Streetwise Professor

July 16, 2018

Oil Spreads Go Non-Linear (Due to Infrastructure Constraints), To the Chagrin of Many Traders: The Pirrong Commodity Catechism in Action

Filed under: Commodities,Economics,Energy,Exchanges — cpirrong @ 3:59 pm

When I wrote about the demise of GEM Trading a few weeks ago, I hypothesized that sharp movements in various spreads had been its undoing.  A story in Reuters says that GEM was not the only firm rocked by these changes.  Big boys–including BP, Vitol, Trafigura, and Gunvor–have also suffered, and the losses have caused traders their jobs at Gunvor and BP:

The world’s biggest oil traders are counting hefty losses after a surprise doubling in the price discount of U.S. light crude to benchmark Brent WTCLc1-LCOc1 in just a month, as surging U.S production upends the market.

Trading desks of oil major BP and merchants Vitol , Gunvor and Trafigura have recorded losses in the tens of millions of dollars each as a result of the “whipsaw” move when the spread reached more than $11.50 a barrel in June, insiders familiar with their performance told Reuters.

The sources did not give precise figures for the losses, but they said they were enough for Gunvor and BP to fire at least one trader each.

The story goes on to say that binding infrastructure constraints are to blame, which is certainly the case.  But implicit in the article is a theme that I have emphasized for literally years (I recall incorporating this into my class lectures in about 2004).  Specifically, bottlenecks imply that marginal transformation costs (e.g., marginal costs of transporting oil between Cushing and the GOM) tend to rise very steeply when capacity constraints are reached.  That is, when you are operating at say 90 percent of capacity, variations in utilization have little impact on marginal transformation costs, but going from 95 to 96 can cause costs to explode, and basically go vertical as capacity is reached.

This has an implication for spreads.  Another part of the Pirrong Commodities Catechism is that spreads equal marginal transformation costs, and are essentially the shadow prices on constraints.  The behavior of marginal transformation costs therefore has implications for spreads: in particular, spreads can be very stable despite variations in the utilization of transformation assets, but as utilization nears capacity, the spreads become much more volatile.  Moreover, and relatedly, small changes in fundamentals can lead to big moves in spreads when constraints start to bind.  The relationship between fundamentals and spreads is non-linear as capacity constraints become binding, and well, here spreads have gone non-linear, to the chagrin of many traders.

Put differently, spread trades aren’t always “widowmakers” (as the article calls them)–sometimes they are quite safe and boring.  But when bottlenecks begin to bind, they can become deadly.

There is one odd statement in the article:

“As the exporter of U.S. crude, traders are naturally long WTI and hedge their bets by shorting Brent. When the spreads widen so wildly, you lose money,” said a top executive with one of the four trading firms.

Well, why would you hedge WTI risk with Brent?  You could hedge your WTI inventory by selling . . . WTI futures.  The choice to “hedge” WTI by selling Brent is effectively a choice to speculate on the spread.  That brings to mind the old Holbrook Working adage that hedging is speculation on the basis.  The difference here is that most, say, country grain elevators about which Working was mainly writing had no choice in hedging instrument (at least not in liquid ones), and perforce had to live with basis risk if they wanted to eliminate flat price risk.  Here, BP and Gunvor and the rest had the choice between two liquid instruments, and if the “top executive’s” statement is correct, deliberately chose the one that exposed them to greater spread (basis) risk.

So this isn’t an example of “sometimes stuff happens when you hedge.”  The firms chose to expose themselves to a particular risk.  They took a punt on the spread, which was effectively a punt that infrastructure constraints would ease.  They lost.

In my 2014 white paper on commodity trading firms (sponsored by Trafigura, ironically) I noted that to the extent that they speculate, commodity trading firms tend to speculate on the spreads, rather than flat prices, because that’s where they have something of an information advantage.  But as this episode shows, that advantage does not immunize them against risk.

This also makes me wonder about the risk models that the firms use, which in turn affect the sizes of positions traders can put on, and where they put them on.  I, er, speculate that these risk models don’t take into account the non-linearity of spread risk.  If that’s true, traders would have been able to put on bigger positions than they would have been had the risk models accurately reflected those risks, and further, that they were incentivized to do these trades because the risk was underpriced.

All in all, an interesting casebook study of commodity trading–what can go wrong, and why.

Correction: Andrew Gowers, head of corporate affairs at Trafigura says in the comments that (a) Trafigura did not suffer a loss, and (b) the company had told this to Reuters prior to the publication of the article.  I have contacted the editor of the story for an explanation.

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July 13, 2018

Blockchain Wunderkinds: Solving Peripheral Problems, Missing the Big Picture

Filed under: Blockchain,Cryptocurrency,Economics,Exchanges — cpirrong @ 7:52 pm

Ethereum wunderkind Vitalik Buterin delivered a rant against centralized crypto exchanges:

“I definitely personally hope centralized exchanges burn in hell as much as possible,” Buterin said speaking to TechCrunch.

When bitcoin, the original cryptocurrency, was founded in 2008 by the anonymous Satoshi Nakomoto, the point was to create a decentralized financial future that renders middlemen useless. Nearly 10 years later, the centralized exchanges — those folks sitting in the middle of buyers and sellers — are among the most powerful players in the market for digital currencies such as ethereum and bitcoin.

Bloomberg News estimates they brought in $3 million a day last year. And exchanges such as Gemini and Coinbase are expanding at a clip, bringing on talent from Wall Street.

“It’s hard to ignore the irony that an asset created to allow decentralization is currently almost completely traded on centralized exchanges,” Peter Johnson, a vice president at Jump Ventures, said in an interview. Buterin, however, wants the crypto community to focus more on decentralization so that cryptos can more frequently trade peer-to-peer. Buterin’s remarks come as so-called decentralized exchange gain more attention.

Like many of his arrogant ilk, Buterin ignores the lesson of Chesterton’s fence: why does this thing you do not like and do not understand exist?

Yes, blockchain and cryptocurrencies allow peer-to-peer transactions.  They were largely designed to facilitate such transactions.  For some, the motivation is ideological: an anarchic belief in radical decentralization, and a deep distrust of centralized institutions.

But just because blockchain and related technologies reduce the costs of peer-to-peer transactions, doesn’t mean that such transactions are cheaper than centralized trading on exchanges.  Transacting requires finding a counterparty.  It requires negotiating a price (for a standardized thing, like a Bitcoin–negotiations of other terms for more complex things).  Negotiating a price is costly when information about value is diffuse, so in a decentralized setting not only is it necessary to search for counterparties, it is advantageous to search for information about prices to (a) find the best price, and (b) to be able to negotiate with better information about value .

Centralization reduces the cost of finding a counterparty.  It enhances competition, which tends to reduce bargaining costs.  It leads to better and more symmetric information about prices, which also tends to reduce bargaining costs.  Further, centralized markets can support specialized intermediaries–market makers–who specialize in smoothing out idiosyncratic temporal imbalances in buy and sell order flow, which further reduces trading costs.

Because of these features, centralized trading is frequently an emergent outcome of individual decisions, and one that economizes on transactions costs.  This is clearly what is happening in crypto world.  Indeed, the main puzzle at present is why there are so many exchanges.  The centripetal forces of liquidity will likely result in a huge consolidation in this space.

Buterin and others are attempting to find ways of mitigating some of the disadvantages of bilateral trading (bilateral just being another, more conventional, way of saying “peer-to-peer”).  Reducing the ways of finding people who want to take the other side of a transaction, for example.  But I am highly skeptical that these measures will overcome the inherent advantages of centralizing trading of homogeneous things that large numbers of people want to buy and sell pretty much 24/7, to the point that peer-to-peer will supplant centralized trading.  Buterin can rant all he wants, but centralization is here to stay, and if anything, this segment of the market will become more centralized.

Buterin’s error is seemingly the opposite of those who bewail the lack of centralization in some markets, e.g., those who want to make swaps trading more centralized and who rail against bilateral OTC transactions, but it is really the same mistake. Those who see too much centralization in some markets, and those who see too little in others, fail to recognize that trading mechanisms are emergent orders that develop diverse niches to accommodate the fact that transactors and transactions are heterogeneous.  Centralization is efficient for some transactors and transactions: bilateral/OTC for others.  That’s why we see both.

(This is a point I made at a Platts blockchain conference in November, BTW.  The theme of my talk was where decentralization can work, and where it is likely inefficient.  Trading of standardized instruments was one of the main cases I discussed.)

Alas, the ignorance of techno-geniuses is not limited to trading mechanisms.  One of the supposed benefits of blockchain that is that it allows the ownership of anything–a painting, a house, you name it–to be divided into shares, with the fractional interests recorded in an immutable register, and traded peer-to-peer.  That is, block chain facilitates equitization of assets.  A breakthrough!

Uhm, not really. The benefits of equitizing assets and risks has been long, long understood by economists.  In particular, it has long been understood that equitization facilitates more efficient risk sharing.

But long ago, economists also recognized that despite these apparent benefits, in fact very few assets and risks are equitized.  A vast literature has come up with explanations why.  Information and incentive problems–moral hazard and adverse selection–are notable among these.  A prosaic example: If I sell off shares in my car, what incentive do I have to maintain it properly and to economize on wear and tear and to reduce the probability of theft?  Who pays for maintenance? Who decides on what maintenance is needed?  When I sell the shares, I am likely to have better information about the value and condition of the vehicle, which would subject the buyers to an adverse selection problem, meaning that I am likely to get a low price for the shares–so why bother selling them?  There are other transactions cost problems associated with measurement (who verifies exactly what the asset is?) and opportunism and governance and control.   Related to the centralized trading point, if an asset is highly idiosyncratic/unstandardized, the desire to trade fractional shares will be small.

A potentially slightly cheaper way of recording and transferring fractional ownership does not address these far, far, far more fundamental impediments to equitizing (or should I say, “tokenizing”?) assets and risks.  But the coder geniuses miss the forest for the trees.  They see the issue that their technology can address, and think that it will be revolutionary, only because they do not understand the broader economic issues in play, and therefore think everyone born before them or who does not code must be an idiot.

No, not really.  They are looking at the capillaries, and missing the heart, veins, and arteries.

It reminds me of the Mark Twain quote: “When I was a boy of fourteen, my father was so ignorant I could hardly stand to have the old man around. But when I got to be twenty-one, I was astonished at how much he had learned in seven years.”  Except seven years haven’t passed for the Buterins of the world, and frankly, I seriously doubt that they will.  Instead, they inhabit a techno-Groundhog Day.

All of this is symptomatic of blockchain hype and froth.  There is an indication that we have reached peak hype.  R3, a bank-led blockchain consortium, is contemplating an IPO.  To me this is a signal that those on the inside of blockchain development, especially in the area where its benefits have been particularly hyped (finance/payments/settlement/fintech) understand that the reality will never match the hyperbole, so it’s best to sell out while hyperbole reigns supreme.  (Yes, they claim that they are being approached by those looking to buy the whole thing, but take that with a big grain of salt–I view it merely as part of the sales pitch.  “This is a hot little property right now.  Better get in before someone snatches it away.”)

In brief: don’t be the greater fool.

I think that blockchain and DLT will have some viable commercial applications.  But I am highly confident that they will not be nearly as revolutionary as the True Believers claim.  This is in large part due to the fact that it is clear that the True Believers have an extremely narrow, blinkered understanding of the broader economic issues associated with transacting, ownership, risk transfer, incentives, and governance.  Blockchain may address some issues, but many–if not most–of these issues are secondary or tertiary, not fundamental.  Some things are done more efficiently in a centralized fashion–the trading of standardized instruments being one.  Some things are not equitized/tokenized not because it is technically infeasible/prohibitively costly to issue and record fractional interests, but because fractional ownership entails substantial incentive and information problems.

So don’t believe the hype.  And take a pass on those R3 shares, if they do come to market.

Addendum: the dominance of crypto exchanges is even more remarkable, given how they, well, pretty much suck.  They are hardly comparable to modern futures or equities trading exchanges.  Yet people still strongly prefer to trade on rather clunky platforms with major potential security issues where you can’t easily convert digital into fiat currency and which are likely rife with manipulation than peer-to-peer.  That tells you something.

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June 28, 2018

A Tarnished GEM: A Casualty of Regulation, Spread Explosions, or Both?

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 6:28 pm

Geneva Energy Markets LLC, a large independent oil market maker, has been shuttered.  Bloomberg and the FT have stories on GEM’s demise.  The Bloomberg piece primarily communicates the firm’s official explanation: the imposition of the Basel III leverage ratio on GEM’s clearer raised the FCM’s capital requirement, and it responded by forcing GEM to reduce its positions sharply.  The FT story contains the same explanation, but adds this: “Geneva Energy Markets, which traded between 50m and 100m barrels a day of oil, has sold its trading book after taking ‘significant losses’ in oil futures and options, a person close to the company said.”

These stories are of course not mutually exclusive, and the timing of the announcement that the firm is shutting down months after it had already been ordered to reduce positions suggests a way of reconciling them. Specifically, the firm had suffered loss that made it impossible to support even its shrunken positions.

The timing is consistent with this.  GEM is primarily a spread trader, and oil spreads have gone crazy lately.  In particular, spread position short nearby WTI has been killed in recent days due to the closure of Canadian oil sands production and the relentless exports of US oil.  The fall in supply and continued strong demand have led to a rapid fall in oil stocks, especially at Cushing.  This has been accompanied (as theory says it should be!) by a spike in the WTI backwardation, and a rise in the WTI-Brent differential (and other quality spreads with a WTI leg).  If GEM was short the calendar spread, or had a position in quality spreads that went pear-shaped with the explosion in WTI, it could have taken a big hit.  Or at least a big enough hit to make it unviable to continue to operate at a profitable scale.

Here’s a cautionary tale.  Stop me if you’ve heard it before:

“The notional value of our book was in excess of $50 billion,” Vonderheide said. “However, the actual risk of the book was always relatively low, with at value-at-risk at around $2 million at any given time.”

If I had a dollar for every time that I’ve heard/read “No worries! Our VaR is really low!” only to have the firm fold (or survive a big loss) I would be livin’ large.  VaR works.  Until it doesn’t.  At best, it tells you the minimum loss you can suffer with a certain probability: it doesn’t tell you how much worse than that it can get.  This is why VaR is being replaced or supplemented with other measures that give a better measure of downside risk (e.g., expected shortfall).

I would agree, however, with GEM managing partner Mark Vonderheide (whom I know slightly):

“The new regulation is seriously damaging the liquidity in the energy market,” Vonderheide said. “If the regulation was intending to create a safer and more efficient market, it has done completely the opposite.”

It makes it costlier to make markets, which erodes market liquidity, thereby making it costlier for firms to hedge, and more difficult to enter and exit positions.  Liquidity reductions resulting from this type of regulation tend to be most acute during periods of high volatility–which can exacerbate the volatility, perversely.  Moreover, like much of Frankendodd and its foreign fellow monsters, it tends to hit small to medium sized firms worse than bigger ones, and thereby contributes to greater concentration in the markets–exactly the opposite of the stated purpose.

As Reagan said: “The most terrifying words in the English language are: I’m from the government and I’m here to help.” Just ask GEM about that.

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May 8, 2018

Libor Was a Crappy Wrench. Here–Use This Beautiful New Hammer Instead!

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 8:02 pm

When discussing the 1864 election, Lincoln mused that it was unwise to swap horses in midstream.  (Lincoln used a variant of this phrase many times during the campaign.) The New York Fed and the Board of Governors are proposing to do that nonetheless when it comes to interest rates.  They want to transition from reliance on Libor to a new Secured Overnight Financing Rate (SOFR, because you can never have enough acronyms), despite the fact that there are trillions of dollars of notional in outstanding derivatives and more trillions in loans with payments tied to Libor.

There are at least two issues here.  The first is if Libor fades away, dies, or is murdered, what is to be done with the outstanding contracts that it is written into? Renegotiations of contracts (even if possible) would be intense, costly, and protracted, because any adjustment to contracts to replace Libor could result in the transfer of tens of billions of dollars among the parties to these contracts.  This is particularly like because of the stark differences between Libor and SOFR.  How would you value the difference between a stream of cash flows based on a flawed mechanism intended to reflect term rates on unsecured borrowings with a stream of cash flows based on overnight secured borrowings?  Apples to oranges doesn’t come close to describing the difference.

Seriously: how would you determine the value so that you could adjust contracts?  A conventional answer is to hold some sort of auction (such as that used to determine CDS payoffs in a default), and then settle all outstanding contracts based on the clearing price in the auction (again like a CDS auction).  But I can’t see how that would work here.

Let’s say you have a contract entitling you to receive a set of payoffs tied to Libor.  You participate in an auction where you bid an amount that you would be willing to pay/receive to give up that set of payoffs for a set of SOFR payoffs.  What would you bid?  Well, in a conventional auction your bid would be based on the value of holding onto the item you would give up (here, the Libor payments).  But if Libor is going to go away, how would you determine that opportunity cost?

Not to mention that there is an immense variety of payoff formulae based on Libor, meaning that there would have to be an immense variety of (impractical) auctions.

So it will come down to bruising negotiations, which given the amounts at stake, would consume large amounts of real resources.

The second issue is whether the SOFR rate will perform the same function as well as Libor did.  Market participants always had the choice to use some other rate to determine floating rates in swaps–T-bill rates, O/N repo rates, what have you.  They settled on Libor pretty quickly because Libor hedged the risks that swap users faced better than the alternatives.  A creditworthy bank that borrowed unsecured for 1, 3, 6, or 12 month terms could hedge its funding costs pretty well by using a Libor-based swap: a swap based on some alternative (like an O/N secured rate) would have been a dirtier hedge.  Similarly, another way that banks hedged interest rate risk was to lend at rates tied to their funding cost–which varied closely with Libor.  Well, the borrowers (e.g., corporates) could swap those floating rate loans into fixed by using Libor-based swaps.

That is, Libor-based swaps and other derivatives came to dominate because they were better hedges for interest rate risks faced by banks and corporates than alternatives would have been.  There was an element of reflexivity here too: the availability of Libor-based hedging instruments made it desirable to enter into borrowing and lending transactions based on Libor, because you could hedge them. This positive feedback mechanism created the vexing situation faced today, where there are immense sums of contracts that embed Libor in one way or another.

SOFR will not have this desirable feature–unless the Fed wants to drive banks to do all their funding secured overnight! That is, there will be a mismatch between the new rate that is intended replace Libor as a benchmark in derivatives and loan transactions, and the risks that that market participants want to hedge.

In essence, the Fed identified the problem with Libor–its vulnerability to manipulation because it was not based on transactions–and says that it has fixed it by creating a benchmark based on a lot of transactions.  The problem is that the benchmark that is “better” in some respects (less vulnerable to a certain kind of manipulation) is worse in others (matching the risk that market participants want to hedge).  In a near obsessive quest to fix one flaw, the Fed totally overlooked the purpose of the thing that they were trying to fix, and have created something of dubious utility because it does a poorer job of achieving that purpose.  In focusing on the details of the construction of the benchmark, they’ve lost sight of the big picture: what the benchmark is supposed to be used for.

It’s like the Fed has said: “Libor was one crappy wrench, so we’ve gone out and created this beautiful hammer. Use that instead!”

Or, to reprise an old standby, the Fed is like the drunk looking for his car keys under the lamppost, not because he lost them there, but because the light is better.  There is more light (transactions) in the O/N secured market, but that’s not where the market’s hedging keys are.

This is an object lesson in how governments and other large bureaucracies go astray.  The details of a particular problem receive outsized attention, and all efforts are focused on fixing that problem without considering the larger context, and the potential unintended consequences of the “fix.” Government is especially vulnerable to this given the tendency to focus on scandal and controversy and the inevitable narrative simplification and decontextualization that scandal creates.

The current ‘bor administrator–ICE–is striving to keep it alive.  These efforts deserve support.  Secured overnight rate-based benchmarks are ill-suited to serve as the basis for interest rate derivatives that are used to hedge the transactions that Libor-based derivatives do.

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May 1, 2018

Cuckoo for Cocoa Puffs: Round Up the Usual Suspects

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 10:39 am

Journalism on financial markets generally, and commodity markets in particular, often resorts to rounding up the usual suspects to explain anomalous price movements.  Nowadays, the usual suspect in commodity markets is computerized/algorithmic/high frequency trading.  For example, some time back HFT was blamed for higher volatility in the cattle market, even though such trading represents a smaller fraction of cattle trading than it does for other contracts, and especially since there is precious little in the way of a theoretical argument that would support such a connection.

Another case in point: a flipping of the relationship between London and New York cocoa prices is being blamed on computerized traders.

Computers are dominating the trading of cocoa in New York, sparking a dramatic divergence in the longstanding price relationship with the London market.

Speculative funds have driven the price of the commodity in New York up more than 50 per cent since the start of the year to just under $3,000 a tonne. The New York market, traded in dollars, has traditionally been the preferred market for financial players such as hedge funds.

The London market, historically favoured by traders and commercial players buying and selling physical cocoa, has only risen 34 per cent in the same timeframe.

The big shift triggered by the New York buying is that its benchmark, which normally trades at a discount to London, now sits at a record premium.

So, is the NY premium unjustified by physical market price relationships?  If so, that would be like hundred dollar bills lying on the sidewalk–and someone would pick them up, right?

Not according to this article:

The pronounced shift in price relationships comes as hedge fund managers with physical trading capabilities and merchant traders have exited the cocoa market.

In the past, such a large price difference would have encouraged a trader to buy physical cocoa in London and send it to New York, hence narrowing the relationship. However, current price movements reflected the absence of such players, said brokers.

Fewer does not mean zero.  Cargill, or Olam, or Barry Callebaut or Ecom and a handful of other traders certainly have the ability to execute a simple physical arb if one existed.  Indeed, given the recent trying times in physical commodity trading, such firms would be ravenous to exploit such opportunities.

What’s even more bizarre is that pairs/spread/convergence trading is about the most vanilla (not chocolate!) type of algorithmic trade there is, and indeed, has long been a staple of algorithmic firms that trade only paper.  Meaning that if the spread between this pair of closely related contracts was out of line, if physical traders didn’t bring it back into line, it would be the computerized traders who would.  Yes, there are some complexities here–different delivery locations, different currencies, different deliverable growths with different price differentials, different clearinghouses–but those are exactly the kinds of things that are amenable to systematic–and computerized–analysis.

Weirdly, the article recognizes this

Others use algorithms that exploit the shifts in price relationships between different markets or separate contracts of the same commodity. [Emphasis added.  I should mention that cocoa is one of the few examples of a commodity with separate active contracts for the same commodity.]

It then fails to grasp the implications of this.

One “authority” cited in the article is–get this–Anthony Ward of Armajaro infamy:

Anthony Ward, the commodities trader known in the cocoa market for his large bets, has been among the more well-known fund managers to close his hedge fund, exiting the market at the end of last year. Mr Ward, dubbed “Chocfinger” due to his influence over the cocoa price, blamed the rising power of algorithmic and systems-based trading for making position-taking based on “fundamental” supply and demand factors more difficult.

Methinks that the market isn’t treating Anthony well, and like many losing traders, can’t take the blame himself so he’s looking for a scapegoat. (I note that Ward sold out Armajaro’s cocoa trading business to Ecom for the grand sum of $1 in December, 2013.)

I am skeptical enough that computerized trading can distort flat prices, but those arguments are harder to refute because of the knowledge problem: the whole reason markets exist is that no one knows the “right” price, hence disagreements are inevitable.  But when it comes to something as basic as an intracommodity spread, I find allegations of computer-driven distortions completely implausible.  You can’t arb flat price distortions, but you can arb distorted spreads, and that business is the bread and butter for commodity traders.

So: release the suspect!

PS. For my Geneva students looking for a topic for a class paper, this would be ideal. Perform an analysis to explain the flipping of the spread.

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Begging the Question on VIX Manipulation

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 9:29 am

Stung by yet another allegation of manipulation of the VIX, Cboe Chairman and CEO Ed Tilly and President and COO Chris Concannon fired off an open letter defending the exchange and VIX.  To say it begs the key questions is an understatement.

Here’s their explanation of the April 18 event:

During the opening auction on April 18th, a single market participant submitted orders to buy approximately 212,000 SPX options across a wide range of strike prices. Five additional market participants submitted buy orders totaling 20,000 options. The size and structure of these buy orders appeared consistent with the weights prescribed by the VIX Index formula. Offsetting this buy interest were sell orders submitted by nine participants for a total of 118,000 contracts. This left a buy order imbalance of 114,000 SPX options. This buy order imbalance contributed to the opening prices of the option series that were used to calculate the final VIX settlement value. Based on the orders that were submitted, we believe the auction process functioned as intended, notwithstanding that the final settlement value was higher than what market participants may have otherwise expected.

Although oddly disconnected from the discussion of the 18 April spike in the VIX, this statement ostensibly directed at the Griffin and Shams paper claiming to find frequent manipulations of the VIX strongly suggests that they are denying there was a manipulation on 18 April as well:

Finally, we would like to again address the claims of possible manipulation of the settlement process. We reiterate that we believe these claims are without merit, and that the academic paper’s analysis and conclusions are based upon a fundamental misunderstanding about how VIX derivatives are traded and settled. The trading behavior the author considered suspicious is
consistent with normal and legitimate trading behavior.

The explanation of what happened a couple of weeks ago begs the question because in no way does it disprove that a manipulation took place.  Indeed, what they describe is exactly how a large trader could and would “bang the auction” to influence the settlement price of VIX derivatives, in order to profit on positions in those derivatives.  What Tilly and Concannon describe involves a single large trader submitting a huge order on one side of a market with liquidity constraints.  That is almost certain to affect the auction price. That’s how that kind of manipulation works.

Note that the order–again, entered by a single participant–represented about 90 percent of the buy side interest, and more than 80 percent of the order imbalance.  Further, Tilly and Concannon’s touting of the Cboe’s efforts to improve liquidity at the auctions (perhaps inadvertently) concedes that the liquidity at the auctions is presently inadequate, which would mean that a huge order imbalance would almost certainly move prices–as occurred on the 18th–and be anticipated to move prices.  “There’s no problem (’the auction process functioned as intended’), but we’re fixing it!” hardly inspires confidence.

Any participant with the heft to enter such a large order would surely be sophisticated enough to know that it would be highly likely to move prices.  Note that non-manipulative traders would typically want to mitigate price impact, not trade in a way that exacerbates it.  So why do this?

Thus, there is evidence to support all of the elements of a manipulation case, but one.  There is evidence for artificial price, causation, and ability to cause.  The missing element is intent.  I’d be open to suggestions as to why this one market participant would enter such a large order but for an intent to distort prices.  Any such explanation would have to show how this was the most economical way of achieving some non-manipulative objective, such as hedging.

Addressing the issue of intent would require knowledge of the large trader’s positions in VIX-related instruments.  Tilly and Concannon are silent on that issue, which makes their confident disavowal of manipulation incomplete and hence unpersuasive.  Discussing the auction alone, disconnected from the VIX derivatives markets tied to the auction, is inadequate to dispel suspicions of manipulation.

Perhaps the exchange execs are right, and this “whale” (as the FT referred to the trader) was not manipulating.  But the information in the public record, including the information in their letter, is not sufficient to demonstrate this claim. The question-begging defense will therefore likely feed suspicions about VIX, rather than lay them to rest, as the letter’s authors intended.

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March 23, 2018

Will Chinese Oil Futures Transform the Oil Market? Highly Unlikely, and Like All Things China, They Will Be Hostage to Government Policy Whims

Filed under: China,Derivatives,Economics,Energy,Exchanges,Regulation,Russia — The Professor @ 11:08 am

After literally years of delays and false starts, the International Energy Exchange (a subsidiary of the Shanghai Futures Exchange) will launch its yuan-denominated, China-delivery crude oil futures contract on Monday.

Will it succeed?  Well, that depends on how you measure success.  No doubt it will generate heavy volume.  Speculative enthusiasm runs deep in China, and retail traders trade a lot.  They would probably make a guano futures contract a success, if it were launched: they will no doubt be attracted to crude.

Whether it will be a viable and successful contract for commercial market participants is far more doubtful.  Its potential to become an international benchmark is even more remote.

For one thing, most successful commodity futures contracts specify delivery in a major production area that is connected to multiple consumption regions, but the INE contract is at a major consumption location.  This will increase basis risk for non-Chinese commercials, even before taking into account the exchange rate issue.  Considering the cash basis (the cash-futures basis is more complicated), basis risk between a delivery location and a location supplied by that delivery point is driven by variability in transformation costs, most notably transportation costs.   The variance in the basis between two consumption locations supplied by a delivery point is equal to the variance in the difference between the transformation costs to the two locations, which is equal to the sum of the variances, minus 2x the covariance.  This is typically bigger than either of the variances.  Thus, non-Chinese hedgers will typically be worse off using the INE contract than the CME’s WTI or DME’s Oman or ICE’s Brent, even before liquidity is considered.

In this respect, the INE’s timing is particularly inauspicious, because the US crude oil export boom, which is seeing large volumes go to Asia and China specifically, has more tightly connected WTI prices with Asian prices.

I deliberately say “transformation costs” (rather than just transport costs) above because there can be disparities between international prices and prices in China due to regulations, currency conversion issues, and taxes.  I don’t know the details regarding the relevant tax and regulatory regime for oil specifically, but I do know that for cotton and other ags the tax and quota regime has and does lead to wide and variable differences between China prices and ICE prices, and that periodic changes in this regime create additional basis volatility.

Related to transformation costs, the INE has implemented one bizarre feature that is likely to undermine contract performance.  Specifically, it is setting a high storage rate on delivery warehouses.  The ostensible purpose of this is to restrain speculation and reduce price volatility:

One of its strategies to deter excessive price swings is to set related crude storage costs in China at levels that are at least twice the rate elsewhere. That’s seen discouraging speculators interested in conducting so-called cash and carry trades, which seek to take advantage of differences between the spot price and futures of a commodity.

This will be highly detrimental to the contract’s performance, and will actually contravene the intended purpose.  Discouraging storage will actually increase volatility.  It will also increase the volatility in the basis between the INE price and the prices of other oil in China.  The fact that discouraging storage will make the contract more vulnerable to corners and squeezes will further increase this basis volatility.  This will undermine the utility of the contract as a hedging mechanism.

Where will hedging interest for the contract come from?  Unlike in say the US, there will not be a large group of producers will big long positions that they need to hedge (in part because their banks insist on it).  Similarly, there is unlikely to be a large population of traders with inventory positions, as most of the Chinese crude is purchased by refiners.  The incentives of refiners to hedge crude costs are limited, because they have a natural hedge: although they are short crude, they are long products.  To the extent that refiners can pass on crude costs through products prices, their incentives to hedge are limited: this is why there is a big net short futures exposure (directly and indirectly) by producers, merchants and processors in WTI and Brent: sellers of crude (producers and merchants) have an incentive to hedge by going short futures because they have no natural internal hedge, and the big refiners’ natural hedge mutes their incentive to take long positions of commensurate size.

Ironically, regulation–price controls specifically–may provide the biggest incentive for refiners to hedge.  To the extent they cannot pass on crude cost increases through higher product prices, they have an incentive to hedge because then they have more of a true short exposure in crude.  Moreover, this hedging incentive is option-like: the incentive is greater the closer the price controls are to being binding.  I remember that refined product price restrictions have been a big deal in China in the past, resulting in periodic standoffs between the government and Sinopec in particular, which sometimes involved fuel shortages and protests by truckers.  I don’t know what the situation is now, but that really doesn’t matter: what matters is policy going forward, and Chinese policies are notoriously changeable, and often arbitrary.  So the interest of Chinese refiners in hedging will vary with government pricing policy whims.

If hedging interest does develop in China, it is likely to be the reverse of what you see in WTI and Brent, with hedgers net long instead of net short.  This would tend to lead to a “Keynesian contango” (the Canton Contango? Keynesian Cantongo?), with futures prices above expected future spot prices, although the vagaries of Chinese speculators make it difficult to make strong predictions.

Will the contract develop into an international benchmark? Left to its own devices, this is highly unlikely.  The factors discussed above that create basis risk undermine its utility as an international benchmark, even within Asia.  But we are talking about China here, and the government seldom leaves things to their own devices.  I would not be surprised if the government explicitly requires or strongly pressures domestic firms to buy crude basis Shanghai futures, rather than Brent or WTI.  This contract obviously involves national prestige, and being launched at a time of intense dispute on trade between the US and China I suspect that the government is highly motivated to ensure that it doesn’t flop.

Requiring domestic firms to buy basis Shanghai could also force foreign sellers to do some of their hedging on INE.

Another issue is one I raised in the past, when China peremptorily terminated trading in stock index futures.  The prospect of being forced out of a position at the government’s whim makes it very risky to hold positions, particularly in long-dated contracts.

All in all, I don’t consider the new contract to be transformative–something that will shake up the world oil market.  It will do better than the laughable Russian Urals oil futures contract (in which volume over six months was one-third of the projected daily volume), but I doubt that it will develop into much more than another venue for speculative churn.  But like all things China, government policy will have an outsized influence on its development. Refined product pricing policy will affect hedging demand.  Attempts to force firms to use it as a pricing mechanism in contracts will affect its use as a benchmark, which will also affect hedging demand.

If you are looking for a metric of success as a commercial tool (rather than of its success as a money making venture for the exchange) look at open interest, not volume.  And look in particular in open interest in the back months.  This will take some time to build, and in the meantime I imagine that there will be a lot of awed commentary about trading volume.  But that’s not the main indicator of the utility of a contract as a commercial risk management and price discovery tool.

Update. I had a moment to catch up on Chinese price regulations.  The really binding regulations, which resulted in shortages and the periodic battles between Sinopec and the government date from around 2007-8, when (a) oil prices were skyrocketing, and (b) I was in China teaching a course to Sinopec and CNPC execs, and so heard first-hand accounts.   These battles continued, but less intensely post-Crisis because the controls weren’t binding when prices collapsed.  Moreover, the government adopted a policy that effectively implemented a peg between crude and refined prices, but only adjusted the peg every 22 days and only if the crude price had moved 4 percent.  Subsequently, in 2013, Beijing revised the policy, and eliminated the 4 percent trigger and shortened the averaging period to 10 days. Then in 2015, after the collapse in oil prices, China suspended this program.  A few months later, it introduced a revised program that makes no adjustments to the price when crude falls below $40 or rises above $130.

Several takeaways.  First, at present the adjustment mechanism reduces the incentives of refiners to hedge crude prices.  Under the earlier adjustment system, the lags and thresholds would have created some bizarre optionality that would have made hedging decisions vary with prices in a highly non-linear way.  The system in effect from 2015 to 2016 would have created little incentive to hedge because the pricing system imposed hardly any constraints on margins that were allowed to vary with crude prices.

Second, the current system with the $40 floor and $130 ceiling actually increases the incentive to hedge (relative to the previous system) by buying futures when prices start to move up towards $130 (if that ever happens again).  That’s actually a perverse outcome (triggering buying in a rising price environment, and selling in a falling price environment–positive feedback loop).

Third, and most importantly, the policy changes often, in response to changing market conditions, which reinforces my point about the new futures contract being subject to government policy whims.  It also creates a motive for a perverse kind of speculation–speculation on policy, which can affect prices, which results in changes in policy.

One thing I should have mentioned in the post is the heterogeneity of refiners in China.  There are the big guys (Sinopec, CNPC, CNOOC), and there are the independents, often referred to as “teapot refineries.”  Teapots might have more of an incentive to hedge, given that they are in more tenuous financial straits–but those very tenuous straits might make it difficult for them to come up with the cash to pay margins.  And even they still have the natural hedge as long as price controls don’t bite.  It’s worth noting, however, that Chinese firms have a penchant for speculating too. I wouldn’t be surprised if some of the teapots turn plunger on INE.

Government policy towards the independents has been notoriously volatile–I know, right? In 2015, China granted the independents the right to import oil directly.  Then in late-2016 it thought that the independents were dizzy with success, and threatened to suspend their import quotas if they violated tax or environmental rules.  As always, there are competing and ever changing motives for Chinese policy.  They’ve lurched from wanting to protect the big three and drive consolidation of industry to wanting to provide competitive discipline for the big three to wanting to rein in the competition especially when the independents sparked a price war with the big firms.  These policy lurches will almost certainly affect the commercial utilization of the new futures market, even by Chinese firms.

Updated update. The thought that cash-and-carry trades are some dangerous speculative strategy puzzled me–it’s obviously not a directional play, so why would it affect price levels. But perhaps I foolishly took the official explanation at face value.  Chinese firms have been notorious for using various storage stratagems as ways of circumventing capital controls and obtaining shadow financing.  Perhaps the real reason for the high storage rate is to deter use of the futures market to play such games.  Or perhaps there is a tax angle.  Back in the day futures spreads were a favored tax strategy in the US (before the laws were changed and the IRS cracked down), and maybe cash-and-carry could facilitate similar games under the Chinese tax code.  Just spitballing here, but the stated rationale is so flimsy I have to think there is something else going on.

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February 22, 2018

VIX VapoRubOut

Filed under: Commodities,Derivatives,Economics,Exchanges — The Profesor 2 @ 12:28 pm

Bloomberg’s Odd Lots podcast from a few days ago discusses “How one of the Most Profitable Trades of the Last Few Years Blew Up in a Single Day.” Specifically, how did short volatility trades perform so well for so long, and then unravel so dramatically in a short period of time?

In fact, these two things are directly related. This trade performed well for a long time precisely because it was effectively selling insurance against an infrequent, severe event–in this case, a volatility spike. In essence, those who shorted volatility (primarily by selling VIX futures either directly or indirectly through exchange traded products like the XIV note) were providing insurance against a volatility spike, collected premiums for a long time, and then ended up paying out large amounts when a spike actually occurred. It is analogous to a company insuring against earthquakes: it’s rolling in the dough collecting premiums until a big earthquake actually happens, at which time the company has to pay out big time.

If you look at a graph of the VIX, you’ll see that the VIX can be well-described as a mean reverting process (i.e., it doesn’t behave like a random walk or a geometric random walk, but tends to return to a base level after it diverges from that level) subject to large upward shocks.  After the spikes, mean reversion kicks in, and the index returns roughly to its previous level.

 

 

So if you are short the VIX, you pay out during those spikes.

And that’s not all.  The VIX is strongly negatively correlated with the overall market.  That is, VIX tends to increase when the market goes down:

 

This means that providing insurance against volatility spikes is costly: the volatility short seller commits to making payouts in bad states of the world.  Thus, risk averse suppliers of volatility insurance will demand a premium to bear the risk inherent in that position.  Put crudely, a short VIX position has a large positive beta, meaning that the expected return (risk premium) on this position will be positive, and large.

The flip side of this is that those with a natural short volatility exposure incur a large cost to bear this risk, and might be willing to hedge (insure) against it.  Indeed, given the fact that such natural short exposures incur losses in bad states of the world, those facing them are willing to pay a premium to hedge them.

In equilibrium, this means that short volatility positions will earn a risk premium.  Since short sellers of volatility futures will have to earn a return to compensate them for the associated risks,  the VIX futures price will exceed the expected future value of VIX at futures expiration.  Thus, VIX futures will be in a Keynesian contango (with the futures above the expected future spot).  Given that VIX itself is a non-traded risk (one cannot buy or sell the actual VIX in the same way one can buy or sell a stock index), this means that the forward curve will also be in contango.*  Further, one would expect that long VIX futures positions lose money on average, and given the spikiness of realized VIX, lose money most of the time with the gains occurring infrequently and being relatively large when they do occur.

And of course, short positions have the exact opposite performance.  Shorts sell VIX futures at a premium over the price at which they expect to cover, and hence make money on average.  Furthermore, losses tend to be relatively infrequent, but when they occur they tend to be large.

And that’s exactly what happened in the period leading up to February 5.  During most of that period, VIX shorts were making money.  When the spike occurred on 2/5/18, however, they were hammered.

But this was not an indication of a badly performing market, or irrational trading.  Given the behavior of volatility and the existence of individuals and firms with a natural short volatility position that some wanted to hedge, this is exactly what you’d expect.  Participants (mainly institutional investors, including university endowments) were willing to take the opposite side of those hedges and receive a risk premium in return. Those short positions would earn positive returns most of the time, but when the returns go negative, they tend to do so in a big way. Again, just like earthquake insurance.

One of the inventors of VIX claims that he doesn’t understand why products such as VIX futures or ETPs that have long or short volatility exposures exist. Really? They exist because they facilitate the transfer of risk from those who bear it at a higher cost to those who bear it at a lower cost.  Absent these markets, the short volatility exposures wouldn’t go away: those with such natural exposures would continue to bear it, and would periodically incur large losses.  Those losses would not be as obvious as when volatility products are traded, but they would actually be more costly.  The pain that volatility short sellers incurred earlier this month might be bad, but it was less than the pain that would have existed if they weren’t there to absorb that risk.

One interesting question is whether technical factors actually exacerbated the size of the volatility spike.  Some sellers of volatility short ETPs (like the XIV exchange traded note that is basically a short position on the front two month VIX futures) hedge that exposure by going short VIX futures.  To the extent that the delta of the ETPs remains constant (i.e., the sensitivity of the value of the product to changes in forward volatility remains constant) that’s not an issue: the hedge positions are static.  However, the XIV in particular had a knock-out feature: payment of the note is accelerated when the value of the position falls to 20 percent of face amount.  The XIV experienced such an acceleration event on the 5th, and to the extent the issuer (UBS) had hedged its volatility exposure this could have caused it to buy a large number of futures, because as soon as the note was paid off, the short VIX position was unnecessary as a hedge, and UBS would have bought futures to close that hedge.  This would have been a discontinuous move in its position, moreover: oh, the joys of hedging barrier options (which is essentially what the acceleration feature created). This buying into a spike could have exacerbated the spike.  Whether UBS actually did this, or whether liquidating its hedge position was big enough to have an appreciable knock-on effect on prices is not known.  But it could have made the volatility event more severe than it would have been otherwise.

Bottom line. These markets exist for a reason–to transfer risk.  Moreover, they behaved exactly as expected, and those who participated got–and paid–in the expected way.  Insurance sellers (those short volatility futures) collected premiums to compensate for the risk incurred.  Most of the time the risk was not realized, because of its “spikey” nature, and those sellers realized positive returns.  When the spike happened, they paid out.  There is never a free lunch.  Yes, the insurance sellers dined out on somebody else most of the time, but when they had to pick up the tab, it was a big one.

*Keynes caused untold confusion by using “normal backwardation” to describe a situation where the futures price is below the expected spot price. In market parlance, backwardation occurs when the futures price is below the actual spot price.  Keynesian backwardation and contango refer to a risk premium, which is not directly observable in the market, whereas actual contango and backwardation are.  It is possible for a market to be in contango, but in a Keynesian backwardation.  Similarly, it is possible for a market to be in backwardation, but a Keynesian contango.  If interest rates exceed dividend yields, stock index futures are an example of the former situation.   No arbitrage forces the market into a contango, but long positions earn a risk premium (a normal backwardation).

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December 4, 2017

Bitcoin Futures: What? Me Worry?

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 9:53 pm

The biggest news in derivatives world is the impending launch of Bitcoin futures, first by CBOE, then shortly thereafter by CME.

Especially given the virtually free entry into cryptocurrencies I find it virtually impossible to justify the stratospheric price, and how the price has rocketed over the past year. This is especially true given that if cryptocurrencies do indeed begin to erode in a serious way the demand for fiat currencies (and therefore cause inflation in fiat currency terms) central banks and governments will (a) find ways to restrict their use, and (b) introduce their own substitutes. The operational and governance aspects of some cryptocurrencies are also nightmarish, as is their real resource cost (at least for proof-of-work cryptocurrencies like Bitcoin). The slow transaction times and relatively high transaction fees of Bitcoin mean that it sucks as a medium of exchange, especially for retail-sized transactions. And its price volatility relative to fiat currencies–which also means that its price volatility denominated in goods and services is also huge–undermines its utility as a store of value: that utility is based on the ability to convert the putative store into a relatively stable bundle of goods.

So I can find all sorts of reasons for a bearish case, and no plausible one for a bullish case even at substantially lower prices.

If I’m right, BTC is ripe for shorting. Traditional means of shorting (borrowing and selling) are extremely costly, if they are possible at all. As has been demonstrated theoretically and empirically in the academic literature, costly shorting can allow an asset’s price to remain excessively high for an extended period. This could be one thing that supports Bitcoin’s current price.

Thus, the creation of futures contracts that will make it easier to short–and make the cost of shorting effectively the same as the cost of buying–should be bearish for Bitcoin. Which is why I said this in Bloomberg today:

“The futures reduce the frictions of going short more than they do of going long, so it’s probably net bearish,” said Craig Pirrong, a business professor at the University of Houston. “Having this instrument that makes it easier to short might keep the bitcoin price a little closer to reality.”

Perhaps as an indication of how untethered from reality Bitcoin has become, the CME’s announcement of Bitcoin futures actually caused the price to spike. LOL.

Yes, shorting will be risky. But buying is risky too. So although I don’t expect hedge funds or others to jump in with both feet, I would anticipate that the balance of smart money will be on the short side, and this will put downward pressure on the price.

Concerns have been expressed about the systemic risk posed by clearing BTC futures. Most notably, Thomas Petterfy sat by the campfire, put a flashlight under his chin, and spun this horror story:

“If the Chicago Mercantile Exchange or any other clearing organization clears a cryptocurrency together with other products, then a large cryptocurrency price move that destabilizes members that clear cryptocurrencies will destabilize the clearing organization itself and its ability to satisfy its fundamental obligation to pay the winners and collect from the losers on the other products in the same clearing pool.”

Petterfy has expressed worries about weaker FCMs in particular:

“The weaker clearing members charge the least. They don’t have much money to lose anyway. For this reason, most bitcoin interest will accumulate on the books of weaker clearing members who will all fail in a large move,”

He has recommended clearing crypto separately from other instruments.

These concerns are overblown. In terms of protecting CCPs and FCMs, a clearinghouse like CME (which operates its own clearinghouse) or the OCC (which will clear CBOE’s contract) can set initial margins commensurate with the risk: the greater volatility, the greater the margin. Given the huge volatility, it is likely that Bitcoin margins will be ~5 times as large as for, say, oil or S&Ps. Bitcoin can be margined in a way that poses the same of loss to the clearinghouses and FCMs as any other product.

Now, I tell campfire horror stories too, and one of my staples over the years is how the real systemic risk in clearing arises from financing large cash flows to make variation margin payments. Here the main issue is scale. At least at the outset, Bitcoin futures open interest is likely to be relatively small compared to more mature instruments, meaning that this source of systemic risk is likely to be small for some time–even big price moves are unlikely to cause big variation margin cash flows. If the market gets big enough, let’s talk.

As for putting Bitcoin in its own clearing ghetto, that is a bad idea especially given the lack of correlation/dependence between Bitcoin prices and the prices of other things that are cleared. Clearing diversified portfolios makes it possible to achieve a given risk of CPP default with a lower level of capital (e.g., default fund contributions, CCP skin-in-the-game).

Right now I’d worry more about big markets, especially those that are likely to exhibit strong dependence in a stress scenario. Consider what would happen to oil, stock, bond, and gold prices if war broke out between Iran and Saudi Arabia–not an implausible situation. They would all move a lot, and exhibit a strong dependency. Oil prices would spike, stock prices would tank, and Treasury prices would probably jump (at least in the short run) due to a flight to safety. That kind of scenario (or other plausible ones) scares me a helluva lot more than a spike or crash in Bitcoin futures does while the market is relatively modest in size.

Where I do believe there is a serious issue with these contracts is the design. CME and CBOE are going with cash settlement. Moreover, the CME contract will be based on prices from several exchanges, but notably exclude the supposedly most liquid one. The cash settlement mechanism is only as good as the liquidity of the underlying markets used to determine the settlement price. Bang-the-settlement type manipulations are a major concern, especially when the underlying markets are illiquid: relatively small volumes of purchases or sales could move the price around substantially. (There is some academic research by John Griffen that provides evidence that the settlement mechanism of the VIX contracts are subject to this kind of manipulation.)  The Bitcoin cash markets are immature, and hardly seem the epitome of robustness. Behemoth futures contracts could be standing on spindly cash market legs.

This also makes me wonder about the CFTC’s line of sight into the Bitcoin exchanges. Will they really be able to monitor these exchanges effectively? Will CME and CBOE be able to?

(I have thought that the CFTC’s willingness to approve the futures contracts could be attributable to its belief that the existence of these contracts would strengthen the CFTC’s ability to assert authority over Bitcoin cash exchanges.)

What will be the outcome of the competition between the two Chicago exchanges? As I’ve written before, liquidity is king. Further, liquidity is maximized if trading takes place on a single platform. This means that trading activity tends to tip to a single exchange (if the exchanges are not required to respect price priority across markets). Competition in these contracts is of the winner-take-all variety. And if I had to bet on a winner, it would be CME, but that’s not guaranteed.

Given the intense interest in Bitcoin, and cryptocurrencies generally, it was inevitable that an exchange or two or three would list futures on it. Yes, the contracts are risky, but risk is actually what makes something attractive for an exchange to trade, and exchanges (and the CCPs that clear for them) have a lot of experience managing default risks. The market is unlikely to be big enough (at least for some time) to pose systemic risk, and it’s likely that trading Bitcoin on established exchanges in a way that makes it easier to short could well tame its wildness to a considerable degree.

All meaning that I’m not at all fussed about the introduction of Bitcoin futures, and as an academic matter, will observe how the market evolves with considerable fascination.

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October 12, 2017

Trump Treasury Channels SWP

SWP doesn’t work for the Trump Treasury Department, and is in fact neuralgic to the idea of working for any government agency. Yet the Treasury’s recent report on financial regulatory reform is very congenial to my thinking, on derivatives related issues anyways. (I haven’t delved into the other portions.)

A few of the greatest hits.

Position limits. The Report expresses skepticism about the existence of “excessive speculation.” Therefore, it recommends limiting the role of position limits to reducing manipulation during the delivery period. Along those lines, it recommends spot month on limits, because that is “where the risk of manipulation is greatest.” It also says that limits should be designed so as to not burden unduly hedgers. I made both of these points in my 2011 comment letter on position limits, and in the paper submitted in conjunction with ISDA’s comment letter in 2014. They are also reflected in the report on the deliberations of the Energy and Environmental Markets Advisory Committee that I penned (to accurately represent the consensus of the Committee) in 2016–much to Lizzie Warren’s chagrin.

The one problematic recommendation is that spot month position limits be based on “holistic” definitions of deliverable supply–e.g., the world gold market. This could have extremely mischievous effects in manipulation litigation: such expansive and economically illogical notions of deliverable supplies in CFTC decisions like Cox & Frey make it difficult to prosecute corners and squeezes.

CFTC-SEC Merger. I have ridiculed this idea for literally decades–starting when I was yet but a babe in arms 😉 It is a hardy perennial in DC, which I have called a solution in search of a problem. (I think I used the same language in regards to position limits–this is apparently a common thing in DC.) The Treasury thinks little of the idea either, and recommends against it.

SEFs. I called the SEF mandate “the worst of Frankendodd” immediately upon the passage of the law in July, 2010. The Treasury Report identifies many of the flaws I did, and recommends a much less restrictive requirement than GiGi imposed in the CFTC SEF rules. I also called out the Made Available For Trade rule the dumbest part of the worst of Frankendodd, and Treasury recommends eliminating these flaws as well. Finally, four years ago I blogged about the insanity of the dueling footnotes, and Treasury recommends “clarifying or eliminating” footnote 88, which threatened to greatly expand the scope of the SEF mandate.

CCPs. Although it does not address the main concern I have about the clearing mandate, Treasury does note that many issues regarding systemic risks relating to CCPs remain unresolved. I’ve been on about this since before DFA was passed, warning that the supposed solution to systemic risk originating in derivatives markets created its own risks.

Uncleared swap margin. I’ve written that uncleared swap margin rules were too rigid and posed risks. I have specifically written about the 10-day margining period rule as being too crude and poorly calibrated to risk: Treasury agrees. Similarly, it argues for easing affiliate margin rules, reducing the rigidity of the timing of margin payments (which will ease liquidity burdens), and overbroad application of the rule to include entities that do not impose systemic risks.

De minimis threshold for swap dealers. I’m on the record for saying using a notional amount to determine the de minimis threshold to determine who must register as a swap dealer made no sense, given the wide variation in riskiness of different swaps of the same notional value. I also am on the record that the $8 billion threshold sweeps in firms that do not pose systemic risks, and that a reduced threshold of $3 billion would be even more ridiculously over inclusive. Treasury largely agrees.

The impact of capital rules on clearing. One concern I’ve raised is that various capital rules, in particular those that include initial margin amounts in determining liquidity ratios for banks, and hence their capital requirements, make no economic sense, and and unnecessarily drive up the costs banks/FCMs incur to clear for clients. This is contrary to the purpose of clearing mandates, and moreover, has contributed to increased concentration among FCMs, which is in itself a systemic risk. Treasury recommends “the deduction of initial margin for centrally cleared derivatives from the SLR denominator.” Hear, hear.

I could go into more detail, but these are the biggies. All of these recommendations are very sensible, and with the one exception noted above, in the Title VII-related section I see no non-sensical recommendations. This is actually a very thoughtful piece of work that if followed, will  undo some of the most gratuitously burdensome parts of Frankendodd, and the Gensler CFTC’s embodiment (or attempts to embody) those parts in rules.

But, of course, on the Lizzie Warren left and in the chin pulling mainstream media, the report is viewed as a call to gut essential regulations. Gutting stupid is actually a good idea, and that’s what this report proposes. Alas, Lizzie et al are incapable of even conceiving that regulations could possibly be stupid.

Hamstrung by inane Russia investigations and a recalcitrant (and largely gutless and incompetent) Republican House and Senate, the Trump administration has accomplished basically zero on the legislative front. It’s only real achievement so far is to start–and just to start–the rationalization and in some cases termination (with extreme prejudice) of Obama-era regulation. If implemented, the recommendations in the Treasury Report (at least insofar as Title VII of DFA is concerned), would represent a real achievement. (As would rollbacks or elimination of the Clean Power Plan, Net Neutrality, and other 2009-2016 inanity.)

But of course this will require painstaking efforts by regulatory agencies, and will have to be accomplished in the face of an unrelentingly hostile media and the lawfare efforts of the regulatory class. But at least the administration has laid out a cogent plan of action, and is getting people in place who are dedicated to put that plan into action (e.g., Chris Giancarlo at CFTC). So let’s get on with it.

 

 

 

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