Streetwise Professor

The scariest kind of counterparty risk is “wrong way” risk.  This kind of risk occurs when there is a dependence between the size of the exposure (i.e., the amount that can be lost in the event of a default) and the probability of the counterparty’s default.  In particular, wrong way exists when the exposure is large when the probability of a counterparty default is large.

A canonical example of wrong way risk is a firm that writes a put on its own stock.  If the firm goes bankrupt, and its stock becomes worthless, it defaults.  When it defaults the exposure is as large as it can be: the strike price of the put.  In contrast, a firm that writes calls on its own stock has “right way” risk.  If the firm does badly, and indeed goes bankrupt, default losses on the call are zero because the call is out of the money.

Central counterparties–clearinghouses–are touted specifically as ways of mitigating counterparty risk.  Post-Financial Crisis, they have been particularly advanced as a means to reduce systemic risk by reducing counterparty risk absorbed by big financial institutions.  This raises interesting questions: Do CCPs have a wrong way risk problem?  If so, what implications does this have for the performance of CCPs during systemic crises?

The answers in brief: yes, they may well have a wrong way risk problem, and that means that it is dangerous to rely on them as a means of reducing the likelihood and severity of truly systemic crises.

As I noted before, the defining feature of wrong-way risk is a dependence between default probability and the size of exposure.  This is often characterized as a “correlation” between default risk and exposure.  But as I’ll discuss below, “correlation” is too limiting a concept.  Correlation implies dependency, but dependency does not imply correlation.

The magnitude of wrong way risk depends on the nature of transactions and counterparties involved.  In particular, out-of-the-money options exposures, very senior tranches of structures, and highly rated counterparties are most vulnerable to wrong way risk.  (For a good book on this subject, see Jon Gregory’s descriptively titled Counterparty Credit Risk.)

Moneyness matters because a deep out of the money option generates an exposure only if the underlying price moves a lot.  But if the underlying price and the creditworthiness of the option writer tend to move in the same direction, a big movement in the underlying that puts the option in the money also tends to be associated with a dramatic erosion in the creditworthiness of the writer. Thus exposure and default risk peak simultaneously.

The seniority of a tranched structure matters for a similar reason.  There will be losses on a senior (or supersenior) tranche only in the event of an extreme adverse shock hitting near simultaneously many of the credits underlying the structure.  If this same adverse shock puts the writer of protection on the tranche into financial difficulties, the writer is most likely to default at the same time that it is supposed to payoff on the protection it sold.  Think monolines, or AIG.

The credit quality of the counterparty matters because a high quality counterparty is likely to default on a contract only if it suffers a severe adverse shock to its balance sheet.  With the right kind–or should I say wrong kind?–of dependence between the exposure and the counterparty’s balance sheet, this big adverse shock leads to a big move in the value of the contract.  Thus, exposure is big precisely when the counterparty is highly likely to default.

Let’s see how this relates to CCPs, and in particular to the default funds of CCPs that are the ultimate backstop of cleared contracts.  Default funds are analogous to protection written on supersenior tranches.  The collateral (margin) that firms must post to CCPs when they hold derivatives positions absorbs most of the losses due to movements in market prices.  Indeed, margins are usually set to absorb 95-99 percent of market moves.  Beyond margin, CCPs often have their own financial resources to cover the losses associated with the default of any member firm not covered by margin.  If the margin and CCP-resource elements of the CCP “waterfall” (note the similarity of terminology used to describe tranched structures and CCPs) are breached, then the members must absorb the remaining default losses, up to some pre-established commitment level.

This means that CCP members must cover defaults only in extreme circumstances, just like writers of protection on supersenior tranches must cover defaults only under extreme circumstances.  Indeed, the oft-touted features of CCPs, such as collateralization create the seniority/out-of-the-moneyness that gives rise to wrong way risk if the pre-requisite dependencies also exist.

So it seems that CCPs are potentially vulnerable to wrong way risk.  They are effectively financial structures of a type that can, given the right (or wrong, depending on your perspective) dependence, give rise to a serious wrong way risk problem.  Which raises the question: are the dangerous dependencies likely to be present?  That is, are the contributors to a CCP default fund likely to be in bad financial straits just when their contributions are needed to absorb default losses? Are those that are insuring default losses (through mutualization) likely to be in dodgy condition precisely when they are most likely to have to pay off on that insurance?

Given that we are talking about tail events, it’s difficult to assess that question analytically and empirically.  But there are reasons to believe that these dependencies are in fact lurking.

A big financial shock that is sufficient to cause movements in derivatives prices big enough to breach margin levels, and/or which damages a CCP member’s balance sheet (or multiple members’ balance sheets) severely enough to force it (them) into default is likely to be associated with severe financial difficulties at other CCP member firms.  For instance, during the financial crisis all banks were cratering simultaneously and prices were moving dramatically; their stock prices all plunged together and their CDS spreads all spiked togehter.  They were all exposed to the same big underlying risk–in the event, real estate prices.  When those prices went south, all financial institutions were in distress, most of them in severe distress.  The financial tumult also resulted in big moves in stock prices, interest rates, credit prices, and commodity prices–all of which could have and did create widening exposures on derivatives trades.  Indeed, since CCPs have zero net positions, a big move in any price is going to create a big exposure for the CCP.

And it’s not just price movements that matter.  Financial and economic shocks are also associated with big changes in volatilities that affect exposures on non-linear positions (notably options or contracts with embedded options). Moreover, big volatility makes it more likely that exposure values and creditworthiness will move substantially.

Perhaps even more crucially, big financial and economic shocks tend to result in correlations in prices shooting towards one and minus one.  This has both direct and indirect effects.  The direct effect is to move–often by a lot–the mark-to-market values on correlation-sensitive positions (e.g., CDOs, multi-product options).  The indirect effect is perhaps even more pernicious, as it is exactly these high correlations between the value of assets on financial institutions’ balance sheets and the values of derivatives exposures that generate acute wrong way risks.  That is, the effects of stressed–crisis–financial conditions on correlation creates the very form of dependency that gives rise to wrong-way risk.

Liquidity effects of crises can also create dependencies.  Liquidity tends to decline during crises, which tends to increase volatilities, thereby exaggerating movements in exposures and creditworthiness.  It also makes it more difficult to manage the risk on exposures, and to trade out of positions in order to reduce exposures.  (The common liquidity shock may be one reason why correlations tend to risk towards one in absolute value during crises.)

These dependencies can be especially exaggerated for certain kinds of products and CCPs.  Consider, for instance, a CCP that clears CDS, a substantial portion of which are written on financial names, and which has financial firms for members.  Exposures tend to spike for such a CCP at the very same time its members are suffering dramatic declines in creditworthiness.  Not good.

Thus, in crisis periods, dependencies between the value of the backers of CCPs–the member firms (often banks)–and the exposures that CCPs are effectively writing protection against are highly likely to be of the wrong way variety.

This means that CCPs offer dubious protection against systemic risk.  A huge economic shock, like that suffered in 2007-2008 creates dependencies that give rise to wrong way risks.  They also give rise to big changes in exposures.  The structures of CCPs have features that are particularly vulnerable to these dependencies.

Even if a CCP does not fail during a crisis, the wrong way risk problem means that the financial institutions that backstop it will have to make payouts at precisely the times that they are under strain.  That is, CCPs load risk onto big financial institutions precisely during crises that are already stressing them.

This is not to say that CCPs cannot share garden variety default risks more efficiently than bilateral arrangements.  But that’s not what the advocates of CCPs hyped when arguing for clearing mandates.  No, these advocates repeatedly and specifically held them up as an antidote for crisis, as a bulwark against systemic risk.

The foregoing analysis of wrong way risk implies, however, that CCPs themselves are most vulnerable to default precisely at the time that their advocates look to them to be the breaks that contain financial firestorms.  Consequently, any sense of security against financial contagion that they provide is very likely a tenuous one, and arguably a false one.  Such complacency is particularly worrisome as it can undermine the urgency to find more effective and reliable measures to reduce the vulnerability of the financial system.

I am not saying that CCPs are as defective in concept as monoline insurers, or as AIG was.  (Jon Gregory argued back in 2008, and argues again in his book, that the monolines and AIG were fundamentally, fatally and irredeemably flawed.)  I am just pointing out that they share key features with those casualties of the last crisis, and as a result, may well be casualties in the next one.

It should also be noted that the Basel III capital requirements for CCPs that I discussed in an earlier post do not capture this risk in any meaningful way.  They cannot provide, therefore, an incentive to reduce it in any meaningful way.

In a classic Rocky and Bullwinkle episode, Captain Peter “Wrongway” Peachfuzz sailed his ship up Wall Street. Let’s hope that’s not a metaphor for the effect of mandated clearing.  But you should be concerned that clearing concentrates wrong way risk, and that this guy becomes the poster child for Frank-n-Dodd and its clearing mandates:

My post on the “points” system under which the CFTC would monitor positions, and then intervene on a discretionary basis when any position breached pre-set levels (“points”) brought to mind a story about the famous–or notorious, depending on your perspective–speculator, Arthur Cutten. Cutten engaged in massive speculations in wheat during the 1920s.  In 1925, he made the largest income tax payment up to that time in the history of northern Illinois–over $500,000.  Importantly, as a result of his market activities, Cutten attracted the attention–and the ire–of the government.

The Grain Futures Act of 1922 required large speculators to report their positions to the government.  Speculation continued apace despite this requirement, and the authorities were impatient to do something to stop it.  Calvin Coolidge’s Secretary of Agriculture, W.M. Jardine, demanded that the Chicago Board of Trade do something to stop the “gambling” in grain. In response, the CBT created the Business Conduct Committee.

Even in the aftermath of the creation of the BCC, Cutten continued his speculations.  Cutten bought millions of bushels of May, 1926 wheat.  The Grain Futures Administration, the division of the Department of Agriculture responsible for enforcing the GFA, “suggested to the Board of Trade that Cutten’s holdings were too large for one person” (Ferris, The Grain Traders, p. 180).  The BCC swung into action and called in Cutten for a little chat.

When Cutten arrived for the meeting May wheat was selling at $1.65/bu.  (He had bought at around $1.50/bu).  His arrival at LaSalle and Jackson* was observed, and traders soon discerned its import: wheat began selling off as he ascended in the elevator to the conference room where the BCC was meeting.

The BCC told Cutten: “the Grain Futures Administration has made the complaint that you are carrying too much open stuff.”  Cutten resisted selling, but the committee persisted.  Finally, one of the committee members put his arm around Cutten, and told him: “You ought to sell some wheat for the sake of the Board of Trade.  You know, this committee is the device we settled upon to keep the government from taking fuller control of trading in futures.  They get the figures and watch the accounts from day to day.”

Cutten still resisted: “Why should I sell before I’m ready?”  The committee member responded: “For the sake of the Board of Trade.”

Cutten finally relented.  Prices fell further.  He later lamented that the elevator ride to the BCC meeting had cost him a million dollars.

The mechanism that forced Cutten to sell looks remarkably similar to that proposed under the point system.  The government monitored large positions, and exerted pressure on a particular trader–in this case, through the CBT–and that trader eventually capitulated.

What is worrisome about this story is that the intervention that forced Cutten to sell occurred in an overtly politicized environment.  The Secretary of Agriculture, in step with a long line of Senators and Representatives viewed commodity speculation as a social ill.  Jardine had demagogued the issue repeatedly: he had dragooned the CBT into creating not only the BCC, but to mandate clearing of all grain transactions as well.  A speculator who had gained considerable notoriety for his previous operations in the market was targeted for pressure.  At least insofar as the public record is concerned, there is no evidence that the GFA or its handmaiden BCC undertook any serious inquiry to determine whether the speculator’s actions had or threatened to distort prices.  Similarly, there is no evidence that less intrusive measures were considered or proposed: to mitigate concerns about a corner, for instance, the BCC could have limited Cutten’s ability to take deliveries of wheat in quantities necessary to effectuate a squeeze.

Thus, one reasonable interpretation of the events of 1926 is that the GFA–the great-grandfather of the CFTC–intervened in the market for political purposes, rather than on the basis of a well-reasoned and empirically supported concern that the market had in fact been distorted by the actions of a particular individual.

Having watched closely–and up close–the fevered battles over commodity speculation in the past several years, I have no confidence that the same thing wouldn’t happen under the points system.  In fact,  I would put that more strongly: I have every confidence that the same thing will happen again.   Discretionary authority is subject to political pressure, not to mention the whims of regulators.  Consequently, it is inevitable that such authority will be abused.

Yesterday was the 5th anniversary of Streetwise Professor.  Time do fly.

I’ll try to keep the navel gazing to a minimum, but I think a few comments are warranted.

The blog, and most notably its reception, have exceeded all the expectations I had when I started it.  I originally envisioned it as a place to think out loud on relatively arcane issues related to financial markets and market structure, and thought that if a few readers stopped by from time-to-time, that would be nice.  It has played that think-out-loud role, but it has attracted many more readers than I had ever anticipated.  Not a huge number by blog standards, but given the rather arcane and arguably eccentric content, a surprising number.

I think a couple of things are responsible.  The first is the wholly unplanned foray into writing about Russia.  That subject generates by far the most comments, and certainly the most heated and passionate ones.  Given the fact that there would be no readily apparent reason for me to write about Russia, it has also resulted in some rather puzzled inquiries from friends and acquaintances, who have offered some rather entertaining hypotheses to explain it.

There is an explanation, convoluted, but an explanation nonetheless.  Several interests serendipitously converged on the subject of Russia.  I attended the Naval Academy in the Cold War, which generated an initial interest in Russia.  I took a year long Russian Civilization sequence at the University of Chicago after I transferred from Navy, taking classes from major scholars Arcadius Kahan and Richard Hellie (both now passed, sadly), which fed that interest.  The interest went into hibernation as I launched into my profession, but as my career developed, I became deeply involved in energy issues (an unexpected departure in its own way with its own story), and also became very interested in institutional economics issues, including property rights economics and political economy.  Russia represented a fascinating case study regarding energy and institutions, and that’s what started me down the path of Russian commentary.  After that, my tendency towards serial intellectual obsessions (which started with Civil War history as a kid) took over, and led me to read and write more; one damn thing led to another, and reading about one thing led to related issues and on and on.  Conditioned response played a role too: I naturally wrote more about the subjects that generated the most feedback.

The second major factor explaining SWP’s unanticipated trajectory was the financial crisis.  As a result of the crisis, aracana that I’d written and researched about for years–financial market structure and clearing, most notably–to the collective indifference of a big swathe of the economics/finance academy all of sudden became extremely topical.

It’s funny, actually.  In October, 2008, (note the timing) I received a rejection letter from a journal for a paper I’d written about the economics of clearing and OTC markets and which had been under review since mid-2007.  The letter said that the topic was of insufficiently general interest to warrant publication.  (It took 18 months to figure that out?)  Well, virtually all of the issues discussed in that paper were soon at the center of debates over financial reform and clearing mandates.  If the journal had actually published it in a timely manner, the editor would have looked prescient.  Instead . . .

But the blog gave me the opportunity to write about topical things in a timely way without having to deal with editorial gatekeepers (whose value added is not necessarily positive).  Although I know a number of who come here to read about Russia, or broader financial issues, groan when they see another clearing post or market structure post, these have served their role as first drafts for some serious academic work, and moreover, have had some influence in business and policy circles.  I’ve been gobsmacked on more than one occasion when some pretty prominent people have mentioned a specific blog post–by title–that had influenced their thinking.  I’ve also had the pleasure of hearing, sometimes directly, sometimes through back channels, that I’ve ticked off a few people.  Given who said people are, I consider it an honor.  I’ve been warned that if I want to have more influence, I need to be more politic.  (The other day somebody at a major financial institution told me that I risked being burned for heresy.)  Well, that cuts against my personal (Jacksonian) grain, and what’s more, being “politic” usually involves pulling punches and leaving important things that need to be said unsaid.  So, that’s not likely to happen.

Where will things go from here?  Who knows?  The moral of the story so far is that the trajectory of SWP is highly contingent on developments in finance, regulation, and yes, Russia, and those are all extremely dynamic.  The subject matter will probably stay in the same general ballparks–financial markets, especially their regulation; Russia; energy; climate issues from time to time–but the specifics will depend on how the world turns.  And the past five years have shown that the world does turn in highly bizarre directions.

I appreciate all of you that have come to visit SWP over the past five years.  It is truly gratifying, and completely unexpected.  It’s been an interesting and rewarding five years, and I look forward to engaging with you all in the years to come.  Thanks, and Happy New Year.

In October, 2007, I wrote a post titled “Cocaine Blues” in which I noted the association between oil prices, and Soviet/Russian aggressiveness/obstreperousness/cussedness/hey-ma-look-at-me-top-of-the-worldness.

Anne Applebaum just noticed the connection:

Why the change of tone? Why now? Many complex theories have been hatched to explain it. This being Russia, none can be proved. But perhaps the explanation is very simple: Oil is once again above $90 a barrel – and the price is rising. And if that’s the reason, it’s nothing new. In fact, if one were to plot the rise and fall of Soviet and Russian foreign and domestic reforms over the past 40 years on a graph, it would match the fall and rise of the international oil price (for which domestic crude oil prices are a reasonable proxy) with astonishing precision.

To see what I mean, begin at the beginning: In the 1970s, oil prices began to rise significantly, along with the then-Soviet Union’s resistance to change. The previous decade (with oil prices at $2 or $3 a barrel, not adjusted for inflation) had been one of flux and experimentation. But after OPEC pushed prices up in the 1970s, oil revenue poured in – and the Soviet Union entered a period of internal “stagnation” and external aggression. Soviet leader Leonid Brezhnev invested heavily in the military, halted internal reforms and in 1979 (when oil was at $25 a barrel) – invaded Afghanistan.

Brezhnev was eventually followed by Yuri Andropov, who had the good fortune to run the Soviet Union when oil prices were still high (at his death, in 1984, they averaged $28 a barrel). Andropov could thus afford both an internal crackdown on dissidents and a continued tense relationship with the West. But Andropov was followed by Mikhail Gorbachev, who took over just as prices plunged. In 1986 (with oil down to $14 a barrel), he launched his reform programs, perestroika and glasnost. By 1989 (when oil was still only at $18) he allowed the Berlin Wall to fall, freed Central Europe and ended the Cold War.

Prices fluctuated, but they did not really rise again in the 1990s (plunging as low as $11 in 1998), the years when Boris Yeltsin was still trying to be best friends with Bill Clinton, the Russian media were relatively free and there was still talk, at least, of major economic reforms. But in 1999 (when oil prices rose to $16 a barrel), Yeltsin’s prime minister, Vladimir Putin, launched the second Chechen war, the West bombed Belgrade, and the mood in Russia turned distinctly anti-Western once again.

The fortunate Putin took over as president in 2000, at the start of a long and seemingly inexorable rise in oil prices. Indeed, Gorbachev’s calls for internal reform were long forgotten by 2003 (when oil prices were creeping up to $27 a barrel). The days when Yeltsin pushed for Russia to join Western institutions were a distant memory by 2008, when Russia invaded Georgia (and oil was at $91 a barrel).

The new Russian president, Dmitry Medvedev, did try to sound nicer in 2009 (when oil prices averaged about $53 a barrel), leaving Putin, now the prime minister again, grumbling in the background. Medvedev locked a draconian treason law, invited democracy activists to the Kremlin, denounced the Belarusan dictator and even seemed to some to have liberalized Russian television just a bit.

But now it is 2011, Putin is very much in the foreground, and Khodorkovsky has just been sentenced by a kangaroo court. As I write these words, oil is at $92.25 a barrel.

Is this analysis too simplistic? Sure it is. But I haven’t yet heard a better explanation.

That’s because there isn’t one.

And as Sergei Guriev and Aleh Tsyvinski note in their “Challenges Facing the Russian Economy after the Crisis” (in the volume Russia After the Global Economic Crisis, Aslund, Guriev, and Kuchins (eds.)), this is a big problem for Russia’s future:

Russia’s internal problems relate to the “resource curse.”  If oil prices remain high, Russia will probably delay much-needed economic reforms.

. . . .

But in Russia it is especially problematic [to improve economic and political institutions] as the ruling elite is not interested in building such institutions.  The “resource curse” provides and explanation.

Guriev and Tsyvinski argue that higher oil prices are antithetical to the political reforms that Russia requires to become a truly modern, innovative, entrepreneurial economy and more humane polity.  To which I would add they are also antithetical to the development of a more neighborly, less revisionist Russian foreign policy.

There’s another interesting implication of the rising oil price that hasn’t drawn attention, at least that I’ve seen.  In particular, it will intensify conflict between Gazprom and its customers.  Gazprom has historically sold gas under contracts with prices tied to the price of oil.  But oil and gas prices have diverged in recent years (for a variety of fundamentals-based reasons).  As a result, Gazprom’s big European customers want to change the contract terms and pricing, but Gazprom does not–and that’s an understatement.  The increase in oil prices has increased the divergence, putting Gazprom’s gas prices even more out of line with cash market values.  Which will only crank up the tension between Gazprom and its customers.  And since there is nothing that happens to Gazprom that doesn’t have a political angle, this will result in some political tensions as well.  (EG, how will BFFs Berlusconi and Putin deal with the issue?)

In a nutshell: higher oil prices will stymie domestic reform in Russia and fuel external tensions.  A fun time will be had by all, because Putin et al can’t lay off that whiskey, and let that cocaine be.

A couple of days back the WSJ ran a rather long article about the demise of the pork bellies contract at the CME. The story has an interesting historical angle, because about 50 years ago the bellies saved the Merc from its own demise.  In the 1950s, onions were the exchange’s lifeblood–its only really active contract–and onion trading was banned in 1958.  The Merc leadership seized on pork bellies as a replacement, and the contract was introduced in 1961.  It soon became a success, and likely saved CME from oblivion.  Given that the CME is now the world’s dominant futures exchange, and has been among the most innovative exchanges since the 1970s, the onion-pork belly saga is one of those contingent events that influenced the way the history of a major industry evolved.

It’s nice that the WSJ spilled some ink on the subject, but the economics in the article is something of a muddle.  Or, perhaps, to be charitable to the writers, they are channeling some muddle thinking.

To wit, the article states that in the absence of an actively traded pork belly contract, market participants have no reliable information about prices:

For independent bacon processors, the decline of the pork-belly futures contract has meant that belly prices are becoming a mystery. The amount they pay for spot bellies is now based on a daily price quoted by the Agriculture Department, which collects it from producers on a voluntary basis.

So what’s the proposed solution?  Cash settlement:

The CME and industry executives are trying to rejuvenate the pork-belly future. The exchange is looking at modifying some of the contract’s specifications, such as allowing traders to settle in cash instead of actual slabs of meat. Currently sellers, if holding a contract through expiration, must deliver 40,000 pounds of inspected frozen pork bellies with a producer certificate within 15 days, and a buyer must take possession. Another exchange idea: to trade fresh pork bellies instead of frozen ones.

“We are keen to change things as soon as we can,” said Tim Andriesen, managing director of commodity products at CME.

. . . .

Changing the contract from physical settlement to cash settlement could help. Financial traders have largely shunned the contract because it requires buyers to take possession of massive quantities of meat.

“For a contract to be successful, you have to have fund participation” from hedge funds and commodity funds, said Dan Norcini, an independent livestock trader in Idaho who has been trading commodities for more than 20 years. “There’re not enough volumes for them to move in and move out.” Mr. Norcini stopped trading pork bellies about three years ago.

So, because of the lack of active futures trading there’s no good information about cash market prices, so the contract should be changed to cash settlement to rejuvenate futures trading.  How does that work, exactly?  The circularity is dizzying.

Whenever a contract exhibits problems, regardless of the cause, it is too often the case that the knee-jerk response is to call for cash settlement.  (As another example, consider calls for cash settlement to fix perceived problems in wheat convergence.)  Usually this response is completely irrelevant to the contract’s real problem.

Cash settlement works if there is an independent, reliable, relatively unmanipulable source of cash market prices that can be used to set a futures price at expiration.  The markets for which these conditions prevail is very, very small.  Cash settlement works in equities for contracts like the S&P500/eMini because there is an active, transparent cash market for stocks.  It works pretty well for live hogs because the USDA collects data on the price paid for every animal bought by processors.

Beyond those examples, cash settlement is problematic, or in many cases, actually counterproductive.  In the late-90s/early-00s, cash settlement in natural gas indexes was rife with misreporting and fraud.  In 2008 I wrote a few posts about reports that banks were putting the lie in LIBOR.

Virtually no commodity market has enough active, transparent cash markets to support cash settlement.  In grains and soybeans, cash prices reported by the USDA are bids and offers from country elevators, barge loading terminals, and processors.  These aren’t bona fide cash transactions, and if these prices were used as the basis for futures settlement prices the temptation for the kind of monkey business that went on in nat gas in the Enron days would corrupt the grain business too.

Frequently the developments that create problems for a particular delivery-settled contract would create problems for cash settlement too.  For instance, the decline in terminal grain markets–most notably Chicago–created problems for the Chicago-based delivery system for corn, wheat, and soybeans in the 1970s and 1980s.  But the decline in terminal grain markets also meant that there were no longer vibrant centralized cash grain markets that could have been used to settle futures contracts.

In commodities in particular, the facts that futures markets are the locus of price discovery, and that market participants rely heavily on futures prices to set cash prices means that cash settlement is often problematic due to the circularity problem I mentioned earlier.

I would also note that, contrary to conventional wisdom, cash settled contracts are not necessarily less vulnerable to market power manipulation that delivery settled ones.  As I showed in a 2000 JOB paper, it is always possible to design a delivery settled contract that is less vulnerable to long market power manipulation than any given cash settled contract, but this delivery settled contract is more vulnerable to short market power manipulation.

Furthermore, the assertion that delivery creates headaches that financial players want to avoid should not be taken seriously.  Financial players trade vast amounts of delivery-settled contracts in a wide variety of commodities from aluminum to corn to crude to wheat to zinc.  (Indeed, isn’t that what keeps Bart Chilton up nights?)  They can–and do–liquidate/roll their positions before they need to make or take delivery.  (Which is why Bart should sleep better.)  The folks active in the delivery market are those who have the expertise and infrastructure to handle the physical commodity.  And ironically, some financial players are realizing that it can be quite profitable to develop that expertise and invest in that infrastructure for some commodities.

Finally, it should be recognized that delivery settlement has a compelling advantage.  At delivery, people have to put their money where their mouths are.  If they think futures prices at expiration deviate from cash market values, they can make or take delivery to take advantage of that perceived disparity.  Delivery is a bona fide transaction: an exchange of the thing for money.  Prices are intended to measure the terms of such transactions, and delivery–or the mere potential for delivery–ensures that happens.  In contrast, with a few exceptions, with cash settlement it is often very, very difficult to collect data from such bona fide transactions, or to execute the trades necessary to exploit perceived divergences between cash values and futures prices (with stocks again being an exception).

It’s long been known that most futures contracts fail because underlying conditions prevent their viability.  Frequently, these underlying conditions relate to industry structure (with vertical integration, for instance, being inimical to futures trading) and marketing practices.  These conditions can evolve over time, making once thriving contracts no longer viable.  That’s what’s happening in bellies, and cash settlement is not a magic formula that will change that.

My post on the Khodorkovsky verdict elicited a very nice comment from Deirdre McCloskey, whose “Bourgeois Dignity” hypothesis I had applied to Russia and its prospects for change.  The comment was–is–greatly appreciated, and in responding, another connection came to mind that deserves mention in a separate post.

McCloskey argues that the revolution in thought and attitude that laid the foundation for the miracle of modern economic growth began with the Dutch in the 17th century.  She notes that the “revaluation” of commercial and entrepreneurial activity began in the United Provinces, and that this elevation in the social status of merchants and entrepreneurs led to a flowering of technological and organizational innovations that was the real source of the explosion in incomes that occurred first in the West, and then worldwide.  Her arrow of causation is: beliefs/values/rhetoric=>innovation.  The former is a necessary condition for the latter.

In thinking about this in the context of Russia, what came to mind was that Peter I traveled (incognito) to Holland early in his reign and was astounded by the technology.  He attempted to bring as much of it back to Russia–a nation he considered backwards–as he could, in the hopes of wrenching the country into modernity.

But if McCloskey is right, Peter saw the results of a deeper underlying cause, but missed that cause altogether.  He saw the material technology, but missed entirely the social and intellectual and rhetorical and spiritual revolution that spawned it.  What was innovative about Holland was not its ships or its manufactures.  Instead, what was innovative–revolutionary–about Holland was its beliefs and bourgeois ideology.  Those created the conditions in which innovation flourished.

But Peter completely missed that.  He saw the superficial but missed the essential, and tried to make Russia modern using methods that were inimical to the Bourgeois Virtues (as McCloskey calls them).  Bringing Dutch technology to Russia, but deepening and intensifying Russian autocratic, anti-bourgeois institutions and values did not result in a self-sustaining modernization as was experienced in Holland, and later elsewhere in Europe.  That is consistent with McCloskey’s hypothesis: in her story, it is the beliefs and rhetoric that give free rein to human creativity that generate the innovation.  By failing to understand that, Peter failed to make Russia truly modern, and a center of self-sustaining innovation.

This is not a matter merely of historical curiosity.  For Peter’s attempt to achieve technological modernization while maintaining patrimonial institutions has been repeated throughout Russian history.  Indeed, yet another attempt is in progress today, with Skolkovo as the exemplar.  Elements in the Russian state want technological modernization, but don’t want social and political and intellectual freedoms (which they identify with “chaos”) that are the source of technological progress.  Again, McCloskey’s hypothesis would imply that this is a fool’s errand, and will turn out badly, as it has repeatedly throughout Russian history.  Which brings to mind Einstein’s definition of insanity which is the title to this post.

Daniel Harvey Hill was an acerbic, cantankerous general in the Confederate Army during the Civil War.  (And, interestingly a former college professor and future university president.)  When a member of a North Carolina regiment in Hill’s command applied for transfer to the regimental band, Hill denied it with the endorsement: “Shooters needed more than tooters.”*

Apparently D.H. Hill’s spirit has been reincarnated in Russia:

With only two weeks remaining before the new year, the moment of truth on conscription has come. Even now, as police in the major cities are busy trying to prevent clashes between ethnic Russians and people from the North Caucasus, many police officers are being diverted from their primary duties to rounding up conscripts. Recruiters are feeling a lot of pressure because the law requires that the 2010 conscription be completed by Dec. 31, and they are way off on their numbers.

This may explain an early morning raid on a dormitory at the Moscow Conservatory of Music to round up about 40 flutists and clarinetists.

Somehow the thought of an army of conservatory students hardly sends shivers of fear down the spine.  And can you imagine how those gentle souls will be treated in the barracks–so no doubt shivers of fear are definitely going down their spines.

This manifestation of desperation, combined with the too-ing and fro-ing over a contract army, reveals the hollowness of the Russian military.  It also makes Medvedev’s and Putin’s tooting (or would that be tweeting, in the case of the former) over the expenditure of over $600 billion on new weapons over the next ten years look utterly farcical.  Who, pray tell, is going to operate this vast panoply of weaponry?  Somehow, clarinetists in fear for their lives, ignorant (and angry) villagers from the Caucasus, and the left-tail kids not clever enough to avoid the draft, or with such bad prospects outside the army as to make it the best option, is not the stuff out of which a modern military is made.

But just imagine the bribery possibilities that come with spending $600 billion!  And all the propaganda that can be spun around shiny new weapons (never mind the lack of trained, career servicemen to use them properly).  Russia: graft meets the Wizard of Oz (“pay no attention to that little man behind the curtain!”) Look at things that way, and what appears to be quite insane makes perfect sense.

* Hill’s biographers, Bridges and Gallagher titled their book “Lee’s Maverick General.”  They relate another version of the story, in which the band requested a group furlough, which Hill denied with the endorsement “Shooters before tooters.”

I have very mixed emotions–believe me–to learn that State Department cables on Russia often read like SWP posts.  (Or is it vice versa?)  This cable from Wikileaks (h/t Sean’s Russia Blog) in particular resonates: it describes the intensity, the presentness, of history and its interpretation in Russia.  I have written, only half in jest, that when I want to juice the comments, all I have to do is write a post on Russian history, and away we–or I should say, you–go.  And where you go is completely unpredictable.

The cable even has a section heading using a quote that I’ve used before, Faulkner’s line: “The past is not dead; it is not even past.”

This bit made me chuckle:

8. (C) XXXXXXXXXXX said he suspected that at least some of the pro-Kremlin bloggers who participate in these historical debates were professionals in the pay of the GOR (and perhaps special services).

All right, anybody feel in a confessional mood?  Come on now, fess up.  Ha!  No, I am sure that all of you are arguing in your spare time (at the 3:39 mark).  Which gives me a greater sense of personal satisfaction, actually.

Actually the main thrust of the cable is pretty optimistic.  Its conclusion is along the lines of the old Soviet joke, “they pretend to pay us, we pretend to work.”  The conclusion could be phrased as: “They pretend to crack down, we pretend to obey”:

9. (C) The fact that Russia currently lacks such a “historical propaganda” institution has thus far prevented any widespread attacks on academic freedom in the name of “anti-falsification.” XXXXXXXXXXXX, told us October 27 that he had heard no reports from any of his MGU colleagues of any pressure on them to present teaching materials or name names in order to ferret out “falsification.” He attributed this at least in part to the fact that, in contrast to neighboring Belarus, Russia has no Ideological Department which examines all teaching materials in schools and universities. XXXXXXXXXXXX also cautioned against leaping to Orwellian conclusions, reminding us not to “underestimate the cynicism” involved in administrative requests like the one at RAN. “Everyone knows how to take such requests,” she said; the request from the government is “ugly,” but unlike in Soviet times, when professors all depended upon the government for their currently there is no way to enforce such decrees. As a result, according to XXXXXXXXXXXX, “people wink”; the administrators, while passing along the government’s request, make it clear to their subordinates that they themselves do not support it. XXXXXXXXXXXX pointed out that many historians may be outraged at the government’s heavy-handedness and its “real falsification of history,” but they don’t see themselves as a unified force. The simplest response is to use the power of inertia, and to stonewall passively.

The analysis argues that the main purpose of these falsification campaigns is to serve as boob bait for internal political consumption:

Goal of GOR rhetoric: score political points at home

10. (C) For the GOR’s part, it held a session of its Commission during the summer, and its director claimed that participants were “not here to censor, but simply to oppose” perceived attempts by other countries to gain at Russia’s expense on the geopolitical scene. Although the stated focus is on international disputes, the GOR’s primary audience for its hardline stance is domestic. Rhetoric defending Russia’s honor on the international stage scores easy political points for the GOR at home.

That said, the report does cite at least one disturbing instance of a crackdown:

More recently, on October 14, the Moscow Times reported that the German government had written a letter to President Medvedev complaining about an investigation into an Arkhangelsk historian, Mikhail Suprun, for “violating privacy rights” by researching deportations of Soviet Germans under Stalin. The police official who gave Suprun access to the archives is also accused of “abuse of office,” while Suprun could receive up to four years in prison, and has had what he called “a lifetime’s work” on computers and research data confiscated by the Federal Security Service (FSB).

It is well known that the imposition of a large punishment with a small probability can be an efficient means of deterrence.  So making of an example of a Suprun and his police collaborator can be a far more effective way of achieving the goal of limiting dissent and heterodoxy than a broad, Soviet-style crackdown: it is hard to measure the extent of self-censorship that occurs as a result of the prospect of playing, historical Russian roulette with “GOR.”

Several times on the blog I’ve mused whether our current situation resembles more the 1930s or the 1970s.  As developments occur, I’m leaning more towards the former (although admittedly it is better to have the rogue states be Iran and North Korea, rather than Germany, Japan, Italy, and Russia, but even then the presence of nukes in the equation limits the comfort one can find in that).  Renowned foreign policy scholar Walter Russell Mead is of a similar mind.  He hearkens to Auden’s despondent 1939 poem, and is dismayed at the puniness of the world’s statesmen (and women) in the face of the current crisis.

He spares virtually no one.  Europe comes in for particular criticism, and very rightfully so.  To watch the delusional performance of the European “leadership” in its efforts to patch the gaping wounds in the Euro project (both the political and economic aspects)–which is doomed, utterly, in my view–is painful.  They are so wrapped up in their dream that they defy reality.  Mead is also quite critical of Japan–again with more than good cause.  He is also harsh in his judgment of the US, but he does not elaborate much on that in this post because he has made his case at length elsewhere.

The most interesting parts of Mead’s analysis pertain to China and Russia.  His analysis of China’s pressing problems, and the leadership’s apparent inability to cope with them, is a useful antidote to the conventional wisdom of China as Colossus, striding from triumph to triumph.  (To those with long enough memories, current portrayals of China evoke the popular image of Japan, circa 1988: although no analogy is exact, the utter failure of conventional wisdom in that instance should give pause to the advocates of the conventional wisdom regarding China, circa 2010.  Are you pausing, Tom Friedman?)

Since this is a periodically Russia-centric blog with a Russia-centric (and often Russia-obsessed) readership, I’ll quote his analysis of Russia in full:

If Europe offers the most shocking example of incompetence, and China faces the greatest possibility of explosion and crisis, Russia’s current suicidal course may be the most tragic example of poor policy intersecting with cultural failure to drive a great people down.Emerging from the sordid shadows of the Soviet Union, Russia faced four great challenges.  It needed to come to terms with the horrors and failures of the past, recognizing the enormous evil that Russia both suffered and inflicted during the Soviet period.  Just as Germany had to come to terms with the Nazi past to build a better future after 1945, Russia had to face the ghosts of Bolshevism and Stalin head on.  It has failed, and Russian life and culture remain poisoned by the residue of unrepented horrors and uncomprehended crimes.

Second, Russia needed to build a modern and competent state that in turn could provide the framework for a new economy and a new society.  Without a full reckoning with the Soviet past — and a full encounter in particular with the evils perpetrated by its security forces — this was not possible.  Nevertheless Russia has fallen well short of what it might have accomplished.    I remain glad that Vladimir Putin halted the disintegration of the Russian state that was visibly under way during the Yeltsin era, but with every passing year the critical failure of the Putin presidency to build the stable institutions and solidify the rule of law that a genuinely strong Russian state would require becomes more clear — and more costly.

The third task, of building the kind of capitalist economy that could provide its citizens with dignity and affluence, has also been left undone.  There is no one who thinks that the rule of law is secure in Russia, or that investors (foreign or domestic) have any real security for their investments.  Accumulating failures of governance ensure that Russia cannot enjoy the full benefits of its natural resources and this unhappy society remains a source of concern and confusion for itself and its neighbors.

The fourth task, of finding a suitable world role for a new Russia, has also been decisively botched.  Russia has no real friends anywhere in the world; there are those it can bully and those (a much greater number) that it can’t.  The United States, Germany and China all seek good relations with Moscow; no one trusts or respects it.  Prime Minister Putin’s recent visit to Germany, a country that quite recently hoped that stronger economic relations with Russia would be a cornerstone of its national strategy, was an embarrassing flop.  Putin’s call for a free trade zone including Russia and the EU was dismissed by Chancellor Angela Merkel; the Russian leader reportedly spent more time with the discredited former chancellor Gerhard Schroeder (who now works for Gazprom) than in substantive talks with German officials.

Russia’s failures in this department are not simply its own fault.  The United States, NATO and the EU have been horribly shortsighted in their Russia policies.  Since 1989 there have been two great western projects in Europe: the expansions of both NATO and the EU.  NATO expansion was seen by Russia as a great threat; EU expansion has the effect of marginalizing Russia both economically and politically.  While Russia’s own many failures and bad behavior did much to determine the west on this course, paying so little heed to Russian interests and sensibilities was unwise; now both Russia and the west must cope with the unpalatable consequences.

It is intriguing that Mead puts Russia’s need to come to grips with its past as its foremost challenge, and its greatest failure.  That resonates with many of the intense debates over Russia’s Soviet legacy that have taken place in the SWP comments.

I would say that Mead’s analysis is pretty fair (although I am sure that there will be outraged denials: bring ’em on, folks.)  Even the last paragraph has merit, although I would probably give more weight to the conclusion that “Russia’s own many failures and bad behavior did much to determine the west on this course.”  The EU’s marginalizing effect also reflects what little Russia had to offer those who were clamoring to get into the EU and NATO.

There’s not much grounds for optimism in what Mead writes.  But that’s because there’s not much room for optimism in the current situation.  Reveries have been dashed, but realities have not been grasped.  Good things seldom come of that.

Not surprisingly, the recent post on Russia’s new law on history sparked numerous comments. Also not surprisingly, the comments careened in a surprising direction, specifically, Russia’s role in WWI.  One skein of that argument was whether Russia saved France by eschewing in 1914 a plan to stand on the defensive against Germany, and instead mounting an offensive that distracted Germany enough to permit the French to fend off the German attack at the Marne.

This exchange spurred me to look at a couple of books on my shelf, William C. Fuller Jr.’s Strategy and Power in Russia, 1600-1914 and Kissinger’s Diplomacy.  These sources put a much less favorable light on Russia’s actions in the lead-up to Europe’s Armageddon.

Fuller argues that Russia’s agreement with France to attack Germany was part of a quid pro quo to get French assistance against Germany.  Russia was convinced that a war against Austria-Hungary was highly likely.  Moreover, it calculated that Germany would intervene on Austria’s behalf because it could not countenance the defeat of its only major ally.  But Russia could not beat Germany and Austria, so an alliance with France was imperative.  As Fuller puts it “[i]n 1912 the Russians began a desperate effort to re-cement the French alliance.”   He says further:

At the staff conversations of 1912 and 1913 the Russians tried to buy French good-will by promising to attack Germany with 800,000 men by the fifteenth day after the declaration of mobilization.”  [p. 439]

Fuller goes into more detail about the forces driving Russian thinking.  He notes that Russia’s tenuous position in Poland and its fear that Austria-Hungary would take advantage of Polish discontent led it to conclude that simultaneous attacks against Germany and Austria were imperative: “If Russia’s alliance policy compelled it to plan to attack Germany, it was its nationality policy that in the end made a simultaneous attack on Austria inescapable . . . . To attack Austria alone would be to imperil the French alliance and was consequently unthinkable.  To attack Germany alone was to risk the Austrian conquest of Poland.” [p. 441]

With respect to Russia’s ability to carry out these plans, Fuller notes how Russia’s pendulum swings between Asia and Europe led it to shift its forces to the east, thereby compromising its ability to fight Germany and Austria in the west.  Similarly, its Asian focus led it to stint on railroad building in Poland, which also compromised its ability to mass in the west.

Kissinger is even more critical of Russian policy.  Indeed, he even puts the blame on Russia for the “military doomsday machine” of responses to mobilization that culminated in the catastrophe of August, 1914.:

The first step in this direction occurred during the negotiation for a Franco-Russian military alliance.  Up to that time, alliance negotiations had been about the causus belli. . . .

In May 1892, teh Russian negotiator, Adjutant General Nikolai Obruchev, sent a letter to his Foreign Minister, Giers, explaining why the traditional method for defining the causus belli had been been overtaken by modern technology.  Obrucev argued that what mattered was how mobilized first . . .

Far from deploring the prospect of automatic escalation, Obruchev welcomed it enthusiastically.  The last thing he wanted was a local conflict. . . .

According to Obruchev, it was in Russia’s interest to make certain that every war would be general.  The benefit to Russia would be a well-constructed alliance with France would be to prevent the possibility of a localized war. . . . [a] defensive war for limited objectives was against Russia’s national interest. . . . However trivial the cause, war would be total; if its prelude involved only one neighbor, Russia should see to it that the other was drawn in.  Almost grotesquely, the Russian general staff preferred to fight Germany and Austria-Hungary jointly than just one of them.  A military convention carrying out Obruchev’s ideas was signed on January 4, 1894.  France and Russia agreed to mobilize together should any member of the Triple Alliance mobilize for any reason whatsoever.  [pp. 202-203; emphasis in original]

Kissinger notes that there were dissenting voices, notably Peter Durnovo, a former Interior Minister.  But from 1894 up through July-August, 1914 Russian policy was committed to fighting Germany and Austria-Hungary simultaneously.  Even when the Tsar tried to mobilize only against Austria-Hungary during the Sarajevo crisis, his military (“without exception disciples of Obruchev’s theories”) forced him out of it.  Kissinger also argues that Russian commitment to support Serbia was not completely rational, but was driven by concerns of reputation and honor and loss of face in the Balkans (evocative of Thucydides’s claim that men go to war out of fear, honor, and interest).

The rest of Kissinger’s (and Fuller’s) discussion of the beginning of WWI makes it plain that every power made calculations that contributed to that world catastrophe.  But Russian calculations were quite important in shaping the outcome, the ultimate consequence of which was, of course, the destruction of the Russian Empire and the Tsarist system.  This ended what one commentor noted was a period of remarkable economic and social transition in Russia.

I don’t know enough about this particular subject to do more than summarize what Kissinger and Fuller state.  I’m sure there are dissenting views.  And I’m sure they will be voiced, and strenuously, in the comments.  I look forward to that with anticipation.