Streetwise Professor

Before departing on his I’ll Golf While the World Burns Vacation and Birthday Party, Obama gave an interview for The Economist. It is beyond belief.

Here is what jumped out at me (from a Reuters article summarizing the interview):

President Barack Obama dismissed Russia as a nation that “doesn’t make anything” . . .

Obama downplayed Moscow’s role in the world, dismissing President Vladimir Putin as a leader causing short-term trouble for political gain that will hurt Russia in the long term.

“I do think it’s important to keep perspective. Russia doesn’t make anything,” Obama said in the interview.

“Immigrants aren’t rushing to Moscow in search of opportunity. The life expectancy of the Russian male is around 60 years old. The population is shrinking,” he said.

Obama told Putin last week that he believes Russia violated the 1988 Intermediate Range Nuclear Forces treaty designed to eliminate ground-launched cruise missiles.

Speaking of Russia’s “regional challenges,” Obama said in the interview: “We have to make sure that they don’t escalate where suddenly nuclear weapons are back in the discussion of foreign policy.”

Of all the Obama idiocies, this has to rank near the top.

Of course, some are cheering the fact that he dissed Putin and Russia. Big. Fucking. Deal.

Those who cheering are missing the import of his remarks. This is Obama’s way of saying that Russia doesn’t matter, and hence its depredations can be ignored. In the long sweep of history, it is doomed to oblivion. So why worry? Ukraine? Temporary issue. This too shall pass.

To quote Keynes: In the long run, we are all dead. Or in the short-to-medium run, if you are Ukrainian (and maybe Lithuanian, Estonian, Georgian, etc.)

I would note that the Mongols, Huns, Vandals, Goths, etc., etc., etc., didn’t make anything either. Aggressive powers are heavy on the destruction, not the production. Their inability to make is one reason why some peoples and nations strive to take. That is exactly why they have to be stopped.

What’s more, “making stuff” is certainly a source of power, it is neither necessary nor sufficient. Putin has proven masterful at exploiting Russia’s pumped and mined, rather than manufactured, wealth to exercise power and influence.* Indeed, Russia’s energy wealth is the primary weapon that Putin has used to intimidate the Europeans into impotence: note that the last round of sanctions, allegedly so harsh, excluded gas, and Gazprom remains untouched. Russia, for all its alleged economic primitiveness, has been far more successful at exercising power using energy than Germany has with all its manufacturing prowess.

By condescendingly criticizing Putin’s short-termism, and apparent failure to understand Russia’s interests as well as he does, Obama overlooks the fact that a short-sighted leader can wreak tremendous carnage in pursuit of those allegedly short-destructive goals.

By dismissing Russia’s importance, and leaving the fate of every bordering country to It Will All Work Out in the End When Russia Collapses, Obama is basically washing his hands of the region.

If Obama’s diagnosis is correct, and Russia is really an aggressive but weak power, his prescription is all wrong. A weak power can be stopped by the application of power by an immeasurably stronger one, before it runs amok. But Obama just wants to stand back, and let nature-or history, actually-take its course.

But it gets worse. Note Obama’s remarks on the nuclear issue. In not so many words (because in using so many words before regarding Syria, he created a huge mess), he drew a red line: as long as Putin doesn’t “escalate where suddenly nuclear weapons are back in the discussion of foreign policy”, it’s OK! More of a green light, than a red line, actually.

So just don’t use nukes, Vlad, and you are good.

Putin will read this interview, and will then rub his hands with glee. Obama clearly expressed his extreme unwillingness to confront Putin in any meaningful way, and by saying implicitly that escalation short of the threatened use of nuclear weapons will draw no US response, Putin has every incentive to escalate.

This frivolity, this egg-head approach to foreign policy that focuses on long run trends while ignoring short run imperatives and the nature of our adversary, is exactly why the world burns.

*I would also take issue with the implication that mining and oil and gas production are somehow technologically backwards and less economically productive than manufacturing. Jed Clampett to the contrary, oil does not just flow from the ground. Nickel and gold are not lying around for the taking. Both require tremendous applications of technology and capital.

I wonder if Obama will denigrate Canada as a country that “doesn’t make anything”?

Never mind. It would be quite in character.

This story from the Independent has gone viral, and for understandable reasons: it claims that Germany and Russia are negotiating a scurrilous deal behind Ukraine’s back.

More controversially, if Ms Merkel’s deal were to be acceptable to the Russians, the international community would need to recognise Crimea’s independence and its annexation by Russia, a move that some members of the United Nations might find difficult to stomach.

Sources close to the secret negotiations claim that the first part of the stabilisation plan requires Russia to withdraw its financial and military support for the various pro-separatist groups operating in eastern Ukraine. As part of any such agreement, the region would be allowed some devolved powers.

At the same time, the Ukrainian President would agree not to apply to join Nato. In return, President Putin would not seek to block or interfere with the Ukraine’s new trade relations with the European Union under a pact signed a few weeks ago.

Second, the Ukraine would be offered a new long-term agreement with Russia’s Gazprom, the giant gas supplier, for future gas supplies and pricing. At present, there is no gas deal in place; Ukraine’s gas supplies are running low and are likely to run out before this winter, which would spell economic and social ruin for the country.

As part of the deal, Russia would compensate Ukraine with a billion-dollar financial package for the loss of the rent it used to pay for stationing its fleets in the Crimea and at the port of Sevastopol on the Black Sea until Crimea voted for independence in March.

However, these attempts by Ms Merkel to act as a broker between President Putin and the Ukraine’s President, Petro Poroshenko, were put on the back-burner following the shooting down of the MH17 plane in eastern Ukraine.

But insiders who are party to the discussions said yesterday that the “German peace plan is still on the table and the only deal around. Negotiations have stalled because of the MH17 disaster but they are expected to restart once the investigation has taken place.”

Pretty explosive stuff. So explosive, in fact, I have a difficult time accepting that the story is anywhere near true, at least insofar as the implication that this is Merkel’s plan is concerned.

If it was true, and Merkel were indeed negotiating a deal along these lines, she would indeed deserve the Frau Ribbentrop epithet that has been hurled at her, especially after her chumminess with Putin in Rio.

There are so many issues here.

First, it is not Germany’s place to negotiate a deal that binds Ukraine, even as a broker that intends to present the deal to Ukraine for its approval later. That would rightly be seen as a stab in the back. Germany’s imprimatur on such a deal-and the fact that it negotiated the deal would inevitably lead people to conclude that Germany vouches for it-would be perceived by Ukraine as a betrayal and abandonment, and an exertion of tremendous pressure to capitulate by a country that it had counted on to be a supporter.

Second, no Ukrainian government could possibly accept these terms. So Merkel is either delusional to think that they would, or she is setting up the Ukrainians to take the blame for rejecting a chance at “peace”, thereby allowing her to wash her hands of the situation and let Putin do as he will. Delusional or Machiavellian manipulator. Quite the choice.

Third, the recognition of Russia’s theft of Crimea, even if compensated by thirty pieces of silver in exchange for lost rent on Sevastapol, would completely undermine a fundamental principle of the modern international order, namely that the border of no state should be changed by force. For a country like Germany, which portrays itself as a Rechtsstaat on international as well as domestic matters, this would be an amazing and despicable action. The precedent would be very ominous indeed. It is hard to imagine anything more threatening to peace and stability as such an endorsement of revanchism, irredentism, and the dominance of might over right.

Fourth, the US and UK, and perhaps other countries, would in no way countenance such an outcome, in part because of the dangerous precedent it would set.

Fifth, Ukraine is looking to free itself from abject dependence on Russian gas, rather than to cement that dependence into the distant future.

These considerations are so grave that I cannot believe that Germany would be doing what the Independent alleges.

So what is the real story here?

The Independent is owned by Alexander Lebedev, an ex-KGB officer and ex-billionaire. He has had a fraught relationship with Putin. He co-owns, along with Gorbachev, the opposition paper Novaya Gazeta. On the surface he is not an obvious Putin shill, and may be an opponent: maybe he ran the story to torpedo a deal that Putin wants. But he could be under pressure. Or he could be wanting to curry favor in Moscow, and thinks this would help him do so. So maybe the story has its roots in the murky world of Putin and rich Russians.

The story paints Merkel in a very bad light: maybe it has been leaked (and slanted) by one of her foes, domestic or foreign. Or maybe someone thinks that she will have to distance herself from the allegations of treachery by becoming more stern in her stance against Putin.

Or maybe this has been planted by the Russians. It could be their statement of the terms they are willing to offer, and to accept. Perhaps Putin even presented it to Merkel, and maybe more than once. Perhaps Merkel rejected it, or she presented a counterproposal and continues to talk, which could be twisted by the Russians to suggest that she has endorsed the basics of the proposal.

I don’t know. But I do know one thing. It is precisely this sort of story, and the possibility that it has its roots in the truth, that makes it imperative that the United States collect intelligence on Germany, German leaders, and German dealings with foreign governments-especially governments like Russia’s. This is exactly why we spy, and why large and important countries that endeavor to exercise their sovereign right to craft and implement an independent foreign policy, are legitimate targets of spying. Germany pursues its interests, and in that pursuit, it might seriously damage American interests. Thus, it is in our vital national interest to know what Germany is up to.*

That’s the price you pay when you want to be an independent actor on the world stage, so Germans from Angela on down can spare us their outraged protests at American espionage.

* Which suggests yet another explanation for the Independent story. Namely, the source is US (or UK, or Ukrainian, or . . . even German) intelligence, which is leaking it to torpedo a perfidious Merkel deal.

I owe the Euros an apology. It turns out that they did implement most of the sanctions recommended in the “non-paper.” So it proved to be more than an orphan straw man.

That said, upon further consideration, there is less here than could have been hoped for. Indeed, these sanctions will impose little real damage on Russia.

There are three major pieces of the new European sanctions. First, Europeans (including foreign subsidiaries and branches of non-EU banks) are prohibited from buying new equity or debt with maturity of greater than 90 days from Russian banks with more than 50 percent state ownership. Second, there is a ban on the sale of oil technology and equipment. Third, there is an arms sales ban.

The US has implemented similar measures, with one peculiar exception: Sberbank is not included in the US sanctions, though it is in the European sanctions.

The bank sanctions are getting the most attention, but they are hardly devastating. I only had enough time today to look at the international borrowings of Sberbank, VTB, and VEB. Sberbank’s foreign debt borrowings total only about 4 percent of its total liabilities, and only a small fraction of those mature in the next year. Therefore, the sanctions put no immediate pressure on Sberbank, especially since it still can borrow from US persons. VTB’s foreign debt with maturities in 2014 and 2015 is no more than 6 percent of its total liabilities: I can’t be more precise because its financial statements only report broad maturity categories. VEB’s total Eurobond issues are about 8 percent of its liabilities: again, only a fraction of these are due in the next year or so.

Loss of this funding would be something of a strain, but the sums involved could readily be replaced by drawing on Russian foreign reserves and borrowing from non-EU and non-US banks.

What’s more, a little financial engineering permits these institutions to circumvent the effect of the sanctions. It seems that they can still enter into derivatives trades: derivatives are explicitly excluded from US sanctions. Since under the sanctions the banks can still borrow with 90 day maturities, they can create a synthetic long term loan with a fixed interest rate by borrowing for 90 days on a rolling basis, and enter into receive floating-pay fix swaps. Yes, there still is some risk here: if sanctions are extended to prevent even short term borrowings, the banks following this strategy would have a short swap position and no offsetting floating rate borrowings.

In brief, the sanctioned banks aren’t heavily dependent on European or US debt markets for their funding; the Russian government has the resources to cover this funding gap; and there is a somewhat riskier alternative (borrow short-term and hedge via swaps). Thus, although it would be unfair to say that the financial sanctions merely damage a few capillaries, it is definitely the case that they don’t come anywhere close to striking at Russia’s financial jugular. They are annoyance, and no more.

It is also important to note that the European sanctions do not target Rosneft. So the Russian oil company still has access to European (and Asian) debt and equity markets. As I noted before, this significantly cushions the blow on the Russian firm.

Insofar as the weapons ban is considered, it is largely symbolic because Russia builds most of its own weaponry. Predictably, existing deals are exempted. Meaning that France can continue with its sales of Mistral assault ships.

A bigger threat to the second Mistral sale is yesterday’s arbitration verdict in the Yukos litigation. If Russia doesn’t pay the $50 billion by January-a metaphysical certainty-the winning claimants can move to seize non-diplomatic Russian government assets in countries that are signatories to the New York Arbitration Convention. Conceivably the claimants could attempt to seize the second Mistral-the Vladivostok, ominously slated for service in the Med and Black Seas-while it is still in France. But no doubt the Russians and French could circumvent this by transferring ownership only after the ship had sailed to Russia. (As an aside, the main effect of the arbitration verdict will be to ensure employment of large number of lawyers for years, because the Russians will fight every attempt to enforce the award by seizing government assets abroad tooth and nail. It is a welcome verdict, but its immediate financial impact on Russia will be pretty much nil.)

The sanctions on oil equipment will have little impact in the near term, and since the European sanctions are time limited, their effect will be diminished even further.

In sum, the new sanctions are far beyond what had been imposed before, but they are still not that damaging to Russia. Putin can legitimately say “’tis but a scratch,” and not in the Black Knight, Monty Python, I’m not going to admit I’m wounded sense.

The United States in particular still has the power to leave Putin financially limbless and bleeding, pitifully claiming his invincibility. But that would require hacking away with a real banking broadsword: cutting off Russian access to dollar markets altogether. But there is no appetite to do this in the west: the Europeans had to screw up their courage to the sticking place to implement even these limited sanctions. And Obama has little appetite for this either: his sanction announcement today was delivered in a listless, phone-it-in fashion, before he ran off to fly to Kansas City for some silly event involving meeting people who had written him letters. He is obviously not engaged in this at all.

The Europeans and Obama believe that they are engaged in a nuanced strategy of graduated escalation that will convince Putin that continued attempts to subvert Ukraine through force will eventually result in Russia incurring unbearable financial costs, and that this will deter him from going further.

Ask the shades of LBJ and McNamara about how hardened dictators interpret graduated escalation. They interpret it as a signal of weakness, not resolve. If anything, it urges them to go further. I would anticipate that this will be true today, with Putin.

The NYT ran a long article yesterday describing the administration’s Hamlet-like agonizing over whether to provide Ukraine with real time intelligence useful for targeting rebel forces. (For the record, I called for this in the immediate aftermath of the flight of Yanukovych. It should be an easy decision.)

One part jumped out at me:

“We’ve been cautious to date about things that could directly hit Russia — principally its territory,” but also its equipment, the official said. A proposal to give the Ukrainians real-time information “hasn’t gotten to the president yet,” the official said, in part because the White House has been focused on rallying support among European allies for more stringent economic sanctions against Moscow, and on gaining access for investigators to the Malaysia Airlines crash site.

There in a nutshell is the passivity of this president, and his negation of executive leadership.

An active and engaged leader would not be waiting for things to reach him. He would be demanding that a full range of options be presented to him immediately, if not sooner. This situation has been metastasizing for months. What’s more, in the aftermath of the MH17 atrocity, and the rebels’ ongoing use of artillery and MLRS systems against civilian targets, the suppression of their weapons systems is both a military and humanitarian imperative. The time for action passed long ago, but it is incomprehensible that 10 days after MH17 that Obama has personally avoided considering, let alone ordering, a reasonable, measured US action that would materially assist Ukraine to defend itself, and which would not put one US serviceman or woman at risk.

Also look at the excuse: he’s focused on the diplomatic channel. This is particularly rich a week after Obama flacks in the administration and media responded to criticisms about his fundraiser-dominated schedule by saying that he can multi-task. So, he can’t simultaneously push the Europeans and evaluate steps to aid the Ukrainian government? What happened to that vaunted multi-tasking capability?

Further, military and diplomatic measures are complementary, and need to be processed in parallel rather than serially.

Another thing that stands out in the article is the hand-wringing about “provoking Russia”:

“The debate is over how much to help Ukraine without provoking Russia,” said a senior official participating in the American discussions.

Look. To Putin, anything short of outright capitulation by Ukraine, and the complete abandonment of Ukraine by the US and the EU is a provocation. Let’s not forget what “provoked” this crisis in the first place: Ukraine’s temerity in moving to sign a trade deal with the EU. Continued Ukrainian resistance is all the provocation Putin needs. Anything the US or EU does will have the merest of effects on Putin’s insatiable desire to subjugate Ukraine.

That’s not quite true, actually. Continued passivity, and waiting for the USPS to deliver military options to POTUS, encourages Putin’s aggressiveness. Weakness and passivity are extremely provocative to Putin.

As to another objection-that disloyal individuals in the Ukrainian leadership will provide the information to Russia: this is a non-issue. Yes, such leaks could undermine the effectiveness of the intelligence, by permitting the rebels to move to avoid a strike. But if they are moving, they aren’t shooting. What’s more, given the realities of communication, it is highly unlikely that  truly real-time information useful for targeting could make it to the rebels before it reached the Ukrainian air or artillery units tasked to strike them. Further, attempts by disloyal elements to communicate with the rebels could actually facilitate their discovery, especially if the information is tightly compartmentalized.

As for the Ukrainians getting to rambunctious if they have better information, the US has the option to cut off the information at any time, and to place conditions on its use. If anything, provision of this intelligence will focus Ukrainian military efforts leading to less risk of misguided strikes on civilians or Russia.

In sum, this should be about as easy a decision as a commander in chief should have to make. But because he has clearly signaled that he wants to distance himself from serious involvement with the Ukrainian military efforts against insurrectionists, subordinates and bureaucrats are consciously choosing not to present him with the options that a real leader would be demanding from them.

Tomorrow is the 150th anniversary of the Battle of Ezra Church, the third of Hood’s assaults against Sherman’s army that attempted to stop the encirclement of Atlanta.

The story of the battle is relatively simple. After cutting the rail line leading into the city from the east, Sherman moved in what has been characterized as one of his whip-like movements to cut the line running in from Macon to the west. As always, the Army of the Tennessee was the tip of the whip. As it moved south to the west of the city, Hood moved Stephen D. Lee’s and Alexander P. Stewart’s corps out of the city’s defenses in the hopes of surprising the Army of the Tennessee (now under the command of very Eastern general Oliver O. Howard, much to the chagrin of very Western general John A. Logan). But the Union troops anticipated the attack, deployed from their marching formation and formed a V-shaped line. Like veterans on all fronts by the summer of 1864, they immediately started to dig in. Not so much dig, really as collect logs, lumber, and even the pews from Ezra Church, which they piled up to form a makeshift breastwork. Here are some contemporary woodcuts that show the impromptu entrenchments:

The battle itself was never really in doubt. The Confederates gained ground on the Union right flank, but Logan (back in command of the XVth Corps) led a counterattack by two regiments (the 40th Illinois and 6th Iowa) which drove off the Rebels. The Iowans lost Major Ennis, a beloved officer who had served since Shiloh.

The 46th Ohio fought at Ezra Church. One of its members, Sergeant Harry Davis, won the Medal of Honor by advancing in front of the lines to wrest a flag from its dying bearer, as illustrated here in another contemporary print:

Other than the fleeting success on the Union right, the Confederate assaults made no progress. The casualties tell the tale. The Union lost about 650 men, the Confederates almost 5 times as many. Of the three assaults in July, this was the one with most disparate losses and the least tactical success. Whereas the Confederates did achieve some local successes at Peachtree Creek and Atlanta. They achieved none at Ezra Church.

The responsibility for actually carrying out the attack lies with Stephen D. Lee. Hood was performing the role of army commander, remaining at his headquarters in Atlanta.

Speaking of Hood, my Battle of Atlanta post generated several thoughtful comments about him. Serendipitously, this weekend I saw a program on CSPAN3 (yes, I am that much of a geek about this stuff) in which a biographer of Hood, Stephen Hood (a distant relation) made a pretty persuasive case that Hood has been unfairly maligned. He presented evidence that many of the anecdotes told at Hood’s expense were specious. He was particularly critical of historian Wiley Sword (whom I know some) for distorting the evidence in his savage attacks on Hood’s generalship, his humanity, and indeed his mental health. He further claims that there is no evidence that Hood actually used opiates, though of course absence of evidence is not definitive evidence of absence.

Overall, his defense was somewhat persuasive, though it cannot and did not answer the brutal facts of Franklin and Nashville. When time permits, I might dig into the sources cited by Hood and Sword to see who gets the better of the argument. Maybe I’ll have a chance to do that by the end of November, when the sesquicentennial of Franklin rolls around.

Pricing benchmarks have been one of the casualties of the financial crisis. Not because the benchmarks-like Libor, Platts’ Brent window, ISDA Fix, the Reuters FX window or the gold fix-contributed in an material way to the crisis. Instead, the post-crisis scrutiny of the financial sector turned over a lot of rocks, and among the vermin crawling underneath were abuses of benchmarks.

Every major benchmark has fallen under deep suspicion, and has been the subject of regulatory action or class action lawsuits. Generalizations are difficult because every benchmark has its own problems. It is sort of like what Tolstoy said about unhappy families: every flawed benchmark is flawed in its own way. Some, like Libor, are vulnerable to abuse because they are constructed from the estimates/reports of interested parties. Others, like the precious metals fixes, are problematic due to a lack of transparency and limited participation. Declining production and large parcel sizes bedevil Brent.

But some basic conclusions can be drawn.

First-and this should have been apparent in the immediate aftermath of the natural gas price reporting scandals of the early-2000s-benchmarks based on the reports of self-interested parties, rather than actual transactions, are fundamentally flawed. In my energy derivatives class I tell the story of AEP, which the government discovered kept a file called “Bogus IFERC.xls” (IFERC being an abbreviation for Inside Ferc, the main price reporting publication for gas and electricity) that included thousands of fake transactions that the utility reported to Platts.

Second, and somewhat depressingly, although benchmarks based on actual transactions are preferable to those based on reports, in many markets the number of transactions is small. Even if transactors do not attempt to manipulate, the limited number of transactions tends to inject some noise into the benchmark value. What’s more, benchmarks based on a small number of transactions can be influenced by a single trade or a small number of trades, thereby creating the potential for manipulation.

I refer to this as the bricks without straw problem. Just like the Jews in Egypt were confounded by Pharoh’s command to make bricks without straw, modern market participants are stymied in their attempts to create benchmarks without trades. This is a major problem in some big markets, notably Libor (where there are few interbank unsecured loans) and Brent (where large parcel sizes and declining Brent production mean that there are relatively few trades: Platts has attempted to address this problem by expanding the eligible cargoes to include Ekofisk, Oseberg, and Forties, and some baroque adjustments based on CFD and spread trades and monthly forward trades). This problem is not amenable to an easy fix.

Third, and perhaps even more depressingly, even transaction-based benchmarks derived from markets with a decent amount of trading activity are vulnerable to manipulation, and the incentive to manipulate is strong. Some changes can be made to mitigate these problems, but they can’t be eliminated through benchmark design alone. Some deterrence mechanism is necessary.

The precious metals fixes provide a good example of this. The silver and gold fixes have historically been based on transactions prices from an auction that Walras would recognize. But participation was limited, and some participants had the market power and the incentive to use it, and have evidently pushed prices to benefit related positions. For instance, in the recent allegation against Barclays, the bank could trade in sufficient volume to move the fix price sufficiently to benefit related positions in digital options. When there is a large enough amount of derivatives positions with payoffs tied to a benchmark, someone has the incentive to manipulate that benchmark, and many have the market power to carry out those manipulations.

The problems with the precious metals fixes have led to their redesign: a new silver fix method has been established and will go into effect next month, and the gold fix will be modified, probably along similar lines. The silver fix will replace the old telephone auction that operated via a few members trading on their own account and representing customer orders with a more transparent electronic auction operated by CME and Reuters. This will address some of the problems with the old fix. In particular, it will reduce the information advantage that the fixing dealers had that allowed them to trade profitably on other markets (e.g.,. gold futures and OTC forwards and options) based on the order flow information they could observe during the auction. Now everyone will be able to observe the auction via a screen, and will be less vulnerable to being picked off in other markets. It is unlikely, however, that the new mechanism will mitigate the market power problem. Big trades will move markets in the new auction, and firms with positions that have payoffs that depend on the auction price may have an incentive to make those big trades to advantage those positions.

Along these lines, it is important to note that many liquid and deep futures markets have been plagued by “bang the close” problems. For instance, Amaranth traded large volumes in the settlement period of expiring natural gas futures during three months of 2006 in order to move prices in ways that benefited its OTC swaps positions. The CFTC recently settled with the trading firm Optiver that allegedly banged the close in crude, gasoline, and heating oil in March, 2007. These are all liquid and deep markets, but are still vulnerable to “bullying” (as one Optiver trader characterized it) by large traders.

The incentives to cause an artificial price for any major benchmark will always exist, because one of the main purposes of benchmarks is to provide a mechanisms for determining cash flows for derivatives. The benchmark-derivatives market situation resembles an inverted pyramid, with large amounts cash flows from derivatives trades resting on a relatively small number of spot transactions used to set the benchmark value.

One way to try to ameliorate this problem is to expand the number of transactions at the point of the pyramid by expanding the window of time over which transactions are collected for the purpose of calculating the benchmark value: this has been suggested for the Platts Brent market, and for the FX fix. A couple of remarks. First, although this would tend to mitigate market power, it may not be sufficient to eliminate the problem: Amaranth manipulated a price that was based on a VWAP over a relatively long 30 minute interval. In contrast, in the Moore case (a manipulation case involving platinum and palladium brought by the CFTC) and Optiver, the windows were only two minutes long. Second, there are some disadvantages of widening the window. Some market participants prefer a benchmark that reflects a snapshot of the market at a point in time, rather than an average over a period of time. This is why Platts vociferously resists calls to extend the duration of its pricing window. There is a tradeoff in sources of noise. A short window is more affected by the larger sampling error inherent in the smaller number of transactions that occurs in a shorter interval, and the noise resulting from greater susceptibility to manipulation when a benchmark is based on smaller number of trades. However, an average taken over a time interval is a noisy estimate of the price at any point of time during that interval due to the random fluctuations in the “true” price driven by information flow. I’ve done some numerical experiments, and either the sampling error/manipulation noise has to be pretty large, or the volatility of the “true” price must be pretty low for it to be desirable to move to a longer interval.

Other suggestions include encouraging diversity in benchmarks. The other FSB-the Financial Stability Board-recommends this. Darrel Duffie and Jeremy Stein lay out the case here (which is a lot easier read than the 750+ pages of the longer FSB report).

Color me skeptical. Duffie and Stein recognize that the market has a tendency to concentrate on a single benchmark. It is easier to get into and out of positions in a contract which is similar to what everyone else is trading. This leads to what Duffie and Stein call “the agglomeration effect,” which I would refer to as a “tipping” effect: the market tends to tip to a single benchmark. This is what happened in Libor. Diversity is therefore unlikely in equilibrium, and the benchmark that survives is likely to be susceptible to either manipulation, or the bricks without straw problem.

Of course not all potential benchmarks are equally susceptible. So it would be good if market participants coordinated on the best of the possible alternatives. As Duffie and Stein note, there is no guarantee that this will be the case. This brings to mind the as yet unresolved debate over standard setting generally, in which some argue that the market’s choice of VHS over the allegedly superior Betamax technology, or the dominance of QWERTY over the purportedly better Dvorak keyboard (or Word vs. Word Perfect) demonstrate that the selection of a standard by a market process routinely results in a suboptimal outcome, but where others (notably Stan Lebowitz and Stephen Margolis) argue that  these stories of market failure are fairy tales that do not comport with the actual histories. So the relevance of the “bad standard (benchmark) market failure” is very much an open question.

Darrel and Jeremy suggest that a wise government can make things better:

This is where national policy makers come in. By speaking publicly about the advantages of reform — or, if necessary, by using their power to regulate — they can guide markets in the desired direction. In financial benchmarks as in tap water, markets might not reach the best solution on their own.

Putting aside whether government regulators are indeed so wise in their judgments, there is  the issue of how “better” is measured. Put differently: governments may desire a different direction than market participants.

Take one of the suggestions that Duffie and Stein raise as an alternative to Libor: short term Treasuries. It is almost certainly true that there is more straw in the Treasury markets than in any other rates market. Thus, a Treasury bill-based benchmark is likely to be less susceptible to manipulation than any other market. (Though not immune altogether, as the Pimco episode in June ’05 10 Year T-notes, the squeezes in the long bond in the mid-to-late-80s, the Salomon 2 year squeeze in 92, and the chronic specialness in some Treasury issues prove.)

But that’s not of much help if the non-manipulated benchmark is not representative of the rates that market participants want to hedge. Indeed, when swap markets started in the mid-80s, many contracts used Treasury rates to set the floating leg. But the basis between Treasury rates, and the rates at which banks borrowed and lent, was fairly variable. So a Treasury-based swap contract had more basis risk than Libor-based contracts. This is precisely why the market moved to Libor, and when the tipping process was done, Libor was the dominant benchmark not just for derivatives but floating rate loans, mortgages, etc.

Thus, there may be a trade-off between basis risk and susceptibility to manipulation (or to noise arising from sampling error due to a small number of transactions or averaging over a wide time window). Manipulation can lead to basis risk, but it can be smaller than the basis risk arising from a quality mismatch (e.g., a credit risk mismatch between default risk-free Treasury rates and a defaultable rate that private borrowers pay). I would wager that regulators would prefer a standard that is less subject to manipulation, even if it has more basis risk, because they don’t internalize the costs associated with basis risk. Market participants may have a very different opinion. Therefore, the “desired direction” may depend very much on whom you ask.

Putting all this together, I conclude we live in a fallen world. There is no benchmark Eden. Benchmark problems are likely to be chronic for the foreseeable future. And beyond. Some improvements are definitely possible, but benchmarks will always be subject to abuse. Their very source of utility-that they are a visible price that can be used to determine payoffs on vast sums of other contracts-always provides a temptation to manipulate.

Moving to transactions-based mechanisms eliminates outright lying as a manipulation strategy, but it does not eliminate the the potential for market power abuses. The benchmarks that would be least vulnerable to market power abuses are not necessarily the ones that best reflect the exposures that market participants face.

Thus, we cannot depend on benchmark design alone to address manipulation problems. The means, motive, and opportunity to manipulate even transactions-based benchmarks will endure. This means that reducing the frequency of manipulation requires some sort of deterrence mechanism, either through government action (as in the Libor, Optiver, Moore, and Amaranth cases) or private litigation (examples of which include all the aforementioned cases, plus some more, like Brent).  It will not be possible to “solve” the benchmark problems by designing better mechanisms, then riding off into the sunset like the Lone Ranger. Our work here will never be done, Kimo Sabe.*

* Stream of consciousness/biographical detail of the day. The phrase “Kimo Sabe” was immortalized by Jay Silverheels-Tonto in the original Lone Ranger TV series. My GGGGF, Abel Sherman, was slain and scalped by an Indian warrior named Silverheels during the Indian War in Ohio in 1794. Silverheels made the mistake of bragging about his feat to a group of lumbermen, who just happened to include Abel’s son. Silverheels was found dead on a trail in the woods the next day, shot through the heart. Abel (a Revolutionary War vet) was reputedly the last white man slain by Indians in Washington County, OH. His tombstone is on display in the Campus Martius museum in Marietta. The carving on the headstone is very un-PC. It reads:

Here lyes the body of Abel Sherman who fell by the hand of the Savage on the 15th of August 1794, and in the 50th year of  his age.

Here’s a picture of it:

The stream by which Abel was killed is still known as Dead Run, or Dead Man’s Run.

Today is the 150th anniversary of what I consider to be the most compelling battle of the Civil War: the Battle of Atlanta.

I find it compelling because it was a true soldier’s battle that demonstrated the unmatched martial virtues of the combatants, especially those in the Union Army of the Tennessee.

It was a soldiers battle because it was not fought according to any plan. There was a plan, and a rather impressive one on paper, but one that did not even make it to the point of first contact with the enemy. Instead, Confederate General John Bell Hood’s plan dissolved before a shot was fired due to the confusion of a night march, the fatigue of soldiers who had been engaged in combat for virtually every day of the previous two-and-a-half months, and wooded terrain crossed by watercourses and millponds.

Hood desired to reprise Jackson’s flank attack at Chancellorsville, a mere 14.5 months prior. But whereas Jackson attacked in depth, with three divisions one behind the other, Hood’s four attacking divisions were were strung out in a long, scraggly line scattered across several miles of Georgia scrub pine forest. Due to the trials of the march, the forbidding terrain, and the need to make haste, Hood’s divisions (commanded by Bate, Walker, Cleburne, and Maney) attacked mainly as brigades operating on their own hook, only tenuously connected with each other, if connected at all.

That said, they caught McPherson’s Army of the Tennessee in a very vulnerable spot. They were assailed from the direct flank (like Jackson had done to O.O. Howard’s hapless XIth Corps at Chancellorsville) and from the rear and front. Most Civil War armies would have fled when hit in force from flank and rear. But in one of the most sublime displays of soldiership in any war, Grant’s old army did not panic. Indeed, with little direction from any officer above brigade or division level, its soldiers reacted to the situation with aplomb. When attacked from the rear, they faced to the rear and beat off the attack. When attacked from the flank, they refused their lines and repelled it.

Some units, particularly those in the XVIIth Corps, were attacked sequentially from the flank, rear, and front. Resolutely, they responded to each threat. When attacked from the rear, they jumped to the front of their earthworks and beat off the assault, sometimes hand-to-hand. In one of the fights, Colonel Belknap of the 15th Iowa reached over the ramparts to grab Colonel Lampley of the 45th Alabama, wrestled him over the earthworks, and made him prisoner. Lampley had been screaming at his men for not following him. Belknap berated him: “Look at your men! They are all dead! What are you cursing them for?” (To demonstrate that martial prowess does not imply moral virtue, Belknap went on to become a corrupt Secretary of War under Grant. He resigned before being impeached for peculation in the matter of Indian trading posts.)

After being attacked in the rear, when attacked from their (previous) front (i.e., from the direction of Atlanta), the XVII Corps men cooly jumped to the proper side of their works, and easily drove off the attack.

When the Confederates assaulted from the flank, they withdrew stubbornly, fighting first from one side of the trenches, then the other, until they eventually formed on Bald Hill.

There the climax of the battle occurred. In ferocious assaults that continued into the dusk and then into the dark, the Rebels tried time and again to drive the Federals from their redoubt and trenches on the hill. But every time, the Illinoisans, Ohioans, Iowans, and Wisconsin men drove them back.

I am not aware of better fighting on any battlefield of the Civil War, or indeed of any other conflict.

Although the conflict around Bald Hill (sadly leveled by the construction of I-20 in the ’50s) is the most stirring part of the battle, the conflict is better known for the action around the Troup Hurt House. The Union counterattack that drove the Confederates from their lodgment in the Federal lines near that mansion is memorialized in the Cyclorama which is still on display in Walker Park in Atlanta. This was indeed an inspiring action that again demonstrated the sterling qualities of the soldiers in each army, but in my view pales in comparison with what occurred to the south on Bald Hill.

Throughout the battle, Confederates attacked ferociously, and the Union troops responded bravely and cooly, even when caught in the most exposed and dangerous positions. I defy anyone to identify a battle in which such a large number of troops (on the order of 30,000) responded as marvelously as did the troops of the XVth, XVIth, and XVIIth Corps of the Army of the Tennessee.

For the most part, they did this on their own initiative, and the initiative of company, regimental, brigade, and sometimes division officers. Their army commander, John B. McPherson, was shot dead early in the engagement. His replacement, John “Black Jack” Logan, provided inspirational leadership, but his tactical role was modest at best. The XVIIth Corps commander, Frank Blair, was far to the rear (which led many to question his courage).

Soldiers fought. Soldiers extemporized. Soldiers won.

Such individual initiative has been the hallmark of American soldiers since 1775. The Army of the Tennessee boys were recalcitrant soldiers in the traditional sense, resentful of discipline, and disdainful of spit and polish. But could they fight! They never lost a battle.

The Army of Northern Virginia is usually considered the exemplar of American armies in the Civil War, and it was indeed a marvel. But man for man, officer for officer, it could not compare to the Army of the Tennessee, especially at its July, 1864 apogee.

I have a personal connection to that Army. My great-grandmother’s brother, John Hatfield, fought in the 46th Ohio Veteran Volunteer Infantry. This unit was in Walcutt’s brigade of the 4th Division (Harrow’s) of the XVth Corps (formerly commanded by Sherman, then by Logan). It performed the signal service of defending the Union flank and rear against the attack of Smith’s Texas Brigade of Cleburne’s division. (John’s brother, Eli, had his arm shattered at the shoulder by a Minie ball at the Battle of Dallas on 28 May, 1864. My great-grandmother, who died when I was 4, talked of “Uncle Eli with the dead arm.” Medical records in the archives reveal that Eli was shot too close to the shoulder to permit amputation, so the surgeon removed all the shattered bone in his arm from the shoulder to the elbow. Ever after, the arm hung limp at his side.)

It is particularly inspiring to me at times like to consider the heroism of men like John and Eli Hatfield; their fellows in Sherman’s army; and even their foes in Hood’s Army of Tennessee. Some redeeming things came out of the carnage of the red clay hills of Georgia 150 summers ago, and these things were not sullied by craven politicians: indeed, it redeemed many of the errors and sins of the political class of 1860s America. That battle sealed the fate of Atlanta (though 6 weeks of grueling combat were to come before the city fell), which in turn sealed the fate of the Confederacy, for the fall of Atlanta secured Lincoln’s re-election, and thus the ultimate victory of the Union. And of course, that victory extinguished slavery in the United States. To have participated in such a thing is a credit to any man.

Would that today, we living Americans could be worthy of those who bled and died on a scorching day in the red clay of central Georgia, 150 years ago.

There were disturbing, but not surprising, signs today that the Obama administration is backing away from holding Putin & Russia to account in any serious way for the MH17 Massacre.

First, Obama had a call with Dutch PM Rutte while on AF1 on his way to (wait for it!) a West Coast fundraising junket. (You are shocked, I’m sure.) He said that he was “concerned” about continued Russian infiltration of weapons into Ukraine. Not gravely concerned. Not deeply concerned. That is soooo last week. Just, “Concerned”. Prediction: Next week it will be “meh.”

Second, the AP ran this very disturbing article, which describes a briefing by anonymous “Senior U.S. intelligence officials.” They bend over backwards to minimize Russia’s-and Putin’s-culpability:

But the officials said they did not know who fired the missile or whether any Russian operatives were present at the missile launch. They were not certain that the missile crew was trained in Russia, although they described a stepped-up campaign in recent weeks by Russia to arm and train the rebels, which they say has continued even after the downing of the commercial jetliner.

In terms of who fired the missile, “we don’t know a name, we don’t know a rank and we’re not even 100 percent sure of a nationality,” one official said, adding at another point, “There is not going to be a Perry Mason moment here.”

White House deputy national security adviser Ben Rhodes said the U.S. was still working to determine whether the missile launch had a “direct link” to Russia, including whether there were Russians on the ground during the attack and the degree to which Russians may have trained the separatists to launch such a strike.

“We do think President Putin and the Russian government bears responsibility for the support they provided to these separatists, the arms they provided to these separatists, the training they provided as well and the general unstable environment in eastern Ukraine,” Rhodes said in an interview with CNN.

Note the emphasis on stating what we (allegedly) don’t know, not on what we do. Note the use of the word “direct” in discussing the linkage to Russia. Classical defense attorney tactics in creating reasonable doubt about the truth of a top charge, like capital murder.

High level intelligence officials brief the press anonymously for two reasons: (1) to kneecap the administration in opposition to policies they dislike, or (2) to prepare the ground for future administration announcements or actions. The fact that the statements of the anonymous officials dovetail with what Rhodes says, (1) is highly unlikely. The fact that multiple officials are saying this further undermines possibility (1). So (2) it is.

Briefings like this do not occur by accident. They are planned. They have a purpose. And here the purpose is to shape expectations, and to lay the groundwork for Obama (and the Euros) to  move on from the horrid, ugly scenes in Donetsk and back away from any confrontation with Putin.

I therefore predict that within a very short interval, we shall see Obama sally forth, and deliver an indictment of Putin for the geopolitical equivalent of Third Degree Manslaughter: “causing the death of another person either through criminal negligence or through the commission of an unlawful act not amounting to a felony.”

Obama-with the Euros nodding furiously in agreement-will accuse Putin of negligently creating the conditions that led to the deaths of 298 innocent people, but no more. Since this is a mere misdemeanor, no harsh penalty will be demanded. Putin will be sentenced to a period of isolation from the international community, not to exceed six months. Which Vlad will probably consider this a vacation, given how much he loathes pretty much every European “leader,” not to mention Obama.

Note: this is not even a plea bargain. Putin will have to make no allocution. It is a preemptive surrender by the prosecutor.

I predict this result primarily because I believe Obama and the Euros have zero appetite to confront Putin. They can live with the low-level warfare in eastern Ukraine. (Not so low-level for the Ukrainians, of course, who have a much harder time living with it: indeed, they often die with it. But they should look out for themselves, because Obama, Merkel, Hollande, et al are casting them in the role of Czechoslovakia in a gala production of Munich!) Conversely, they blanch at the prospect of going eyeball to eyeball with Putin, even with economic weapons alone.

Of course the Panic! in the Kremlin Disco gang interpret the AP interview as “an unforced error.” A mistake that mis-states administration policy. They are invested in the belief that a steely Obama will force Putin to capitulate in panic.

Deluded fools. Denial ain’t a river in Egypt. I understand Obama and the Euros. More importantly, Putin understands Obama and the Euros. They will run to form. Meaning that they will run.

I do not write this with joy, to the contrary.

Last night I said to bet on form, and that Putin would be doing so. And indeed, it seems that everyone is reverting to form.

The Euros are talking tough and angry, but when it comes to actually doing something, pretty much nothing. As is their wont, they are squabbling over how to divide the costs. No major country will agree to sanctions that require it to bear a greater burden than other EU members. So the response is, as usual, driven to the least common denominator. Cameron proposes that future arms sales to Russia be stopped: but that conveniently lets the French proceed with the Mistral sale. Other proposals involve adding a few more names to the lists of sanctioned individuals, but no companies, and certainly no level 3 sanctions.

Perhaps taking a cue from the Europeans, to whom he has largely deferred, Obama spoke this morning and just hit the replay button. Russia risks becoming more isolated. Unless Russia acts to de-escalate, “the costs for Russia’s behavior will only continue to increase.” Yadda, yadda, yadda. A remake ofGroundhog Day, with Obama threatening costs and isolation replacing “I Got You Babe” in the soundtrack.

Check out that last phrase. Note the passive voice. Very telling. Just who, pray tell, is going to impose these costs, and how? God? Santa Claus? More seriously: The “international community”? The “community of nations”? What is the US going to do? What are you going to do, Barry?

There is no way this pablum is going to induce panic in the Kremlin. Quite the reverse. Doesn’t Obama realize that repetitions of vacuous statements unaccompanied by serious action only embolden Putin, and are exactly why we are where we are?

That question was completely rhetorical.

The only people who would panic when hearing such empty statements directed at them are those more timorous and craven than those uttering them. If such people exist.

Another disturbing fact that strongly suggests that Obama is shying away from any robust action. His statement focused disproportionately on access to the crime scene, rather than who carried out the crime itself. Although Obama has hinted at Russian culpability in the past, this statement made no connection between Russia and the shootdown. He just made a brief remark about getting the facts out there and holding people accountable.

Look. The public record makes the guilty party obvious for all to see. Obama, with access to US intelligence sources, certainly knows far more. The fact that he continues to be reticent is damning. Five days after KAL007, Reagan had given a national address from the Oval Office (not a quickie on the WH lawn), laid out in detail the case for Soviet guilt, and played tapes of intercepted Soviet communications. We are five days out, and if anything, Obama is being less forthcoming about US information on Russian responsibility.

The crime scene issue is pretty much done with now, anyways. Moreover, it is relatively easy for Putin to make pleasant noises on this issue, now that his thugs have be in control of the place for 5 days.

Further on the panic meme, this article from Bloomberg has gotten huge play. It claims that the Russian economic elite is horrified by Putin’s course in Ukraine. Maybe they are, but the article just quotes some think tank guy who claims that’s what the business class is thinking.

And it’s not as if it matters. Even if they are horrified, will they challenge Putin? Their silence-not a single one was quoted-speaks volumes. If these individuals united in opposition, perhaps they could threaten Putin. But they show no signs of doing so, and some basic game theory says they almost certainly will not. They face a coordination problem. Who will go first in opposition, and lose everything with virtual certainty?: better to stick with Putin, and take a big hit to one’s wealth but be left with something. Including one’s freedom (and maybe one’s life). Everyone  will play Alfonse and Gaston, letting the other guy go first. Trying to conspire secretly is extremely dangerous, given the inability to trust anyone and the omnipresent surveillance and informants.

So even if the business elite is horrified, and indeed panicked, this means exactly squat politically.

One last thing about playing to form. The Russian Ministry of Defense gave its X-Files versions of the causes of the destruction of MH17. The only thing that surprised me is that they did not blame HAARP, for which they have blamed crop failures, earthquakes, and the loss of a space probe. Maybe they’re holding that one in reserve, just in case the other stuff doesn’t pan out.

As the evidence of Russian guilt for the MH17 massacre mounts and becomes irrefutable, there is widespread conjecture that Putin has been backed into a corner, and that he and the siloviki may be in a state of panic. Color me skeptical. I don’t sense any panic! in the Kremlin disco.

Of course the massacre creates huge complications for Putin. But he will not even begin to panic until he is confronted with something far more threatening than has come out of western capitals in days since the atrocity.

Yes, there have been expressions of outrage. This outrage has been intensified by the desecration carried out by Putin’s thugs on the ground. But outrage is easy. Action is hard.

Here, the signs are much more encouraging to Putin. Merkel made it plain that she still thought it was essential to maintain good relations with Russia, and did not say anything serious about an increase in sanctions. France and Italy have been almost completely silent. Even the nation that suffered worst-the Netherlands-was still willing to give Putin “one last chance.”

Obama and Cameron may actually be playing the role of B’rer Fox to Putin’s B’rer Rabbit. Obama said the US will not provide arms to Ukraine, and again stated-as if this was necessary-US troops would not be deployed. Moreover, he called for an immediate cease fire in eastern Ukraine.

Well guess what. Putin is adamantly opposed to western arms flowing to Ukraine, and is also calling for a cease fire. Precisely because this would buy time and breathing space for his increasingly beleaguered creatures in Donetsk and Luhansk, and precisely because he knows that the obligations under any cease fire would be enforced asymmetrically, with Ukraine being under much more pressure from the west to conform than  the Russian proxy forces would be.

Meaning that Putin might throw Obama just like he did in Syria with regards to chemical weapons. By agreeing to what Obama has demanded, and which Germany and other Euros have demanded-a cease fire-Putin can defuse the pressure for now, and use the respite to bolster the battered rebels, and to give them time to continue to fortify the territories they hold. So by demanding a cease fire, Obama (and other western leaders) are throwing B’rer Rabbit Putin right into the briar patch.

Cameron demanded that Russia guarantee access to the site where MH17 landed. Putin could well grab at this too, and say that the only way he can do that is if Russian “peacekeepers” move in. This is another thing he’s wanted to do. (There are many pictures of armor in Russia with peacekeeping insignia painted on them.) Again into the briar patch.

But the main thing that Putin needs to do is to stall for time. He is no doubt calculating that previous spasms of outrage have dissipated rapidly, especially when corporate champions in Europe ramp up the pressure on their governments, and that this one will too. He has heard the “last chance” mantra before, and his experience is that each last chance is followed by another one. He knows that the Euros have no stomach for a confrontation, even one conducted purely with economic weapons, and that Obama has only little more appetite.

Even while the bodies remain unburied, Europe is divided over intensifying sanctions. Those divisions will only increase as time passes. And you may rest assured that Putin’s connections and agents of influence in the west are working overtime to exploit those divisions, and stoke the well-established tendencies in western governments to procrastinate and avoid confrontation. He saw it after Georgia. He saw it after Crimea. He has seen it repeatedly in the past 3 months over Ukraine.

Certainly Putin could have done without this. The massacre served no military purpose, and has interfered with his schemes in Ukraine. But it has not created an existential, panic-inducing threat to him or his regime. He views it as a setback, but one that he can manage with his usual mixture of double-talk, pacific gestures, and behind the scenes pressure exerted by his corporate allies in Europe and to a lesser extent the US.

The only thing that has the possibility of inducing anything approaching panic in Putin is for Obama and Merkel and the lesser lights in Europe to upset his calculations by playing against type. Impose crippling sanctions with the promise of removing them if Putin essentially capitulates on Ukraine, rather than threatening to impose more costs if he keeps it up.

That is, all the talk about a cornered, panic Putin is so much wishful thinking. It presumes that the shock of the event has caused western governments finally to see Putin as a monster who must be confronted robustly. There’s no evidence that this is the case even while emotions are running their hottest. And past experience suggests that the image of Putin as a monster can actually work to his advantage, because it makes timorous governments all the more intimidated from confronting him.

I would like to believe that the deaths of 298 innocents has not been in vain, and that their murders will resolve western leaders to do what it takes to confront Putin’s aggression. But I’m betting on form. And I am sure Putin is too.  He has weighed his foes, and found them wanting.