Streetwise Professor

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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April 30, 2020

WTI-WTF? Part 3: Did CLK20 Get TAS-ed?

Matt Levine wrote a typically amusing piece highlighting the role of Trade at Settle (TAS) contracts in the 4/20/20 oil futures debacle:

But actually a lot of oil changed hands at those negative prices. Not because a bunch of investors came to the market all at once looking to sell, and no one would buy from them at negative prices, but for a more technical reason. Some oil traders use “trade-at-settlement” contracts: Instead of buying (or selling) oil futures at the market price at the time of your trade, you agree in advance to buy (or sell) them at whatever the official 2:30 p.m. settlement price is that day. 1  This is a good trade, for you, if your job is to obtain the day’s settlement price: For instance, if you run an index fund or exchange-traded fund that is benchmarked to that price, using TAS futures guarantees you the benchmark price. If you invest in oil futures and your boss fires you if you miss the benchmark, you might use TAS futures, that sort of thing. If you are a savvy oil trader attuned to minute-by-minute changes in supply and demand and trying to capture as much value as possible from your skills, you’ll probably just trade the futures at their current prices, selling if the price is too high and buying if it’s too low. But a lot of oil traders are doing something else, something a bit more passive, and for them the ability to guarantee the settlement price is useful.

He goes on to ponder whether the TAS mechanism could be manipulated, and whether manipulation could have contributed to the settlement fire that Red Adair couldn’t have put out:

The basic pattern—agree in advance to buy (sell) stuff at the official settlement price at some fixed future time, and then sell (buy) a bunch of that stuff in the minutes leading up to the official settlement time with the effect of pushing down (up) the price at which you are buying (selling)—is incredibly common, and the gradation from “sensibly pre-hedging the exposure you will get at settlement” to “sloppily pre-hedging the exposure you will get at settlement” to “manipulating the market to push down the price you will get at settlement” is blurry. If you type in a chat room “lol I’m gonna pound out 500 contracts to push down the settlement price and make fortune on my TAS trades, I am really ripping those muppets’ faces off, hope I don’t go to prison bro, hashtag fraud hashtag crime hashtag manipulation,” you will get in trouble. But if you don’t type that, and you quietly sell the 500 contracts and the price goes down, then as far as anyone knows that was just pre-hedging.

So could somebody have popped CLK20 with a TASer last Monday?

Funny you should ask. I wrote a paper on TAS manipulation a while ago. My interest was sparked by the CFTC’s action against Dutch trading firm Optiver, which the agency accused of doing exactly the kind of thing Levine writes about in crude, gasoline, and heating oil futures back in March, 2008. You can read the complaint–and listen to some actual “ripping those muppets’ faces off” trader braggadocio.

How does manipulation work here? First, to make manipulation profitable, there has to be an asymmetric price response to purchases and sales. If the manipulator’s purchases impact prices the same as sales, just buying and selling a lot can’t move prices in a profitable direction. Indeed, the manipulator would have to pay transactions costs (crossing the spread, brokerage, etc.) and this would cause the trading to be unprofitable.

The model in the paper derives conditions under which purchases and sales of TAS have a smaller impact on prices than do trades in the underlying futures. The basic idea is that if information is short-lived, or if there is intense competition among informed traders, new information will be incorporated into prices very quickly. Under those circumstances, informed traders will not want to trade TAS: their information will already be incorporated into the price by the time settlement occurs. Thus, TAS is a mechanism that allows traders to signal that they are uninformed: many “muppets” choose to trade TAS, and the informed don’t. Thus, the price impact of TAS trades is smaller than the price impact of regular outright trades: trades move prices because of the possibility that they are motivated by private information, so trades that are unlikely to be privately informed move prices less than trades that are more likely to be so.

This creates the asymmetry that makes manipulation possible: the manipulator buys, say, the TAS and then sells in quantity immediately before and during the settlement period and profits as Levine describes.

This type of manipulation is particularly pernicious because manipulative trades have persistent price impacts because they cannot be distinguished from informed trades (or liquidity trades, for that matter). Note that in Optiver, prices did not reverse after the firm’s trades,

This strategy is likely to be particularly profitable when markets are relatively illiquid, as in an illiquid market outright trades have bigger price impacts. Liquidity (measured by the bid-ask spread, quantity at the top of the book, price impact coefficients, etc.) has plummeted for everything since the CovidCrisis began, and the decline in CL liquidity has been particularly pronounced. Moreover, contracts close to expiration are less liquid anyways. Add to this the extreme physical constraints (which mean that small shocks to fundamentals have big price impacts) and the raging uncertainty about the logistical situation at Cushing, and it is likely that small volumes at the settle could have big impacts on prices.

To this I would add that an unexpected shortfall in buy orders (due to shorts exercising market power) at the settle could have price impacts, and exacerbate the price impacts of sell orders by exacerbating order imbalances.

Thus, the potential for a big asymmetry in price impact was pronounced on that fatal Monday.

In sum, it is not implausible that the market did indeed get TASed. Or at the very least, a TASer jolt contributed to the collapse. (Sort of like in this video!)

A final remark on the economic benefits and costs of TAS trading. TAS is a form of “cream skimming”–i.e., the skimming off of uninformed order flow. This tends to make the order flow in the regular continuous market more toxic, which reduces liquidity in that market. For this reason, other cream skimming mechanisms used primarily in equity markets (payment for order flow, dark pools, block trades) are frequently criticized. (This is why some regulators, particular in Europe, have attempted to curb such activity and force more trading into “lit” venues.)

I showed in my Market Macrostructure paper that things aren’t so simple. If the regular market isn’t perfectly competitive, the increased competition from a cream skimming mechanism can improve welfare. Moreover, there are distributive effects here: the uninformed traders who can utilize the TAS mechanism (e.g., those who are hedging exposures tied to the settlement price) benefit, while uninformed traders who can’t lose. Informed traders can lose too. Moreover–and this is a point that is almost always overlooked–some informed trading is essentially rent seeking (e.g., trading on information that will be released shortly anyways, and accelerating its incorporation into prices has little effects on resource allocation decisions). Reducing rent seeking informed trading is a good thing.

All in all, the role of the TASer is yet another piece of the 4/20/20 WTI WTF puzzle. The forensic analysis of this entire episode will be fascinating.

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April 20, 2020

WTI–WTF?

Today was one of the most epochal days in the history of oil trading, which is saying something. The front month May contract–which expires tomorrow (21 April, 2020)–(a) settled at a negative price of -$37.63, (b) declined $55.90 from the previous day’s settlement, and (c) exhibited a trading range of $58.17, which is about 3.5x Friday’s settlement price.

Even these eye-popping numbers don’t tell the full story. The last traded price was -$13.10. Note that the settlement price is based on the volume weighted average price during the last two minutes of trading, so an average price of $-37.63 in the last two minutes and a last traded price of -$13.10 means prices moved more that $25/bbl in these minutes.

And we’re not done yet! As I write at 1841 CDT, the price is up to -$5.00–an increase of $32.63.

That there’s what they call volatility, folks.

To put these numbers in perspective, the largest trading range on the any day of the last three trading days of CL contracts from 2000-2019 is $26.65, a day around the time of the financial crisis and the aftermath of Hurricane Ike (October 2008 contract): here’s what I wrote about that event. The median intra-day range on the last three days is $1.6, the mean is $1.5, and the standard deviation is $1.47. So we are around a 40 standard deviation event here.

The largest daily price change during the last 3 trading days is $16.37, with a median of $.73 and a standard deviation of $1.45.

The calendar spread is also extreme, settling at $58.06 between the June and the May. Meaning that if you had storage, you could get paid to take delivery, sell it forward, and lock in that $58.06 (net of what the storage costs you). I guess you could call that the megacontango.

All in all, a historically unprecedented day.

The proximate cause of these wild gyrations, and unprecedented negative prices is, of course, the collapse of demand and the looming exhaustion of storage space, including at the delivery point of Cushing, OK. But although this is a necessary condition for today’s events, it is not a full explanation.

The storage issue has been known for weeks, and discussed intensely. It had been priced in to a considerable degree: contango was already at a historically high level. What information about the availability of storage arrived between Friday and today? Unlikely to be anything that could cause such chaotic price movements.

The likely cause is the difficulty of liquidating about 100,000 open contracts (100 million barrels!) in such extreme technical conditions. It is plausible, and indeed likely, that strategic behavior–perhaps rising to the level of manipulation–is the major cause of how prices moved today against the background of conditions that were widely known on Friday.

Let me start out by noting that something similar, though not as extreme, occurred during the demand collapse and associated flooding of storage during the Financial Crisis. As I documented here, the expiries of the January, February, and March 2009 WTI contracts saw what were then historically unprecedented price collapses. So did other US grades of oil. Here’s a picture from the linked document:

The big downward spikes in the front month-back month spreads correspond with the days around expiry.

How does strategic behavior/market power/manipulation play into this? The model of short manipulation in my 1996 book (only $169 paperback–buy two!) and 1993 J. of Business article formalizes the argument, but the intuition is fairly straightforward. Manipulation exploits frictions and bottlenecks. (My article/book refer to “frictional manipulations.”). There is now a huge friction/bottleneck in Cushing–constrained storage. This bottleneck makes the demand curve for crude at Cushing extremely inelastic, and means that the movement of even small excess quantities of oil into that location will cause prices to decline dramatically.

In these conditions, a trader, or a group of traders with modest-sized short positions can exercise market power by delivering even a small amount of oil over and above the quantity that should flow to Cushing. This drives down the price and allows the trader or traders to cover his (their) position(s) at artificially low prices.

In this situation, the storage bottleneck is the gasoline, the exercise of the market power is the match. With 100,000,000 barrels of open long positions needing to liquidate, given the storage constraint, the resulting conflagration can be epic.

This is, at this stage, a hypothesis. It is a possible explanation of the beyond extreme movements observed today. Under the circumstances, it is a very plausible explanation, and one that deserves scrutiny. And given the amount of money that changed hands today (~$6 billion on a mark-to-market basis) I’m sure that it will get it.

The only parallel I can think of is the onion market in 1955, when the movement of a couple of superfluous carloads of onions into Chicago, and delivery thereof against futures, caused the price to crash below the cost of the bags that they had to be delivered in. There was no demand for the onions (being perishable, and people eat only so many hot dogs), so many of the excess plants ended up getting dumped into the Chicago River. (Which, in 1955, probably improved the water quality.) (Another irony being that Chicago means “stinky onions” in the Miami-Illinois Indian language.)

In 1955, demand was inelastic because onions are perishable (i.e., they can’t be stored). In a way, the lack of storage space makes oil perishable. Even if that analogy isn’t perfect, the economics are the same: an economic constraint (the non-storability of, or the lack of storage space) leads to extremely inelastic demand that makes short market power manipulation possible.

Tomorrow is the last trading day for CLK20. Strap it up! It’s going to be a wild ride.

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March 24, 2020

It Really Does Pain Me to Say I Told You So About Clearing, But . . .

In the aftermath of the last crisis, I played the role of Clearing Cassandra, warning that in the next crisis, supersizing of derivatives clearing would create systemic risks not because clearinghouses would fail, but because of the consequences of what they would do to survive: hike initial margins and collect huge variation margin payments that would suck liquidity out of the system at the same time liquidity supply contracted. This, in turn, would lead to asset fire sales, that would distort asset prices which would lead to further knock-on effects.

I wrote a lot about this 2008-2012, but here is a convenient link. Key quote from the abstract:

The author also believes that the larger collateral mandates and frequent marking‐to‐market will make the financial system more vulnerable since margin requirements tend to be “pro‐cyclical.” And more rigid collateralization mechanisms can restrict the supply of funding liquidity, and lead to spikes in funding liquidity demand that can reduce the liquidity of traded instruments and generate destabilizing feedback loops. 

Well, the next crisis is here, and these (conditional) predictions are being borne out. In spades.

Here’s what I wrote a few days ago as a contribution to the Regulatory Fundamentals Group newsletter:

In the aftermath of the last crisis of 2008-2009, G20 nations decided to mandate clearing of standardized OTC derivatives transactions.  The current coronavirus crisis is the first since those reforms were implemented (via Dodd-Frank in the US, for example), and this therefore gives the first opportunity to evaluate the performance of the supersized clearing ecosystem in “wartime” conditions.  


So far, despite the extreme price movements across the entire derivatives universe–equities, fixed income, currencies, and commodities (especially oil)–there have been no indications that clearinghouses have faced either financial or operational disruption.  No clearing members have defaulted, and as of now, there have been no serious concerns than any are on the verge of default. 

That said, there are two major reasons for concern.


First, the unprecedented volatility and uncertainty show no signs of dissipating, and as long as it continues, major financial institutions–including clearing firms–are at risk.  The present crisis did not originate in the banking/shadow banking sector (as the previous one did), but it is now demonstrably affecting it.  There are strong indicators of stress in the financial system, such as the blowouts in FRA-OIS spreads and dollar swap rates (both harbingers of the last crisis).  Central banks have intervened aggressively, but these worrying signs have eased only slightly.  

Second, as I wrote repeatedly during the debate over clearing mandates in the post-2008 crisis period, the most insidious systemic risk that supersized clearing creates is not the potential for the failure of a clearinghouse (triggered by the failure of one or more clearing members).  Instead, the biggest clearing-related systemic risk is that the very measures that clearinghouses take to ensure their integrity–specifically, frequent variation margining/marking-to-market–lead to large increases in the demand for liquidity precisely during circumstances when liquidity is evaporating.  Margin payments during the past several weeks have hit unprecedented–and indeed, previously unimaginable–levels.  The need to fund these payments has inevitably increased the demand for liquidity, and contributed to the extraordinary demand for liquidity and the concomitant indicators stressed liquidity conditions (e.g., the spreads and extraordinary central bank actions mentioned earlier).  It is impossible to quantify this impact at present, but it is plausibly large.  

In sum, the post-2008 Crisis clearing system is operating as designed during the 2020 Crisis, but it is unclear whether that is a feature, or a bug.  

It is becoming more clear: Bug, and the bugs are breeding. There have been multiple stories over the last couple of days of margin calls on hedging positions causing fire sales, with attendant price dislocations in markets like for mortgages. Like here, here, and here. I guarantee there are more than have been reported, and there will be still more. Indeed, I bet if you look at any pricing anomaly, it has been created by, or exacerbated by, margin calls. (Look at the muni market, for instance.)

But those in charge still don’t get it. CFTC chairman Heath Tarbert delivers happy talk in the WSJ, claiming that everything is hunky dory because all them margins bein’ paid! and as a result, derivatives markets are functioning, CCPs aren’t failing, etc.

This is exactly the kind of non-systemic thinking about systemic risk that I railed about a decade ago. Mr. Tarbert has a siloed view: he is assigned some authority over a subset of the financial system, sees that it is working fine, and concludes that rules regarding that subset are beneficial for the system as a whole.

Wrong. Wrong. Wrong. Wrong. WRONG.

You have to look at the system as a whole, and how the pieces of the system interact.

In the post-last-crisis period I wrote about the “Levee Effect”, namely, that measures designed to protect one part of the financial system would flood others, with ambiguous (at best) systemic consequences. The cascading margins and the effects of those margin calls are exactly what I warned about (to the accompaniment a collective shrug by those who mattered, which is why we are where we are).

What we are seeing is unintended consequences–unintended, but not unforeseeable.

Speaking of unintended consequences, perhaps one good effect of September’s repo market seizure was that it awoke the Fed to its actual job–providing liquidity in times of stress. The facilities put in place in the aftermath of the September SNAFU are being expanded–by orders of magnitude–to deal with the current spike in liquidity demand (including the part of the spike due to margin issues). Thank God the Fed didn’t have to think this up on the fly.

It also appears that either (a) the restrictions on the Fed imposed by Frankendodd are not operative now, or (b) the Fed is saying IDGAF so sue me and blowing through them. Either way, such liquidity seizure are what the Fed was created to address.

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November 27, 2019

Back to the Future: Exchanges That Price Other Things Don’t Price Their Own Things Right

Filed under: Derivatives,Economics,Exchanges — cpirrong @ 7:54 pm

The first post I wrote almost 14 years ago was about an electronic trading system (in Japan) being overwhelmed by a avalanche of orders. The main conclusions I drew were: (a) since communications capacity is costly, it is uneconomic to build so much capacity as to make such outages impossible, and (b) pricing of capacity is the best way to ensure that it is utilized efficiently.

What is old is new again. A few weeks ago the CME was strained by a deluge of message traffic in the Eurodollar futures market. The surge was in part the result of something only dimly–if that–grasped 14 years ago: algorithmic trading. More specifically, algorithmic trading combined with the order matching and confirmation protocols of the CME and Eurodollar markets. Eurodollar futures utilize a pro rata secondary priority rule in the absence of a “TOP” order, i.e., an order that improves the best bid or offer. Moreover, the biggest order at the inside market gets informed of executions slightly before smaller orders. This advantage (on the order of 10-20 millionths of a second) provides a valuable edge.

This institutional setup provided incentives for two algorithmic traders to attempt to get a slight edge in quote size. Thus, each would send a message to increase its size when the other had the edge, which induced the prior leader to send a message to increase its size to regain the lead, which induced the other to send a message to send a message to regain the lead . . . which continued until the maximum quote size was reached. This race for priority in the book led to a surge in message traffic which put stress on the CME system.

Matt Levine wondered why the two algos didn’t just keep their orders at the maximum size. My surmise is risk: the larger size you show, the greater the risk. Furthermore, if someone else improved the price and became the TOP order, size didn’t confer an edge, so it makes sense to cut size.

The CME has responded by announcing fines of $10,000, with the threat of cutting off a violator’s trading connection altogether, for violations of a message traffic threshold. This is a rough form of pricing, so why call it a fine? Why not just call it a non-linear message pricing schedule?

I guarantee that a variant on this story will recur. Because capacity is costly, exchanges don’t price it, and rules adopted for other reasons (e.g., priority rules intended to promote quoting in size) provide an incentive to use this unpriced resource.

As I argued years ago, it’s odd that institutions–exchanges–that specialize in providing the platform to allow the pricing of scarce resources don’t find a better way to price their own scarce platform resources.

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September 20, 2019

The Simple (and Very Old) Economics of the Stock Market Data Pricing Controversy

Filed under: Economics,Exchanges,Regulation — cpirrong @ 4:20 pm

The most contentious battle in American securities markets right now is being waged over exchange pricing of data, in particular over proprietary order book feeds. The battle pits the exchanges against market users (e.g., HFT firms, institutional traders) with the latter claiming that the prices charged by the former border on the extortionate.

The critics actually have a very good point. The economics of the situation imply that the prices the competing exchanges charge are ABOVE the price a monopoly would charge.

No. Really.

So how could competing firms charge a supra-monopoly, let alone supra-competitive, price? The answer to this question is something pointed out by the first true mathematical economist, Augustin Cournot, in his Principes Mathematique, published in 1838. In that book, Cournot laid out “the problem of complements.” Cournot showed that imperfectly competitive firms overprice complementary goods. (Cournot’s example involved zinc and copper in the production of brass. They are complements used in fixed proportion.)

The basic issue is that when goods are complements, if firm A raises its price firm B that produces a complement to A’s good cannot steal sales from A by cutting its price (as would be the case of A’s and B’s goods were substitutes). This reduces the incentive to cut price, and actually provides an incentive to increase prices in order to get a bigger piece of the surplus that is generated when the consumer buys both goods.

This situation fits the stock market case perfectly. Execution services on US exchanges (e.g., NYSE, BATS) are substitutes, but data services are complements.

Consider an HFT firm. One source of profits for this firm is to exploit price discrepancies across exchanges. This requires having near immediate and simultaneous access to prices across all exchanges. Or consider a buyside firm that is trying to minimize execution costs by a clever order routing strategy. Optimizing the allocation of orders across exchanges requires knowing the order book on all the exchanges.

In other words, there are many market participants who have to collect the entire set (of exchange data). This makes the data provided by competing exchanges complements, which by the Cournot logic, forces prices above the competitive level, and indeed, above the monopoly level.

Furthermore, the problem becomes worse, the larger number of exchanges. This is a situation in which lower concentration leads to less competitive outcomes. (Robin Hansen made a similar point recently.)

This is yet another example of the only law that is never repealed: the law of unintended consequences. The intent of RegNMS was to increase competition in the execution of stock trades, and it has done a marvelous job of that. However, the unintended effect of this “fragmentation” (i.e., the increase in the number of execution venues and decline in concentration across exchanges) has been to create and exacerbate a complements problem in data.

A couple of final points. Perhaps one could make a second-best argument here: low execution fees and high data fees may be a good way of covering the fixed costs of operating exchanges (a la Ramsey pricing). Perhaps, but unproven.

What is the right regulatory response? Not clear. I addressed similar conundrums in my 2002 Market Macrostructure article. Natural monopoly-style/pricing regulation could mitigate the overpricing problem, but entails its own costs (e.g., undermining incentives to innovate). The issue is particularly challenging here because efficiency-enhancing competition on one dimension (execution) leads to inefficient problems-of-complements competition on another (data).

As I argued in Market Macrostructure, it really comes down to an issue of property rights. Should exchanges have exclusive ownership of their data? Should this ownership be attenuated in some way, such as limitation on prices, or a required pooling of data that would be sold by a monopolist, with revenues shared by the exchanges? Here is a case where a monopoly would actually improve outcomes.

Maybe that is the way to split the baby, politically. Exchanges would get rents, but efficiency would be improved. Not a first-best solution, but maybe a second best one, and one that could represent a Coasean bargain between exchanges and their customers. And perhaps the regulator–the SEC–could help facilitate and coordinate that deal.

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September 17, 2019

Funding Market Tremors: Today May Not Have Been “The Big One,” But It Was Bad Enough

The primary reason for my deep skepticism about the wisdom of clearing mandates was liquidity risk. As I said repeatedly, in order to reduce counterparty risk, clearing necessarily increased liquidity risk through the variation margining mechanism. Further, it was–and is–my opinion that liquidity risk is a far graver systemic concern that counterparty risk.

A major liquidity event has occurred in the last couple of days: rates in the repurchase market–the major source of short term funding for vast amounts of trading activity–shot up to levels (around 5 percent) nearly double the Fed’s target ceiling for that rate. Some trades took place at far higher rates than that (e.g., 9.25 percent).

Market participants have advanced several explanations, including big cash demands due to corporate tax payments coming due. Izabella Kaminska at FTAlphavile offered this provocative alternative, which resonates with my clearing story: the large price movements in oil and fixed income markets in the aftermath of the attack on the Saudi resulted in large margin calls in futures and cleared OTC markets that increased stresses on the funding markets.

To which one might say: I sure as hell hope that’s not it, because although there was a lot of price action yesterday, it wasn’t The Big One. (The fact that Fred Sanford’s palpitations occurred because he couldn’t get his hands on cash makes that bit particularly apropos!)

I did some quick back-of-the-envelope calculations. WTI and Brent variation margin flows (futures and options) were on the order of $35 billion. Treasuries on CME maybe $10 billion. S&P futures, about $1 billion. About $2 billion on Eurodollar futures.

The Eurodollar numbers can help give a rough idea of margin flows on cleared interest rate swaps. Eurodollar futures open interest is about $12 trillion. Cleared OTC notional volume (not just USD, but all IRS) is around $80 trillion. But $1mm in notional of a 5 year swap is equivalent to 20 Eurodollar futures with notional amount of $20 trillion. So, as a rough estimate, variation margin flows in the cleared IRS market are on the order of 100x for Eurodollars. That represents a non-trivial $200 billion.

Yes, there are potentials for offsets, so these numbers are not additive. For example, a firm might have offsetting positions in EDF and cleared IRS. Or be short oil and long Treasuries. But variation margin flows on the order of $300 billion are not unrealistic. And since market moves were relatively large yesterday, that represents an increment over the typical day.

So we are talking real money, which could certainly contribute to an increased demand for liquidity. But again, yesterday was not remotely a truly epic day that one could readily imagine happening.

A couple of points deserve emphasis. The first is that perhaps it was coincidence or bad luck, but the big variation margin flows coincided with other sources of increased demand for liquidity. But hey, stuff happens, and sometimes stuff happens all at once. The system has to be able to withstand such simultaneous stuff.

The second is related, and very concerning. The spikes in rates observed periodically in the repo market (not just here, but notoriously in China) suggest that this market can go non-linear. Thus, even if the increased funding needs caused by the post Abqaiq fallout wasn’t The Big One, in a non-linear market, even modest increases in funding needs can have huge impacts on funding costs.

This highlights another concern: inter-market feedback. A shock in one market (e.g., crude) puts stress on the funding market that leads to spikes in repo rates. But these spikes can feedback into prices in other markets. For example, if the inability to fund positions causes fire sales that cause big price moves that cause big variation margin flows which put further stress on the funding markets.

Yeah. This is what I was talking about.

Today’s events nicely illustrate another concern I raised years ago. Clearing/margining make markets more tightly coupled: the need to meet margin calls within hours increases the potential stress on the funding markets. As I tell my classes, unlike in the pre-Frankendodd days, there is no “fuck you” option when your counterparty calls for margin. You don’t pay, you are in default.

This tight coupling makes the market more vulnerable to operational failings. On Black Monday, 1987, for example, the FedWire went down a couple of times and this contributed to the chaos and the potential for catastrophic failure.

And guess what? There was a (Fed-related!) operational problem today. The NY Fed announced that it would hold a repo operation to supply $75 billion of liquidity . . . then had to cancel it due to “technical difficulties.”

I hate it when that happens! But that’s exactly the point: It happens. And the corollary is: when it happens, it happens at the worst time.

The WSJ article also contains other sobering information. Specifically, post-crisis regulatory “reforms” have made the funding markets more rigid/less-flexible and supple. This would tend to exacerbate non-linearities in the market.

We’re from the government and we’re here to help you! The law of unintended (but predictable) consequences strikes again.

Hopefully things will normalize quickly. But the events of the last two days should be a serious wake-up call. The funding markets going non-linear is the biggest systemic risk. By far. And to the extent that regulatory changes–such as mandated clearing–have increased the potential for demand surges in those markets, and have reduced the ability of those markets to respond to those surges, in their attempt to reduce systemic risks, they have increased them.

I have often been asked what would cause the next financial crisis. My answer has always been: the regulations intended to prevent a recurrence of the last one. Today may be a case in point.

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