Streetwise Professor

I’ve often written that every big move in commodity prices leads to a reprise of Casablanca: “Round up the usual suspects!”

The usual suspects, of course, being speculators.

And here we have a case of the usual suspects calling for a roundup of the usual suspects. People like Michael Greenberger and Tyler Slocum. I would be more than glad to move on. Them apparently not so much.

Now they feel especially energized because they can blame speculators not just for a rise in the price of this or the price of that, but the price of everything. Yes, boys and girls, speculators cause INFLATION!!!!! THEY ARE DRIVING UP THE PRICE OF EVERYTHING!!!!

A handful of congressional Democrats are turning their attention to an arcane loophole that, as TYT previously reported, is driving high prices for gas and food. Rep. Ro Khanna, D-Calif., told TYT that he wants the Biden administration to close the loophole, which lets Wall Street speculators gamble on commodity prices, driving inflation.

I’ll get back to “Ruh Ro” Khanna in a moment.

What Greenberger and others are serving up is the same-old, same-old that was discredited long ago. It’s too tedious to reprise the arguments: go back and look at my posts from 2006-2009 or so. The BS hasn’t changed, so the response to the BS hasn’t changed.

The quickest counterpoint: If–and even Paul Krugman and I agree on this, people, so the apocalypse must be nigh–speculators are driving prices above the competitive level determined by supply and demand fundamentals, (a) inventories increase, and (b) speculators hold the inventories.

Well, inventories are dropping to rock bottom levels in everything from oil, to diesel, to industrial metals. So (a) isn’t happening. And if (a) isn’t happening, (b) can’t happen.

QED.

But this would require Greenberger et al to have a modicum of understanding of economics. In fact, I once forced him to admit he has no such understanding.

We were witnesses at a House Ag Committee hearing on speculation and oil prices in July, 2008. Right about the time WTI hit its all time high. (I published a WSJ oped about the same time.). Greenberger and I were on a panel. He tried to make an argument that prices were irrational because they hadn’t gone down when the Saudis announced an increase in output. I pointed out that the real shortage was in low-sulfur crude (like WTI), driven in large part by Europe’s new low sulfur diesel rules. The Saudi oil was high in sulfur and didn’t address this issue at all, so it didn’t impact the prices of WTI and Brent (which are low sulfur).

In reply, Greenberger stuttered: “Well, I’m not an economist . . .” I interrupted: “That’s the first thing you’ve ever said that I agree with.” (Yeah. I know I’m bad. I can never pass up an easy shot.)

That still holds true. He ain’t an economist. He knows no economics. And anybody who listens to him bloviate about economics is wasting time and killing brain cells. (Though looking at his audience–Salon AKA Daily Dipshit readers, congressional Democrats–that latter is pretty much impossible.)

These geniuses think they’ve uncovered some damning new evidence. In footnotes:

But thanks to an obscure CFTC passage — Footnote 563, in regulatory guidance — buyers and sellers of oil and other commodities are outnumbered something like 10 to one by Wall Street traders, none of whom have a genuine buyer’s incentive to keep prices low, because few of them ever actually buy it; they mostly bet on it.

Uhm, that factoid, or a variant thereon, has been tossed around every time this tiresome debate has occurred. It was irrelevant every one of those times. It’s irrelevant now. It means nothing.

But some geniuses in Congress are going to flog this dead horse yet again. FFS.

But this is not the only idiocy that is being resurrected. Ron Wyden D-But you knew that-OR is proposing a revival of the windfall profit tax.

Another ’70s acid flashback. I’m trippin’, man!

pic.twitter.com/Wxw4EMk27e

— streetwiseprof (@streetwiseprof) June 14, 2022

Yeah that worked so well under Carter. Hey! Here’s an idea! Let’s reduce the incentive to invest by reducing payoffs when the investments are most valuable! What could go wrong?

Another hardy perennial: Our ranting senile narcissist in chief is demanding refiners cut prices and increase output. Er, look at the EIA capacity utilization numbers, dude. Refineries are operating flat out.

Apparently they did that, because today they mooted restricting exports instead. Another dumb idea.

And then there’s Ruh Ro Khanna:

Thanks for the heads up on "Ruh Roh" Khanna's insanity. I'll do a little more research and then bring the lumber to him. pic.twitter.com/WOn6Ls9l8X

— streetwiseprof (@streetwiseprof) June 3, 2022

h/t @CantillonCH

Khanna’s brainstorm is–get this–to have the government “buy the dips” and then sell commodities to consumers at low prices.

WHY HASN’T ANYBODY THOUGHT OF THIS BEFORE????

Well, because it’s so stupid only a California Democrat could come up with it.

Of the top of my head, Family Feud fashion, the top 4 reasons why this is stupid:

1. The best traders can’t time the market consistently. Why would anyone possibly believe government GS-13s or whatever could?
2. The government wouldn’t be a price taker–it would be driving prices.
3. Every trader in the world would be trying to front run the government. Talk about creating speculative opportunities! Speculate on what the government is going to do!
4. A California Democrat came up with it.

Bad economic times bring out bad economic ideas. Stupid never goes out of style in politics, and bad ideas never die. And that’s our reality today.

So today inflation as measured by the Consumer Price Index checked in at 8.6 percent annualized. Which is an uptick in the rate rather than the promised easing.

Sic transit transitory.

The Queen of Transitory, Janet Yellen (Jerome Powell being the King) acknowledged as much earlier this week in Congressional testimony, admitting that her prediction had been wrong. Whoopsie!

One wonders about her (and Powell’s and the rest of the herd’s) mental model of inflation, especially under current circumstances. The usual explanation is some version of the Phillips Curve inflation-unemployment tradeoff. Which is stupid because it is just a correlation, and a worthless one at that since it is about as stable as Amber Heard.

But even that idiocy obviously won’t fly here, so Yellen mumbled about COVID and supply chains and Putin and blah blah blah (as well as holding forth on gun control and abortion, which are OBVIOUSLY primary responsibilities of the Treasury Secretary). These explanations are also inadequate.

Insofar as COVID is concerned, arguably the policy response to it (not COVID itself) shifted back supply curves as stores were closed and people stayed home from work. But those restrictions peaked in early-2021 and have been easing then, so can’t explain by themselves accelerating inflation in the subsequent months.

Yes, COVID has had lingering effects on certain sectors that have constrained supply while demand has rebounded. For example, a lot of truckers that left the industry in 2020-2021 haven’t come back. Interestingly, trucking schools shut down during the pandemic, which has constrained the flow of new labor to the market. In industries such as lumber and oil refining, the largely policy-driven collapse in demand in 2020 led to actual disinvestment and a loss of capacity. We saw the impacts of that in the lumber market a year ago, and are seeing it in the markets for refined products now.

But those factors alone cannot explain the recent spikes: demand has to be part of the equation as well.

Also, supply constraints (and supply chain bottlenecks) cannot explain increases in the general price level, especially as measured by broader measures such as the Producer Price Index and the GDP Deflator. Here’s a straightforward example.

Consider computer chips, inadequate supplies of which hit the auto industry hard, and which are blamed as a major culprit for inflation. Yes, the chip supply constraint limited the production of new automobiles, raising the prices of both new and used cars (which are substitutes for new ones). But, the limitation on the output of automobiles reduced the derived demand for other automobile inputs, such as aluminum, steel, rubber, labor, and capital goods. Ceteris paribus, that should have put downward pressure on the prices of those inputs.

Put differently, bottlenecks increase prices on one side of the bottleneck relative to the prices on the other side. One cannot attribute a rise in the price level (in which the prices of most if not all goods and services are rising, albeit some more than others) to bottlenecks, at least not directly. Bottlenecks can cause prices to fall too. You can’t just look at the impact on the downstream side.

A more indirect story is that by limiting output (and therefore income) bottlenecks cause real income to be lower, thereby reducing the demand for real money balances. Given the nominal supply of money, the only way to equilibrate the now lower demand for real balances with a given nominal supply is to reduce the real value of the money stock by increasing the price level.

Color me skeptical that this can explain the magnitude of the inflation we’ve seen. (The Fed juicing base money by almost 50 percent in 2021 could have added to this impact.)

I therefore am deeply skeptical that supply constraints, attributable to COVID or otherwise, explain the broad rise in prices that has been accelerating over the past year plus.

What about Putin, Biden’s favorite scapegoat? Well, the Ukraine War doesn’t really explain the timing. Consider diesel prices.

There was a spike in the crack spread right at the time of the invasion in late-February, but that subsided quickly. The subsequent runup, especially the ramp-up in mid-April, is harder to ascribe to the war and almost certainly reflects some demand side factors.

Furthermore, it usually takes some time for upstream shocks to translate into higher prices at the consumer level (e.g., a wheat price shock impacting retail food prices). Meaning that a lot of the impact of a disruption first occurring in March is yet to have been fully felt. Good news all around, eh?

No, I think that the stock explanations that the likes of Yellen, Biden and the media fall back on to explain the accelerating inflation are woefully inadequate. Supply chain (and the effects of COVID thereon) in particular.

The most plausible explanation to me is the fiscal theory of the price level, developed formally some years ago by Thomas Sargent and recently studied deeply by John Cochrane. In a nutshell, the theory posits that the price level adjusts to equate the real value of government debt to the discounted real value of government primary surplus. Holding primary surplus constant, an increase in government obligations requires a price level rise to reduce the real value of outstanding debt by the amount of the new debt. Similarly, given the level of government debt, any reduction in expected future surpluses requires a rise in the price level. (The theory is obviously a lot more complicated: that’s a Cliffs’ Notes version of the Cliffs’ Notes of John’s book.)

The massive COVID-driven fiscal stimuluses of both Trump and Biden dramatically increased the nominal value of US government debt. Moreover, the clear preference of this administration and Congress is to expand government spending (and debt) further (e.g., student debt forgiveness, among other things). (It will be interesting to see what happens to inflation if there is a big shift in Congress in 2022.)

I would also suggest that the big regulation plus big “green” agenda pursued by this administration and Congress are also inimical to growth, and expectations about growth. (I put “green” in quotes because as I’ve written before, a monomaniacal focus on CO2 is not a balanced environmental policy, and is indeed inimical to the environment in many ways.)

The green agenda is particularly pernicious. BIden and others (not just in the US) keep yammering away about the wonderful transition to green energy that will occur. What this really means is a transition to more expensive energy and lower incomes. Sic transit transition? I wish.

Less growth means lower future GDP means less future government revenue means smaller primary surpluses.

Meaning that both from the debt side and the growth/surplus side the COVID and post-COVID years are, according to the fiscal theory of the price level, a recipe for large increases in the price level. We’ve seen just such an increase. The timing works out. The fact that the increase in prices is broad works out.

This administration–of which Yellen is unfortunately an accurate avatar–not only does not believe in the fiscal theory, but finds it an anathema because its implications regarding the need to restrain government spending and to jettison onerous regulations and its cherished CO2 agenda require it to become, well, Reaganites. So what is likely the right model of the current inflation will never be their mental model.

Which means we will not be able to say sic transit inflation anytime soon.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Nah. GiGi hasn’t thought that through either.

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

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

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

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

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

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

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

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

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

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

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

FTX’s Sam Bankman-Fried is backtracking somewhat:

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

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

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

I am a longtime critic of Elon Musk. I have criticized his rent seeking, most notably his extensive reliance on government subsidies to build his business empire. I have criticized his deceptiveness and self-dealing in the Tesla acquisition of Solar City–which despite all his bloviation about synergies was flatly a bailout of a failing company paid for by Tesla shareholders. I have criticized his numerous misleading statements over the years, most notably his promising the moon and then failing to deliver (e.g., heard of the solar roof lately?).

I am also a longtime critic of Twitter. It is a censorship engine masquerading as a social media company. Its management has, and still does, viewed its mission as enforcing the leftist progressive political narrative, and in pursuit of that mission ruthlessly suppresses all dissenting voices–especially if they gain any prominence.

Therefore, my first reaction to the news of Elon mounting a takeover attempt of Twitter was cognitive dissonance. That soon passed, however. Life is about choices between less than ideal alternatives, and as problematic as he is, Elon still dominates Twitter and its allies, hands down.

He at least talks the talk on free speech, and his criticisms of Twitter are trenchant and largely in agreement with my views. Although one may question how truly committed he is (he blocks people who needle him, myself included) there is considerable option value here. We know Twitter is committed to being the speech police, Musk offers the possibility of a freer and fairer platform.

The hysterical (in both senses of the word) response of Twitter management, employees, and the phalanxes of leftist, statist orthodoxy is wildly entertaining, and suggests that Elon is a real threat to what they viewed as their plaything: they certainly believe he is. There is so much material to choose from here, but Robert Reich’s widely mocked article in the Guardian provides a good summary of the various panicked arguments opposing Musk’s move. This was particularly hysterical (again in both senses of the word):

Elon Musk’s vision for the Internet is dangerous nonsense: Musk has long advocated a libertarian vision of an ‘uncontrolled’ internet. That’s also the dream of every dictator, strongman and demagogue.

Dictators, strongmen, and demagogues have libertarian visions. Who knew?

It is also beyond amusing that those who for years sneeringly dismissed Twitter critics by saying “it’s a private company so it can do what it wants” are now in full psychological meltdown over the prospect that someone might take a company private and do what he wants–because it’s not what they want. Say, here’s an idea: if he takes over Twitter, start your own platform, bitches. That’s what you’ve been telling us for years, isn’t it?

If I had any doubts about whom to support in this battle, two of my other bêtes noires, Gary Gensler (SEC) and the Department of Justice immediately mounted up to ride to Twitter’s rescue:

BREAKING: As @elonmusk offers to buy the rest of @Twitter a legal source tells @FoxBusiness @SECGov and @TheJusticeDept have launched what he described as a "joint investigation" into a myriad of Musk regulatory issues primarily involving @Tesla https://t.co/TDFLED1XuI

— Charles Gasparino (@CGasparino) April 14, 2022

Regardless of whether there are issues at Tesla, they existed before he dropped his bomb on Twitter. But I’m sure the timing of this is just a coinky dink, right?

Like Peruvian General Benavides said: ““For my friends, everything; for my enemies, the law.”

Further proof, moreover, that Twitter is just an appendage of the ruling class.

And the SEC should actually be more focused on corporate governance at Twitter. The company implemented a poison pill defense in order to fend off an offer at a price that Twitter would have no possibility in hell of reaching without it. (NB: it’s stock price is up 8 percent since its IPO.) But it’s OK to screw the shareholders to protect the guardians of the narrative, right?

(Musk has threatened to sue the board over this. Alas, poison pill defenses have survived legal challenges, and in fact thrived. That’s why hostile takeovers are largely a thing of the past. The political economy of American regulators and the judiciary decidedly works in favor of incumbent corporate interests.).

This epic thread is spot on:

Thank you everyone for coming in at such an ungodly hour. The folks at Blackrock have informed me that we need the collective brain trust here urgently to deal with this Elon offer. So – why doesn’t someone tell me what they think is going on here? ? pic.twitter.com/toeCBCKqcT

— Perpetua Hughes (@PerpetuaHughes) April 15, 2022

Seriously. Read the full conversation.

So how will it turn out? Well, it will provide numerous opportunities for schadenfreude. It will reveal the utter hypocrisy of the ruling class. It will reveal how Twitter is really an apparatchik of the ruling class. But I think Elon’s odds of success are low. He will be taking on the ruling class. And very practically speaking, poison pill defenses are extremely hard to overcome. And that will be especially true in this case because Twitter’s board is not using it as a means of extracting a better price: I seriously doubt that there is any price that they would accept if that involved giving control to Elon. But if anyone can beat these odds, it’s likely Elon. The very thing that I have criticized in the past, specifically the lack of any scruple in pursuing what he wants, is exactly what is needed to win a battle like this.

The LME restarted trading of nickel. Well, sort of. In the first five sessions prices were limit down, and trading stopped as soon as the limits were hit. The LME deemed two subsequent sessions “disrupted” and declared the trades in these sessions “null and void.”

In other words: more mulligans after the trade cancellations that followed the spike to $100K/tonne prices. The LME should change its name to the London Mulligan Exchange. Which is not a good look.

Departing LME CEO Matthew Chamberlain tried to shift blame last week, claiming that the problem was that the exchange did not have visibility into risk due to the fact that approximately 80 percent of Tsingshan’s nickel position was in the form of OTC trades with big banks, such as JP Morgan. This is weak excuse. It is highly likely that the banks hedged their Tsingshan exposure on the LME, so the exchange saw the positions, but just didn’t know for sure exactly who was behind them. But the LME has known for months (years actually) that Tsingshan was the elephant in the nickel ring, and that the banks who were short the LME were almost certainly hedging an OTC exposure. The LME should have been able to add two and two.

The price increases today and in the previous session suggest that the short covering is ongoing, and that the “I’m going to hang on to my position” rhetoric from Tsingshan, and the insinuations that the banks were allowing it to extend and pretend, are therefore not correct. It (and perhaps other shorts) are trying to reduce positions. Continued gyrations are therefore likely, and a default that would make recent “disruptions” look like child’s play is not out of the question. The fear of this is likely what is causing the LME to take actions (voiding trades) that only further blacken its already dusky reputation. To a fox caught in a trap, chewing off a leg is the best option.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

In a weird counterpoint to the LME nickel story, another big clearing-related story that is causing a lot of consternation in derivatives circles is FTX exchange’s proposal to move to a direct clearing model that would dispense with FCMs as intermediaries. Instead of having an FCM interposed between a customer and the clearinghouse, the customer interfaces directly with the FTX Derivatives Clearing Organization (DCO).

What is crucial here is how this is supposed to work: FTX will utilize near real time mark-to-market and variation margin payments. Moreover, the exchange will automate the liquidation of undermargined positions, again basically in real time.

The mechanics are described here.

FTX describes this as being the next big thing in the derivatives markets, and a way of addressing systemic risks. Basically the pitch is simple: “real time margining allows us to operate a pure no credit/loser pays system.”

FTX touts this as a feature, but as the nickel experience demonstrates (and other previous episodes demonstrate) it is not. Margining generally can be destabilizing, especially during stressed market conditions, and the model FTX is advancing exacerbates the destabilizing potential of margining.

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

This instability potential can be exacerbated by the ability of traders to hold collateral in the form of the “underlying” (i.e., crypto, at present). Well, the collateral value can fluctuate, and that can contribute to margin shortfalls which again trigger stops.

Market participants can mitigate getting stopped out by substantially over-margining, i.e., holding a lot of excess margin in their FTX account. But this is a cash inefficient way of trading.

It’s not clear to me whether FTX will pay interest on collateral. It seems not. Hmmm. Implementing a model that incentivizes holding a lot of extra cash at FTX and not paying interest. Cynic that I am, that seems to be a great way to bet on higher interest rates! Maybe that’s FTX’s real game here.

I would also note that the “no leverage” story here reflects a decidedly non-systemic view (something that I pointed out years ago in my critiques of clearing mandates). Yes, real time margining plus holding of substantial excess margin reduces to a small level the amount of leverage extended by the CCP/DCO. But that is different than reducing the amount of margin in the system as a whole. People who have borrowing capacity and optimal total leverage targets can fund their deposits at FTX with leverage from other sources. They can offset the leverage they normally obtain from FCMs by taking more leverage from other sources.

In sum, FTX is arguing that its mechanism of direct clearing and real time margining creates a far more effective “no credit” clearing system than the existing FCM-intermediated structure. That’s likely true. But as I’ve banged on about for years, that’s not necessarily a good thing. The features that FTX touts as advantages have very serious downsides–especially in stressed market conditions where they tend to accelerate price moves rather than dampen them.

Insofar as this being a threat to the existing intermediated system, which many in the industry appear to fear, I am skeptical. In particular, the cash inefficiency of this mechanism will make it unattractive to many market participants. Not to be Panglossian, but the existing intermediated system evolved as it did for good economic reasons. It trades off credit risk and liquidity risk. It does so in a somewhat discriminating way because it takes into account the creditworthiness of market participants (something that FTX brags is unnecessary in its system). FTX is something of a corner solution that the market has not adopted despite the opportunity to do so. As a result, I don’t think that corner solution will have widespread appeal going forward.

If you use the official LME nickel and copper prices from Monday, before the exchange stopped trading of nickel, you can determine that the value of the metal in a US nickel coin is worth a dime. As the shutdown lingers, one wonders whether the LME is too.

The broad contours of the story are understood. A large Chinese nickel firm (Tsingshan Holdings, largest in the world) was short large amounts of LME nickel, allegedly as a hedge. But the quantity involved seems very outsized as a hedge, representing something like two years of output. And if the position was concentrated in nearby prompt dates (e.g., 3 months) it involved considerable curve risk.

The Russian invasion juiced the price of nickel, not surprising given Russia’s outsized presence in that market. That triggered a margin call (allegedly $1 billion) that the firm couldn’t meet–or chose not to. That led its brokers to try to liquidate its position in frenzied buying on Monday evening. This short covering drove the price from the close of around $48,000 to over $100,000.

That’s where things got really sick. The LME shut the nickel market. It was supposed to reopen today, but that’s been kicked down the road. But the LME didn’t stop there. It decided that these prices did not “[reflect] the the underlying physical market,” and canceled the trades. Tore them up. Poof! Gone!

Now in a Back to the Future moment echoing the 1985 Tin Crisis, the LME is trying to get the longs and shorts to set off their positions. “Can’t we all just get along?” Well likely not, because it obviously requires agreeing on a price. Which is obviously devilish hard, if not impossible given how much money changes hands with every change in price. (In my 1995 JLE paper on exchange self-regulation, I argued that exchanges historically did not want to intervene in this fashion even during obvious manipulations because of the rent seeking battles this would trigger.)

So the LME remains closed.

Some observations.

First, told ya. Seriously, in my role as Clearing Cassandra during the Frankendodd era, I said (a) clearing was not a panacea that would prevent defaults, and (b) the clearing mechanism was least reliable precisely during periods of major market stress, and that the rigid margining mechanism is what would threaten its ability to operate. That’s exactly what happened here.

Second, clearing is supposed to operate under a “loser pays/no credit” model. That’s really something of a misconception, because even though the clearinghouse does not extend credit, intermediaries (brokers/FCMs) routinely do to allow their clients to meet margin calls. But here we evidently have a situation in which the brokers (or Tsingshan’s banks) were unwilling or unable to do so, which led to the failure of the loser to pay.

Third, by closing the market, the LME is effectively extending credit (“you can pay me later”), and giving Tsingshan (and perhaps other shorts) some time to stump up some additional loans. Apparently JPM and the Chinese Construction Bank have agreed in principle to do so, but a deal has been hung up over what collateral Tsingshan will provide. So the market remains closed.

For its part, Tsingshan and its boss Xiang “Big Shot” Guangda are hanging tough. The company wants to maintain its short position. Arguably it has a strong bargaining position. To modify the old joke, if you owe the clearinghouse $1 million and can’t pay, you have a problem: if you owe the clearinghouse billions and can’t pay, the clearinghouse has a problem.

The closure of the market and the cancelation of the trades suggests that the LME has a very big problem. The exact amounts owed are unknown, but demanding all amounts owed now could well throw many brokers into default, and the kinds of numbers being discussed are as large or larger than the LME’s default fund of $1.2 billion (as of 3Q21 numbers which were the latest I could find).

So it is not implausible that a failure to intervene would have resulted in the insolvency of LME Clear.

The LME has taken a huge reputational hit. But it had to know it would when it acted as it did, implying that the alternative would have been even worse. The plausible worst alternative would have been a collapse of the clearinghouse and the exchange. Hence my quip about whether the exchange that trades nickel is worth a dime.

Among the reputational problems is the widespread belief that the Chinese-owned exchange intervened to bail out Chinese brokerage firms and a Chinese client. To be honest, this is hard to differentiate from intervening to save itself: the failure of the brokerages are exactly what would have brought the exchange into jeopardy.

I would say that one reason Xiang is hanging tough is that the CCP has his back. Not CCP as in central counterparty, but CCP as in Chinese Communist Party. That would give Tsingshan huge leverage in negotiations with banks, and the LME.

So the LME is playing extend and pretend, in the hope that it can either strongarm market participants into closing out positions, or prices return to a level that reduce shorts’ losses and therefore the amounts of variation margin they need to pay.

I seriously wonder why anyone would trade on the open LME markets (e.g., copper) for reasons other than reducing positions–and therefore reducing their exposure to LME Clear. The creditworthiness of LME Clear is obvious very dodgy, and it is potentially insolvent.

Fourth, in an echo of the first point, this episode demonstrates that central clearing, with its rigid “no credit” margining system is hostage to market prices. This is usually presented as a virtue, but when markets go wild it is a vulnerability. Which is exactly why it is–and always was–vain to rely on clearing as a bulwark against systemic risk. It is most vulnerable precisely during periods of market stress.

All commodity markets are experiencing large price movements that are creating extraordinary variation margin flows, potential positive feedbacks, and the prospect for troubles at other clearers. Further, the broader economic fallout from the Ukraine war (which includes, for example, a large recession resulting from the commodity price shocks, or a Russian debt default) has the real potential to disrupt equity and bond markets. This would put further strains on the financial markets, and the clearing system in particular. Central Banks–notably the Fed–had to supply a lot of liquidity to address shocks during the Covid Panic of March 2020. Two years later, they may have to ride to the rescue again.

When playing Spin the Bottleneck with my students I say to look at what lies between the price of a transformed and untransformed commodity to identify the bottleneck. In my earlier post on the gaping spread between European (and Asian) LNG prices and the price of US gas (which is on the margin for both destinations) I noted two possible constraints: shipping and liquefaction capacity.

Well, it ain’t shipping.

There is a surfeit of LNG shipping capacity. So much that LNG shipping is effectively free between the US and Europe (down from $273K/day in December). Yet the spread remains very wide. So the binding constraint is definitely liquefaction capacity, in the US in particular. Those who have the rights to that capacity–notably firms that entered into contracts with the likes of Cheniere or Freeport that buy gas at the US price and pay a contractually fixed liquefaction/tolling fee–are coining it. They capture the bulk of the existing spread between TTF or UK Balancing Point prices and Henry Hub. (The LNG companies are benefitting only to the extent that they reserved some of their capacity for their own trading, which is rather de minimis).

So in the short run liquefaction capacity is quite valuable. The question is what will its value be over the longer term? Will current events convince enough financiers to provide capital for a large expansion of US capacity? Given the long gestation period of these projects it is a hard issue for banks and equity to analyze.

One thing to note. Another thing I discuss extensively in my classes is the importance of government/regulatory bottlenecks. Such bottlenecks may be a constraint on expansion of US LNG capacity. Many of the projects under development do not have the requisite federal permits. The Biden administration is unlikely to grant more. Thus, like taxicab medallions in NYC, existing permits likely have a substantial scarcity value–thanks to a government-created bottleneck.

This has interesting implications for financing of US LNG projects. Financiers of a given project face less risk of a glut of capacity coming online in a few years, and this should make them more willing to finance already permitted projects. But, of course, they are taking on political risk by doing so: might a new administration change course post-2024? Or might political pressure induce a change in course by the current administration? There are already a lot of political risks in investing in anything fossil-fuel related (attributable to climate hysteria). This is a US LNG-specific risk.