issue that the apocalypse that could result from our complete agreement on anything will be averted–without the intervention of the Fed.

A coda to my previous post. The EU natural gas price regulation avoids many of the faults of price controls, largely as a result of its narrow focus on a single market: TTF natural gas futures. That said, the fact that it potentially applies to one market means that there are still potentially negative consequences.

These negative consequences are not so much to the allocation of natural gas per se, but to the allocation of natural gas price risk. Futures markets are first and foremost markets for risk, and the price regulation has the potential to interfere with their operation.

In particular, the prospect of being locked into a futures position when the price cap binds will make market participants less likely to establish positions in the first place: traders dread being stuck in a Roach Motel, or Hotel California (you can check out but you can never leave). Thus, less risk will be hedged/transferred, and the market will become less liquid. Relatedly, price caps can lead to perverse dynamics when the price approaches the cap as market participants look to exit positions to avoid being locked in. This can lead to enhanced volatility which can perversely cause the triggering of the cap.

Caps also interfere with clearing. There is a potential for large price movements when the cap no longer binds. Thus, in the EU gas situation, ICE Clear Europe has said that it will have to charge substantially higher initial margins (an estimated $33-47 billion more), and indeed, may choose to exit the EU.

These negative effects are greater, the closer prices are to the cap. Europe’s good luck with weather this winter has provided a relatively large gap between the market price and the cap, so the negative impacts are relatively unlikely to be realized. But that’s a matter of luck rather than a matter of economic principle.

Risk transfer is a vital economic function that generates substantial economic value. The cost of interfering with this mechanism is material, and should not be ignored when evaluating the EU policy. That policy avoids many of the standard problems with price caps, but its narrow focus to the futures market means that it has the potential to create economic costs not typically considered in evaluations of price controls. Meaning that not even Saul Goodman would come to its defense.

At the very end of last year the European Union finally agreed on a rule capping natural gas prices. And what a strange duck it is–unlike any price cap I’ve seen before, which is probably for the best for reasons I discuss below.

Rather than a simple ceiling on the price of natural gas–which is what many EU nations were clamoring for–the rule limits trading in front month, three month, and one year TTF futures if (a) the front-month TTF derivative settlement price exceeds EUR 275 for two week(s) and (b) the TTF European Gas Spot Index as published by the European Energy Exchange (EEX) is EUR 58 higher than the reference price during the last 10 trading days before the end of the period referred to in (a).  The “reference price” is: “the daily average price of the price of the LNG assessments “Daily Spot Mediterranean Marker (MED)”, the “Daily Spot Northwest Europe Marker (NWE)”, published by S&P Global Inc., New York and of the price of the daily price assessment carried out by ACER pursuant to Article 18 to 22 of Council Regulation .”

So in other words: (a) the TTF price has to be really high for two weeks straight, and (b) the TTF price has to be really high relative to the European LNG price over that period.

In the event the cap is triggered, “Orders for front-month TTF derivatives with prices above EUR 275 may not be accepted as from the day after the publication of a market correction notice.” So basically this is a limit up mechanism applied to front month futures alone that basically caps the front month price alone. Moreover, it will not go into effect until mid-February, meaning that the last two weeks of February would have to be really cold in order to trigger it. (The chart below shows how far below prices currently are below the flat price cap trigger.)

These conditions are so unlikely to be met that one might get the idea that the cap is intended never to be triggered, and if it is, its impact is meant to be limited to front month futures. And you’d probably be right. Some nations definitely wanted a traditional cap on the price of gas inside the EU, but the Germans and Dutch especially realized this would be a potential disaster as it would cause of of the usual baleful effects of price controls, notably shortages.

The rule as passed does not constrain the physical/cash market for natural gas anywhere in the EU. This is the market that allocates actual molecules of gas, and it will continue to operate even if the front month futures market is frozen. The freezing of futures may well interfere with price discovery in the physical/cash market, but regardless, prices there can rise to whatever level necessary to match supply and demand. As a result, the cap will not achieve the objectives of those pressing for a traditional price ceiling, and won’t result in the consequences feared by the Germans and Dutch.

So the cap is unlikely ever to be triggered, and if it does, won’t interfere with the operation of the physical market or have much of an impact on the prices that clear that market. So what’s the point?

One point is political: the Euros can say they have imposed a cap, thereby appeasing the suckers who don’t understand how meaningless it is.

Another point is distributive–which is also political. The document setting out and justifying the rule spends a tremendous amount of effort discussing a very interesting fact: namely, that when prices spiked last year, basis levels got way out of line with historical precedents. Notably, TTF traded at a big premium relative to LNG prices, and to prices at other hubs in the EU. Sensibly, the document attributes these extreme basis levels to infrastructure constraints within the EU, namely constraints on gasification capacity, and pipeline constraints for moving gas within the EU. (Although I note that squeezing the TTF could have exacerbated these basis moves.)

Again, the rule won’t have any impact on the basis levels in the physical market. So again–what’s the point? Well almost in passing the document notes that many natural gas contracts throughout the EU are priced at the TTF front month futures price plus/minus a differential. What the rule does is prevent prices on these contracts from being driven by the TTF front month price when those infrastructure constraints cause TTF to trade at a big premium to LNG or to prices at other hubs. So for example, a buyer in Italy won’t pay the market clearing TTF price when that would have traded at a big premium and high flat price level: instead, the buyer in Italy will pay the capped TTF front month price.

In other words, the mechanism mitigates the impact of a very common pricing mechanism adopted in normal times against the impacts of very abnormal times. A buyer outside of NW Europe takes on basis risk by purchasing at TTF plus a differential, but usually that basis risk is sufficiently small as to be outweighed by the benefits of trading in a more liquid market (with TTF being the most liquid gas market in Europe, just as Henry Hub is in the US). However, the stresses of the past year plus have greatly increased that basis risk. The price cap limits the basis risk on legacy contracts tied to TTF, without unduly interfering with the physical market. The marginal molecules will still be priced in the (unconstrained) physical market.

So there you have it. Beneath all the political posturing and smoke and mirrors, all the rule does is limit the potential “windfall” gains of those who sold gas forward basis front month TTF, and limit the “windfall” losses of those who bought basis front month TTF. If demand spikes and the infrastructure constraints bind (or if someone exploits these constraints to squeeze TTF futures) causing the basis to blow out, the rule will constraint the impact on those who benchmarked contracts to the front month TTF.

In some respects this isn’t surprising. All regulation, in the end, is distributive.

Putting it all together, this is probably the least bad price control I’ve seen. It is unlikely to go into effect, and even if it does its impact is purely distributive rather than allocative.

The meltdown of FTX continues to spark controversy and commentary. A recent theme in this commentary is that the FTX disaster represents a failure of centralization that decentralized finance–DeFI–could correct. Examples include contributions by the very smart and knowledgeable Campbell Harvey of Duke, and an OpEd in today’s WSJ.

I agree that the failure of FTX demonstrates that the crypto business as it is, as opposed to how it is often portrayed, is highly centralized. But the FTX implosion does not demonstrate that centralization of crypto trading per se is fundamentally flawed: FTX is an example of centralization done the worst way, without any of the institutional and regulatory safeguards employed by exchanges like CME, Eurex, and ICE.

Indeed, for reasons I have laid out going back to 2018 at the latest, the crypto market was centralized for fundamental economic reasons, and it makes sense that centralization done right will prevail in crypto going forward.

The competitor for centralization advocated by Harvey and the WSJ OpEd and many others is “DeFi”–decentralized finance. This utilizes the nature of blockchain technology and smart contracts to facilitate crypto trading without centralized intermediaries like exchanges.

One of the exemplars of the DeFi argument is “automated market making” (“AMM”) of crypto. This article provides details, but the basic contours are easily described. Market participants contribute crypto to pools consisting of pairs of assets. For example, a pool may consist of Ether (ETH) and the stablecoin Tether (USDT). The relative price of the assets in the pool is determined by a formula, e.g., XETH*XUSDT=K, where K is a constant, XETH is the amount of ETH in the pool and XUSDT is the amount of Tether. If I contribute 1 unit of ETH to the pool, I am given K units of USDT, so the relative price of ETH (in terms of Tether) is K: the price of Tether (in terms of Ether) is 1/K.

Fine. But does this mechanism provide price discovery? Not directly, and not in the same way a centralized exchange like CME does for something like corn futures. DeFi/AMM essentially relies on an arbitrage mechanism to keep prices aligned across exchanges (like, FTX once up an time and Binance now) and other DeFi AMMs. If the price of Ether on one platform is K but the price on another is say .95K, I buy ETH on the latter platform and sell Ether on the former platform. (Just like Sam and Caroline supposedly did on Almeda!) This tends to drive prices across platforms towards equality.

But where does the price discovery take place? To what price do all the platforms converge? This mechanism equalizes prices across platforms, but in traditional financial markets (TradFi, for the consagneti!) price discovery tends to be a natural monopoly, or at least has strong natural monopoly tendencies. For example, it the days prior to RegNMS, virtually all price discovery in NYSE stocks occurred on the NYSE, even though it accounted only for about 75-80 percent of volume. Satellite markets used NYSE prices to set their own prices. (In the RegNMS market, the interconnected exchanges are the locus of price discovery.)

Why is this?: the centripetal forces of trading with private information. Something that Admati-Pfleiderer analyzed 30+ years ago, and I have shown in my research. Basically, informed traders profit most by trading where most uninformed traders trade, and the uninformed mitigate their losses to the informed by trading in the same place. These factors reinforce one another, leading to a consolidation of informed trading in a single market, and the consolidation of uninformed trading on the same market except to the extent that the uninformed can segment themselves by trading on platforms with mechanisms that make it costly for the informed to exploit their information, such as trade-at-settlement, dark pools, and block trading. (What constitutes “informed” in crypto is a whole other subject for another time.)

It is likely that the same mechanism is at work in crypto. Although trading consolidation is not as pronounced there as it is in other asset classes, crypto has become very concentrated, with Binance capturing around 75-80 percent of trading even before the FTX bankruptcy.

So theory and some evidence suggests that price discovery takes place on exchanges, and that DeFi platforms are satellite markets that rely on arbitrage directly or indirectly with exchanges to determine price. (This raises the question of whether the AMM mechanism is sufficiently costly for informed traders to insure that their users are effectively noise traders.)

The implication of this is that DeFi is not a close substitute for centralized trading of crypto. (I note that DeFi trading of stocks and currencies is essentially parasitical on price discovery performed elsewhere.) So just because SBF centralized crypto trading in the worst way doesn’t mean that decentralization is the answer–or will prevail in equilibrium as anything more than an ancillary trading mechanism suited for a specific clientele, and not be the primary locus of price discovery.

The future of crypto will therefore almost certainly involve a high degree of centralization–performed by adults, operating in a rigorous legal environment, unlike SBF/FTX. That’s where price discovery will occur. In my opinion, DeFi will play an ancillary role, just as off-exchange venues do today in equities, and did prior to RegNMS.

One last remark. One thing that many in the financial markets deplore is the fragmentation of trading in equities. It is allegedly highly inefficient. Dark pools, etc., have been heavily criticized.

Fragmentation and decentralization is also a criticism leveled against OTC derivatives markets–here it has been fingered as a source of systemic risk, and this criticism resulted in things like OTC clearing mandates and swap execution facility mandates.

It’s fair to say, therefore, that in financial market conventional wisdom, decentralization=bad.

But now, a failure of a particular centralized entity is leading people to tout the virtues of decentralization. Talk about strange new respect!

All of these criticisms are largely misguided. As I’ve written extensively in the past, fragmentation in TradFi is a way of accommodating the diverse needs of diverse market participants. And just because some hopped up pervs found that running a centralized “exchange” was actually a great way to steal money from those blinded by their BS doesn’t mean that centralization is inherently unfitted for crypto because decentralized mechanisms also exist.

If crypto trading is to survive, well-operated centralized platforms will play an outsized role, supplemented by decentralized ones. Crypto is not so unique that the economic forces that have shaped market structure in stocks and derivatives will not operate there.

So don’t overgeneralize from a likely (and hopefully!) extreme case driven by the madness of woke crowds.

As day follows night, the vaporization of FTX has spurred calls for regulation of crypto markets. Well, what kind of regulation, exactly? It matters.

It appears highly likely that SBF and his Merry Gang (of pervy druggies?) broke oodles of laws, in multiple jurisdictions. Class action lawsuits are definitely incoming, and the DOJ’s SDNY attorneys’ office is commencing a criminal investigation. No doubt criminal investigations will follow in other locations. So what would more laws accomplish, and what kind of laws and regulations would help?

It is interesting to note that SBF was going around DC and the media talking up regulating the industry, and winning effusive plaudits (but not from CZ!) for doing so, but his proposals didn’t come within a million miles of his alleged wrongdoing. I’m sure you’re shocked.

On CNBC, Bankman-Fried endorsed three regulatory endeavors: stablecoin auditing, “markets regulation” of spot trading, and token registration (at about the 4:30 mark):

None of which touches on the fundamental issue in the FTX fiasco, and in crypto market structure generally: the role of “exchanges” in supplying broker dealer and banking services, including liquidity, maturity, and credit transformations.

No doubt SBF was adding to his savior glow by pushing regulation that he knew was utterly irrelevant to the core of his business (and the business of all other crypto “exchanges”). And look at how many suckers fell for it.

So what would help? As I noted at the outset, FTX, Bankman-Fried, et al likely violated numerous laws. So what additional laws would reduce the likelihood and severity of such actions?

In thinking about this, remembering the distinction between ex ante and ex post regulation is important. Ex post regulation involves the imposition of sanctions on malfeasors after they have been found to have committed offense: the idea is to deter bad conduct through punishment after the fact. In contrast, ex ante regulation attempts to prevent bad acts by imposing various constraints on potential wrongdoers.

The choice between ex ante and ex post depends on a variety of factors. Two of the most important (and related) are whether the bad actor is judgment proof (i.e., will have the resources to recompense those he has harmed) and the probability of detection. (These are related because a low probability of detection requires a higher penalty to achieve deterrence, but a higher penalty increases the chances that the wrongdoer is judgment proof).

In the case of things like what has apparently happened here, the probability of detection is high (1.00 actually), but the magnitude of the harm is so great and the (negative) correlation between the harm and the wrongdoer’s ability to pay is so high (essentially -1.00) that ex post deterrence is problematic.

(Judgment proof-ness is actually a justification for criminal law and the use of incarceration as punishment. Deterrence through fines doesn’t work with broke bad guys, so non-monetary punishment is necessary–but often not sufficient!)

So there is a case for ex ante regulation here, just as there is a case for ex ante regulation of banks and intermediaries like broker dealers and FCMs. Banking examiners, regulatory audits, customer seg rules, and the like.

But these are obviously not panaceas. Bank fraud still occurs with depressing regularity, and the things that facilitate it, like valuation challenges, accounting shenanigans, and so on, occur in spades in crypto. And, even in highly regulated US markets, violation of seg rules and misuse of customer assets occurs: yeah, I’m looking at you John Corzine/MF Global.

The big problems in crypto markets are essentially agency problems, especially since the crucial agents–crypto “exchanges”–are so concentrated and so vertically integrated into both execution and various forms of financial transformations.

Ex ante regulation focused on such issues could be a boon, and could help stabilize crypto markets generally. The spillovers we are seeing from FTX’s vaporization are essentially a reputational contagion: the mini (so far) runs on other “exchanges” reflect FUD about their probity and solvency. (NB: Binance, as the biggest “exchange,” and as opaque as FTX, is a serious run risk. BlockFi and AAX may already be in the crosshairs here: glitch in the systems upgrade. Riiiiigggghhhht.)

The challenge is that the demise of financial intermediaries is well-described by a famous Hemingway quote:

“How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually, then suddenly.”

An intermediary can go along swimmingly, meeting all seg requirements and the like, and a big market move or bad bet or an operational SNAFU can put it on the brink very suddenly–and encourage gambling for resurrection by using customer funds to extend and pretend. So don’t expect such regulation to be a panacea, and prevent the recurrence of FTXs. Regulation or no, this happens with intermediaries that engage in liquidity, maturity, and credit transformations that are inherently fragile. (And may be fragile by design, as Doug Diamond has pointed out.)

On the regulation issue, one fascinating sidebar is my old bête noire, Gary Gensler. You don’t need to play 6 Degrees From SBF to ensnare most of the Democratic establishment: one or two degrees will do, and Gensler definitely qualifies.

In addition to the MIT connection, Gensler apparently had other interactions with Bankman-Fried. And of course Gensler is a player in the Democratic Party (he was Hillary’s campaign’s finance chair, after all), and Bankman-Fried was a major Dem donor (second largest after Soros in the most recent cycle, and he had talked about spending up to a billion in the 2024 campaign).

Questions have been raised.

When initially questioned about FTX, Gensler was very defensive:  “Building the evidence, building the facts often takes time.”

I am reserving judgment, but I hope someone takes the time to examine the links and interactions between SBF/FTX and Gensler (and other DC creatures)–and build the evidence and facts, if it comes to that.

My guess is that Gensler will try to pull a judo move and use this fiasco as a justification for expanding the power of the SEC. Indeed, I expect him to be in high dudgeon precisely to deflect attention from his (and his party’s) links to SBF. Don’t let him get away with it.

And don’t think that these links can be exposed through a FOIA. Gensler has long been known for using his private email to conduct official business. (Which is precisely why I didn’t bother FOAI-ing him years ago regarding my suspicions of his interactions with David Kocieniewski.) So deeper digging is required, and it should commence, post haste.

HC Group were kind enough to include me in their HC Insider podcast. Paul Chapman and I discussed systemic risk issues in commodity markets, which is a hot topic these days given the tumult in commodities since last fall. Central banks and regulators are paying closer attention to commodities now than they ever have.

Here’s a link to the Podcast. As you can see from the categories, we covered a lot of ground. Hope you find it informative.

Gary Gensler is back, as clueless as ever. Perhaps in a future post I will discuss his malign proposal on corporate climate disclosure, but today I will focus on his latest brainwave: the restructuring of US equity markets.

In a speech, Gensler outlined his incisive critique of market structure:

“Right now, there isn’t a level playing field among different parts of the market: wholesalers, dark pools, and lit exchanges,” Gensler said in remarks delivered virtually for an event hosted by Piper Sandler in New York. “It’s not clear, given the current market segmentation, concentration, and lack of a level playing field, that our current national market system is as fair and competitive as possible for investors,” adding that there was a cost being borne by retail investors.  

“Level playing field” is a favorite trope of his, and of regulators generally. But what does it even mean in this context? Seriously–I have no idea. It’s just something that sounds good to the gullible that has no analytical content whatsoever. Yes, there are a variety of different types of market participants in competition and cooperation with one another. How does the existing setup disadvantage or advantage one group of participants in an inefficient way? How do we know that the current distribution of winners and losers does not reflect fundamental economic conditions? Gensler doesn’t say–he doesn’t even define what a level playing field is. He just makes the conclusory statement that the playing field isn’t level.

Furthermore, note the mealy mouthed statement “It’s not clear . . . that our current national market system is as fair and competitive as possible.” Well, then it’s not clear that it isn’t as fair and competitive as possible. And if Gensler isn’t clear about the fairness and competitiveness of the current system, how can he justify a regulator-mandated change in that system?

For God’s sake man, at least make a case that the current system is inefficient or unfair. If your case is bullshit, I’ll let you know. But to call for a massive change in policy just because you aren’t certain the current system is perfect is completely inadequate.

The Nirvana Fallacy looks good by comparison. At least the Nirvana Fallacy is rooted in some argument that the status quo is imperfect.

Foremost in GiGi’s crosshairs is payment for order flow (“PFOF”). This practice exercises a lot of people, but as Matt Levine notes, and as I’ve noted for years, it exists for a reason. Different types of order flow have different costs to service. Retail order flow is cheaper to trade against because retail traders are unlikely to be informed, which reduces adverse selection costs. PFOF is a way of segmenting order flow and charging retail traders lower prices which reflect their lower costs, in the current environment through zero (or very low commissions). This passes some (and arguably all) of the value of retail order flow to the retail traders.

The main concern over PFOF is that retail investors won’t see the benefit. Their brokers will pocket the payments they get from the wholesalers they sell the order flow to, and won’t pass it on to investors. Well, overlooking the fact that’s a distributive and not an efficiency issue, that’s where you rely on competition in the brokerage sector. Competition will drive the prices brokers charge customers down to the cost of serving them net of any payments they receive from wholesalers. In a highly competitive market for brokerage services, retail traders will capture the lion’s share of the value in their order flow.

So if you think retail customers are not reaping 100 pct of the benefits of PFOF (which begs the question of whether that’s the appropriate standard), then the focus should be on documenting some inadequacy of competition (which has NOT been done, and which Gensler does not even discuss); and if (and only if) that analysis does demonstrate that competition is inadequate, devising policies to enhance competition in the brokerage sector.

Only if (a) it is somehow efficient (or “fair”) for retail investors to reap 100 pct (or a large fraction) of PFOF revenues, (b) brokerage competition is inadequate to achieve objective (a), and (c) policies to enhance brokerage competition are inferior to banning or restricting PFOF is such a restriction/ban sufficient.

Does Gensler do any of that? Surely you jest. He says “unlevel playing field blah blah blah crack down on PFOF QED.” It is fundamentally unserious intellectual mush.

Gensler’s approach to equity market structure is disturbingly similar–and disturbingly similarly idiotic–to his approach to swap market structure in the Frankendodd days. As I (tediously after a while) wrote repeatedly while the CFTC was working on Swap Execution Facility regulations, Gensler favored a one-size-fits-all approach that failed to recognize that market structures develop to accommodate the disparate needs and preferences of heterogeneous traders. OTC and exchange markets served different clienteles and trading protocols and market structures were adapted to serving those clienteles efficiently. He did not analyze competition in any serious way at all. He did not address the Chesterton’s Fence question–why are things they way they are–before charging full speed to change them.

History is repeating itself with equity market structure. PFOF is an institution that has evolved in response to the characteristics of a particular class of market participants, (relatively) uninformed retail investors.

Crucially, it is an institution that has evolved in a competitive environment. There is value in retail order flows. There will be competition to capture that value. Considerable competition will ensure that retail investors will capture most of the value.

Gensler has proposed requiring routing all retail order flow through an auction mechanism where wholesalers will compete to offer the best price. The idea is that the auction prices will be inside the NMS spread, giving retail customers a better execution price.

But it’s a leap of faith to assert that this improvement in execution price will exceed the loss of PFOF that is passed back to investors through lower commissions. Will the auction be more competitive than the current market for retail order flow (including both the broker-wholesale and broker-customer segments)? Who knows? Gensler hasn’t even raised the issue–which demonstrates that he really doesn’t understand the real economic issues here. (Big shock, eh?)

And again, this means that the appropriate analysis is a comparative one focusing on competition under alternative institutional arrangements/market structures.

And insofar as competition is concerned, if auctions are such a great idea, why didn’t an exchange or an ECN or some other entity create one? Barriers to entry are low, especially in the modern electronic world.

I further note the following. One potential reason to eliminate or reduce PFOF that would actually be grounded in good economics is that segmentation of order flow exacerbates adverse selection problems on lit markets (exchanges) causing wider spreads there. However, the auction proposal would not mitigate that problem at all. The exacerbation of adverse selection is due to segmentation of order flow. The auction is just another way of segmenting order flow, and executing that order flow outside the lit exchange markets.

And here’s an irony. Assume arguendo that the auction does benefit retail investors–they capture more of the value inherent in their order flow. That would tend to lead to more order flow being directed to the auction market, and less to the lit markets. This would increase adverse selection costs in lit markets, exacerbating the inefficiencies of segmentation.

Nah. GiGi hasn’t thought that through either.

Talleyrand said of the Bourbons: they have learned nothing, and they have forgotten nothing. That’s Gary Gensler in a nutshell. He hasn’t learned any real economics, especially the economics of market structure and competition. But he hasn’t forgotten that he knows best, and he hasn’t forgotten the things that he knew that just aren’t true. That is a poisonous combination that damaged the derivatives markets when he was CFTC chair. But Gensler figures his work isn’t done. He has to damage the equity markets too based on his capricious understanding of how markets work–which is really no understanding at all.

FTAlphaville had a fascinating piece this week in which it described a discussion at a CFTC roundtable debating the FTX proposal that is generating so much tumult in DerivativesWorld. In a nutshell, Chris Edmonds of ICE revealed that due to a “technical issue” during the market chaos of March 2020 (which I wrote about in a Journal of Applied Corporate Finance piece) a large market participant was arguably in default to the ICE clearinghouse, but ICE (after consulting with the CEO, i.e., Jeff Sprecher) did not pull the trigger and call a default. Instead, it gave some time for the incipient defaulter to resolve the issue.

This raises an issue that I have written about for going on 15 years–the “tight coupling” of the clearing mechanism, and the acute destabilizing potential thereof. Tightly coupled systems are subject to”normal accidents” (also known as systemic collapses–shitshows): in a tightly coupled system, everything must operate in a tight sequence, and the failure of one piece of the system can cause the collapse of the entire system.

If ICE had acted in a mechanical fashion, and declared a default, the default of a large member could have caused the failure of ICE clearing, which would have had serious consequences for the entire financial system, especially in its COVID-induced febrile state. But ICE had people in the loop, which loosened the coupling and prevented a “normal accident” (i.e., the failure of ICE clearing and perhaps the financial system).

I have a sneaking suspicion that the exact same thing happened with LME during the nickel cluster almost exactly two years after the ICE situation. It is evident that LME uncoupled the entire system–by shutting down trading altogether, apparently suspending some margin calls, and even tearing up trades.

Put differently, it’s a good thing that important elements of the financial system have ways of loosening the coupling when by-the-book (or by-the algorithm) operation would lead to its destruction.

The ICE event was apparently a “technical issue.” Well that’s exactly the point–failures of technology can lead to the collapse of tightly coupled systems. And these failures are ubiquitous: remember the failures of FedWire on 19 October, 1987, which caused huge problems. (Well, you’re probably not old enough to remember. That’s why you need me.)

This issue came up during the FTX roundtable precisely because FTX (and its fanboyz) tout its algorithmic, no-man-in-the-loop operation as its innovation, and its virtue. But that gets it exactly backwards: it is its greatest vulnerability, and its greatest threat to the financial markets more generally. We should be thankful ICE had adults, not algos, in charge.

As I pointed out in my post on FTX in March:

The mechanical means of addressing margin shortfalls on a real time frequency increases the tight coupling on the exchange, and is tailor made to create destabilizing positive feedback loops: prices move a lot leading to margin shortfalls in real time that trigger real time trades that accentuate the price movement. It is like seeding the market with huge numbers of stop orders, which are inherently destabilizing. Further, they can create incentives to manipulate. Anyone who can get some idea of where the stops are can “gun the stops” and trigger big price moves.

It’s particularly remarkable that FTX still is the subject of widespread adulation in light of Terra’s spiraling into the terra firma. As I said in my Luna post, it is lunatic to algorithmize positive feedback (i.e., doom) loops. (You might guess I don’t have a Luna tattoo. Not getting an FTX tattoo either!*)

FTX’s Sam Bankman-Fried is backtracking somewhat:

In the face of the agricultural industry complaints, Bankman-Fried gave ground. While maintaining his position that automated liquidations could prevent bad situations from growing worse, he said the FTX approach was better suited to “digitally settled” contracts — such as those for crypto — than to trades where physical collateral such as wheat or corn is used

Sorry, Sam, but digital settlement vs. physical settlement matters fuck all. (And “physical collateral”? Wut?) And you are deluded if you believe that “automated liquidations” generally prevent bad situations from growing worse. If you think that, you don’t get it, and are a positive threat to the financial markets.

*FTX bought the naming rights for a stadium in Miami. I say only slightly in jest that this is another indication of the dangers posed by FTX and its messianic founder. FFS, you’d think after the 2000 tech meltdown people would recognize that buying naming rights is often a great short selling signal, and a harbinger of future collapse. To say that those who forget the past are condemned to repeat it is too strong, but those who follow in the footsteps of failures that took place before their time betray an an arrogance (or an ignorance) that greatly raises the odds of repeating failure.

The tumult in the commodity markets has led to suggestions that major commodity trading firms, e.g., Glencore, Trafigura, Gunvor, Cargill, may be “Too Big to Fail.”

I addressed this specific issue in two of my Trafigura white papers, and in particular in this one. The title (“Not Too Big to Fail”) pretty much gives away the answer. I see no reason to change that opinion in light of current events.

First, it is important to distinguish between “can fail” and “too big to fail.” There is no doubt that commodity trading firms can fail, and have failed in the past. That does not mean that they are too big to fail, in the sense that the the failure of one would or could trigger a broader disruption in the financial markets and banking system, a la Lehman Brothers in September 2018.

As I noted in the white paper, even the big commodity trading firms are not that big, as compared to major financial institutions. For example, Trafigura’s total assets are around $90 billion at present, in comparison to Lehman’s ~$640 billion in 2008. (Markets today are substantially larger than 14 years ago as well.). If you compare asset values, even the biggest commodity traders rank around banks you’ve never heard of.

Trafigura is heavily indebted (with equity of around $10 billion), but most of this is short term debt that is collateralized by relatively liquid short term assets such as inventory and trade receivables: this is the case with many other traders as well. Further, much of the debt (e.g., the credit facilities) are syndicated with broad participation, meaning that no single financial institution would be compromised by a commodity trader default. Moreover, trading firm balance sheets are different than banks’, as they do not engage in the maturity or liquidity transformation that makes banks’ balance sheets fragile (and which therefore pose run risk).

Commodity traders are indeed facing funding risks, which is one of the risks that I highlighted in the white paper:

The extraordinary price movements across the entire commodity space have resulted in a large spike in funding needs, both to meet margin calls (which at least in oil should have been reversed with the price decline in recent days–nickel remains to be seen given the fakakta price limits the LME imposed) and higher initial and maintenance margins (which exchanges have hiked–in a totally predictable procyclical fashion). As a result existing lines are exhausted, and firms are either scrambling to raise additional cash, cutting positions, or both. As an example of the former, Trafigura has supposedly held talks with Blackstone and other private equity firms to raise $3 billion in capital. As an example of the latter, open interest in oil futures (WTI and Brent) has dropped off as prices spiked.

To the extent margin calls were on hedging positions, there would have been non-cash gains to offset the losses on futures and other derivatives that gave rise to the margin calls. This provides additional collateral value that can support additional loans, though no doubt banks’ and other lenders terms will be more onerous now, given the volatility of the value of that collateral. All in all, these conditions will almost certainly result in a scaling back in trading firms’ activities and a widening of gross margins (i.e., the spread between traders’ sale and purchase prices). But the margin calls per se should not be a threat to the solvency of the traders.

What could threaten solvency? Basis risk for one. For examples, firms that had bought (and have yet to sell) Russian oil or refined products or had contracts to buy Russian oil/refined products at pre-established differentials, and had hedged those deals with Brent or WTI have suffered a loss on the blowout in the basis (spread) on Russian oil. Firms are also likely to handle substantially lower volumes of Russian oil, which of course hits profitability.

Another is asset exposure in Russia. Gunvor, for example, sold of most of its interest in the Ust Luga terminal, but retains a 26 percent stake. Trafigura took a 10 percent stake in the Rosneft-run Vostok oil project, paying €7 billion: Trafigura equity in the stake represented about 20 percent of the total. A Vitol-led consortium had bought a 5 percent stake. Trafigura is involved in a refinery JV in India with Rosneft. (It announced its intention to exist the deal last autumn, but I haven’t seen confirmation that it has.). If it still holds the stake, I doubt it will find a lot of firms willing to step up and pay to participate in a JV with Rosneft.

It is these types of asset exposures that likely explain the selloff in Trafigura and Gunvor debt (with the Gunvor fall being particularly pronounced.). Losses on Russian assets are a totally different animal than timing mismatches between cash flows on hedging instruments and the goods being hedged caused by big price moves.

But even crystalization of these solvency risks would likely not lead to a broader fallout in the financial system. It would suck for the owners of a failed company (e.g., Torben Tornqvuist, who owns ~85 percent of Gunvor) but that’s the downside of the private ownership structure (something also discussed in the white papers); Ferrarri and Bulgari sales would fall in Geneva; banks would take a hit, but the losses would be fairly widely distributed. But in the end, the companies would be restructured, and during the restructuring process the firms would continue to operate (although at a lower scale), some of their business would move to the survivors (it’s an ill wind that blows no one any good), and commodities would continue to move. Gross margins would widen in the industry, but this would not make a huge difference either upstream or downstream.

I should also note that the Lehman episode is likely not an example of a domino effect in the sense that losses on exposures to Lehman put other banks into insolvency which harmed their creditors, etc. Instead, it was more likely an informational cascade in which its failure sent a negative signal about (a) the value of assets held widely by other banks, and (b) what central banks could or would do to support a failing financial institution. I don’t think those forces are at work in commodities at prsent.

The European Federation of Energy Traders has called upon European state bodies like European Investment Bank or the ECB to provide additional liquidity to the market. There is a case to be made here. Even though funding disruptions, or even the failure of commodity trading firms, are unlikely to create true systemic risks, they may impede the flow of commodities. Acting under the Bagehot principle, loans against good collateral at a penalty rate, is reasonable here.

The reason for concern about the commodity shock is not that it will destabilize commodity trading firms, and that this will spill over to the broader financial system. Instead, it is that the price shock–particularly in energy–will result in a large, worldwide recession that could have financial stability implications. Relatedly, the food price shocks in particular will likely result in massive civil disturbances in low income countries. A reprise of the Arab Spring is a serious possibility.

If you worry about the systemic effects of a commodity price shock, those are the things you should worry about. Not whether say Gunvor goes bust.