Streetwise Professor

May 8, 2018

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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May 2, 2018

When You Play With Fire, Eventually You Get Burned–Even if You are Glencore

Filed under: Commodities,Economics,Politics,Regulation,Russia — The Professor @ 6:10 pm

Even by the standards of the commodity business (and the commodity trading business in particular) Glencore is known for its appetite for political and legal risk, and its willingness to deal with sketchy counterparties.  It does so because by taking on these risks, it gets deals at good prices.  But the bigger the appetite, the greater the indigestion when things go wrong.

In the past several weeks, Glencore has hit the going wrong trifecta.

It has a longstanding relationship–including marketing deals and equity investment–with Rusal, entered when the Russian company’s reputation was particularly dubious in the aftermath of the aluminum wars, and its owners were involved serial litigation.

We know what happened to Rusal–it is in dire straits because of US sanctions.  Yes, the Treasury has indicated that it will take Rusal’s case on appeal, but there is no guarantee that it will grant a stay of execution when the appeal process is completed.

Glencore also partnered with very dubious Israeli businessman Daniel Gertler in the Democratic Republic of the Congo (DRC).  Gertler was sanctioned by the US government in December for a history of corrupt dealings in that country.  Glencore bought out Gertler in 2017.  After the sanctions were imposed, Glencore stopped paying Gertler royalties, but now Gertler is suing for $3 billion in royalties that he claims Glencore owes him.

Also in the DRC, Glencore is in a dispute with the government’s mining company, which claims that a Glencore subsidiary operating in the country is undercapitalized.  This is really a battle over rents: in essence, the government claims that foreign miners (including Glencore) overburden operating subsidiaries with debt in order to reduce dividend payments to the government (which is part owner).  The government has moved to dissolve the Glencore subsidiary.

I don’t know enough to comment on the substance of the various legal disputes in Africa.  But I can say that the risks of such disputes are material, and that they can be very costly.

In some respects, the Glencore political/legal risk strategy is like a short vol trade.  It can be a money printing machine when things go well, but when it goes bad, it goes really bad.

In a way Glencore is lucky.  It can withstand these hits now, having clawed its way back from its near death experience in the fall of 2015.  If these hits had occurred back then, well . . .

In sum, when you play with fire, eventually you are going to get burned.  Even if you are Glencore.

PS. The tumult in the Congo could disrupt cobalt supplies.  This would put pressure on one of my fave targets–Tesla–which is already in a parlous state.  Elon gave a crazed performance at today’s Tesla earnings call.  To me it came off as the meltdown of a narcissist who is facing failure and cannot handle being questioned.

I’ve been biding my time on some additional Tesla posts.  The time may be near!

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May 1, 2018

Rusal: Premature Celebration

Filed under: Commodities,Derivatives,Economics,Politics,Regulation,Russia — The Professor @ 9:31 am

Rusal shares rose sharply and aluminum prices fell sharply on the news that the US Treasury had eased sanctions on the company.  The concrete change was an extension in the time granted for those dealing with Deripaska-linked entities to wind down those dealings.  But the market was more encouraged by the Treasury’s statement that the extension was being granted in order to permit it to evaluate Rusal’s petition to be removed from the SDN list.  It is inclusion on that list that sent the company into a downward spiral.

Methinks that the celebration is premature.  Treasury made clear that a stay of execution for Rusal was contingent upon it cutting ties with Deripaska.  Well, just how is that supposed to happen? This is especially the case if any transaction that removes Deripaska from the company not benefit him financially.  Well, then why would he sell?  He would have no incentive to make certain something–the total loss of his investment in Rusal–that is only a possibility now.

Of course, Putin has ways of making this happen, the most pleasant of which would be nationalization without compensation to Deripaska, perhaps followed by a sale to … somebody (more on this below). (Less pleasant ways would involve, say, Chita, or a fall from a great height.)

But if the US were to say that this was sufficient to bring Rusal in from the cold, the entire sanctions regime would be exposed as an incoherent farce.  For the ultimate target of the sanctions is not Deripaska per se, but the government of Russia, for an explicit foreign policy purpose–a “response to the actions and polices of the Government of the Russian Federation, including the purported annexation of the Crimea region of Ukraine.”

Deripaska didn’t personally annex Crimea or support insurrection in the Donbas.  The Russian government did.  The idea behind sanctions was to put pressure on those the Russian government (allegedly) cares about in order to change Putin’s policies.  They are an indirect assault on Putin/the Russian government, but an assault on them nonetheless.

So removing Rusal from the SDN list because it had been seized by the Russian government would make no sense based on the purported purpose of the sanctions.  Indeed, under the logic of the sanctions, the current discomfiture of the Russian government, facing as it does the potential unemployment of tens of thousands of workers, should be a feature not a bug. The sanctions were levied under an act whose title refers to “America’s adversaries,” which would be the Russian state, and were intended to punish said adversaries.

Mission accomplished!  Which is precisely why the Russian government is completely rational to view the Treasury announcement “cautiously,” and to view the US signals as “contradictory.”  The Russians would be fools to believe that nationalization and kicking Deripaska to the curb would free Rusal from the mortal threat that sanctions pose.

Perhaps Treasury has viewed the market carnage, and is trying to find a face-saving way out.  But it cannot do so without losing all credibility, and appearing rash, and quite frankly stupid, for failing to understand the ramifications of imposing SDN on Deripaska.  Also, doing so would feed the political fire that Trump is soft on Russia.

Further, who would be willing to take the risk buying Rusal from Deripaska either directly, or indirectly after nationalization?  They would only do so if they had iron clad guarantees from the US government that no further sanctions would be forthcoming.  But the US government is unlikely to give such guarantees, and I doubt that they would be all that reliable in any event.  Analogous to sovereign debt, just what could anyone do if the US were to say: “Sorry.  We changed our mind.”?

Indeed, the Treasury’s signaling of a change of heart indicates just how capricious it can be.  Any potential buyer would only buy at a substantial discount, given this massive uncertainty.  A discount so big that Deripaska or the Russian government would be unlikely to accept.

And who would the buyers be anyways?  Glencore already has a stake in Rusal, and a long history of dealings.  But it is probably particularly reluctant to get crosswise with the US, especially given its vulnerabilities arising from, say, its various African dealings.

The Chinese?  Well, since China is already on the verge of a trade war in the US, and a trade war involving aluminum in particular, they would have to be especially chary about buying out Deripaska.  Such a deal would present the US with a twofer–an ability to shaft both Russia and China.  And perhaps a three-fer: providing support to the US aluminum industry in the bargain (although of course harming aluminum consuming industries, but that hasn’t deterred Trump so far.)

So short of the US going full Emily Litella (and thus demolishing its credibility), it’s hard to see a viable path to freeing Rusal from SDN sanctions.  Meaning: Put away the party hats.  The celebration is premature.

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Begging the Question on VIX Manipulation

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

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

Here’s their explanation of the April 18 event:

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

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

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

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

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

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

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

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

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

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March 23, 2018

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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March 3, 2018

Trump Cuts the Hair Suspending the Trade Sword of Damocles

Filed under: China,Economics,Energy,Politics,Regulation — The Professor @ 11:04 am

Overall, I have found the Trump administration’s economic policies to be favorable.  The tax bill was pretty good, even though it was worse than the administration’s original proposal.  The chipping away at the encrustation of regulation has been highly beneficial.

But there was always a sword of Damocles hanging by a thread over our heads: protectionism. Heretofore, that sword has remained dangling, but last week the hair broke (perhaps by Trump’s hair-trigger temper) when he announced plans to impose substantial tariffs on imported steel and aluminum.

This is egregiously bad policy, even on its own terms. Like all tariffs, these will impose far greater costs on consumers than they will generate benefits for producers.  Since steel and aluminum are intermediate goods, the first consumers are manufacturers that use the metals.  The cost will be borne in the form of lower output from these firms, lower employment and wages in the consuming industries, and higher prices for the final goods.

These tariffs are a failure on their own terms, and demonstrate Trump’s economic ignorance. Trump wants to bolster American manufacturing: these tariffs will harm US manufacturing overall, even though they benefit relatively small subsectors thereof.   This is because US manufacturing is a big consumer of these materials.  As an example, Trump touts the American energy revolution and promotes American energy exports.  Well, the energy business is a huge consumer of steel in particular, in everything from pipelines to rigs to drill pipe to storage tanks to oil refineries to LNG liquefaction plants.  By helping one shrunken sector of the US economy, Trump is imposing substantial harm on a growing one–and one that he touts, no less.

A common retort to criticisms like mine is that the trade playing field is unfair, and that countries like China in particular advantage domestic producers at the expense of foreigners.  Well, they do that in many sectors, but even though that is inefficient, it redounds to the benefit of other sectors in the US economy: for example, subsidizing aluminum benefits US auto manufacturers, who increasingly utilize aluminum (in part to achieve compliance with self-inflicted regulatory harms, namely CAFE standards).

What is little understood is that a tax on imports is a tax on trade: it reduces both imports and exports.  Similarly, subsidizing exports increases trade–including exports by the country importing the subsidized good.

This is true over the long run: in the short run capital flows adjust as well as trade flows.  For example, Chinese subsidies can lead to an increased US trade deficit (Chinese trade surplus), which means that the Chinese accumulate US dollar claims–pieces of paper (or, more accurately, electronic book entries).  Then one of two things happens.  Either the dollar claims prove worthless, or the Chinese spend the dollars on US goods.  So we either get goods in exchange for worthless pieces of paper (or electronic records), or we export goods later.

If retaliatory measures like Trump’s tariffs could result in some bargain or accommodation that levels the playing field, then perhaps the benefit would exceed the cost (although ironically much of the overall benefit will redound to those who tip the playing field, because they bear the brunt of the cost of doing so). The track record on this is hardly encouraging, however. I predict that the likelihood is that Trump’s actions will not materially reduce imbalances in the trade playing field, and that as a result they will be highly detrimental to the US economy–including the sectors which Trump claims to champion.

When Trump was a candidate, I was highly critical of his views on trade, e.g.:

Perhaps to give him more intellectual credit than he deserves, Trump is a died-in-the-wool mercantilist who believes trade is a zero sum game, and who favors protectionism and beggar-thy-neighbor currency policies. He talks like it is the late-80s, and Japan is still an economic juggernaut that will overwhelm the US, completely overlooking the fact that Japan’s crypto-mercantilist policies gifted it a 25 year long lost decade, and that neo-mercantilist China is on the brink of the same fate. If it is lucky.

and:

What is bizarre is that the sin of “giving our industrial markets to the Japanese” was somewhat dated by 1999, but Trump pounds on that theme today, when it is well past its sell date. Decades past. Just yesterday, in  Greenville, SC, he said something to the effect that “the Japanese are up here [holding his hand over his head] and we are down here [holding his hand by his knee].” Fact: Japanese per capita GDP is $36K, and US per capital GDP is exactly 50 percent higher, at $54K. But facts don’t matter. The image of Japanese domination (now accompanied by the image of Chinese domination) resonates intensely among Jacksonians.

I was hoping that he would not act on these impulses, or that he would be constrained from doing so. No such luck. Impulsive ignorance has won out.

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January 2, 2018

Buyer Beware: Bart Does Crypto

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 8:08 pm

Back in the day, Bart Chilton was my #2 whipping boy at the CFTC (after Gary Gensler AKA GiGi). Bart took umbrage (via email) at some of my posts, notably this one. Snort.

Bart was the comedian in that dynamic duo. He coined (alert: pun foreshadowing!) such memorable phrases as “cheetah” to criticize high frequency traders (cheetah-fast cheater–get it? Har!) and “massive passives” to snark at index funds and ETFs. Apparently Goldilocks could never find a trading entity whose speed was just right: they were either too fast or too slow. He blamed cheetahs for causing the Flash Crash, among other sins, and knocked the massive passives for speculating excessively and distorting prices.

But then Bart left the CFTC, and proceeded to sell out. He took a job flacking for HFT firms. And now he is lending his name (I won’t say reputation) to an endeavor to create a new massive passive. This gives new meaning to the phrase sell out.

Bart’s massive passive initiative hitches a ride on the crypto craze, which makes it all the more dubious. It is called “OilCoin.” This endeavor will issue said coins, and invest the proceeds in “reserve barrels” of oil. Indeed, the more you examine it, the more dubious it looks.

In some ways this is very much like an ETF. Although OilCoin’s backers say it will be “regulatory compliant,” but even though it resembles an ETF in many ways, it will not have to meet (nor will it meet, based on my reading of its materials) listing requirements for ETFs. Furthermore, one of the main selling points emphasized by the backers is its alleged tax advantages over standard ETFs. So despite the other argle bargle in the OilCon–excuse me, OilCoin–White Paper, it’s primarily a regulatory and tax arb.

Not that there’s necessarily anything wrong with that, just that it’s a bit rich that the former stalwart advocate of harsher regulation of passive commodity investment vehicles is part of the “team” launching this effort.

I should also note some differences that make it worse than a standard ETF, and worse than other pooled investment vehicles like closed end funds. Most notably, ETFs have an issue and redemption mechanism that ensures that the ETF market price tracks the value of the assets it holds. If an ETF’s price exceeds the value of the assets the ETF holds, an “Authorized Participant” can buy a basket of assets that mirrors what the ETF holds, deliver them to the ETF, and receive ETF shares in return. If an ETF’s price is below the market value of the assets, the AP can buy the ETF shares on the market, tender them to the ETF, and receive an equivalent share of the assets that the ETF holds. This mechanism ties the ETF market price to the market prices of its assets.

The OilCoin will not have any such tight tie to the assets its operators invest in. Insofar as investment policy is concerned:

In addition to investing in oil futures, the assets supporting OilCoin will also be invested in physical oil and interests in oil producing properties in various jurisdictions in order to hold a diversified pool of assets and avoid the risk of holding a single, concentrated position in exchange traded futures contracts. As a result, OilCoin’s investment returns will approximate but not precisely track the price movement of a spot barrel of crude oil.

I note the potential illiquidity in “physical oil” and in particular “interests in oil producing properties.” It will almost certainly be very difficult to value this portfolio. And although the White Paper suggests a one barrel of oil to one OilCoin ratio, it is not at all clear how “interests in oil producing properties” will figure into that calculation. A barrel of oil in the ground is a totally different thing, with a totally different value, than a barrel of oil in storage above ground, or an oil futures contract that is a claim on oil in store. This actually has more of a private equity feel than an ETF feel to it. Moreover, even above ground barrels can differ dramatically in price based on quality and location.

Given the illiquidity and heterogeneity of the “oil” that backs OilCoin, it is not surprising that the mechanism to keep the price of the OilCoin in line with “the” price of “oil” is rather, er, elastic, especially in comparison to a standard ETF: the motto of OilCoin should be “Trust Us!” (Pretty funny for crypto, no?) (Hopefully it won’t end up like this, but methinks it might.)

Here’s what the White Paper says about the mechanism (which is a generous way of characterizing it):

OilCoin’s investment returns will approximate but not precisely track the price movement of a spot barrel of crude oil.

. . . .

In order to ensure measurable intrinsic value and price stability, each OilCoin will maintain an approximate one-to-one ratio with a single reserve barrel of oil. [Note that a “reserve barrel of oil” is not a barrel of any particular type of oil at any particular location.] This equilibrium will be achieved through management of the oil reserves and the number of OilCoin in circulation.

As demand for OilCoin causes the price of a single OilCoin to rise above the spot price of a barrel of oil on global markets [what barrel? WTI? Brent? Mayan? Whatever they feel like on a particular day?], additional OilCoin may be issued in private or open market transactions and the proceeds will be invested in additional oil reserves. Similarly, if the price of an OilCoin falls below the price of a barrel of oil, oil reserves may be liquidated with the proceeds used to purchase OilCoin privately or in the open market. This method of issuing or repurchasing OilCoin and the corresponding investment in or liquidation of oil reserves will provide stability to the market price of OilCoin relative to the spot price of a barrel of crude oil and will provide verifiable assurances that the value of oil reserves will approximate the aggregate value of all issued OilCoin.

OilCoin’s price stability program will be managed by the OilCoin management team with a view to supporting the liquidity and functional operation of the OilCoin marketplace and to maintaining an approximate but not precise correlation between the price of a single OilCoin and the spot price of a single barrel of oil [What type of barrel? Where? For delivery when?]. While maintaining price stability of digital currencies through algorithmic purchase and sale may be appropriate in certain circumstances, and while it is possible as a technical matter to link such an algorithm to a programmed purchase and sale of oil assets, such an approach would be likely to result in (i) the decoupling of the number of OilCoin in circulation from an approximately equivalent number of reserve barrels of oil, and (ii) a highly volatile stock of oil reserve assets adding unnecessary and avoidable transaction costs which would reduce the value of OilCoin’s supporting oil reserve assets. Accordingly, it is expected that purchases and sales of OilCoin and oil reserves to support price stability will be made on a periodic basis [Monthly? Annually? When the spirit moves them?] as the price of OilCoin and the price of a single barrel of oil [Again. What type of barrel? Where? For delivery when?] diverge by more than a specified margin [Specified where? Surely not in this White Paper.]

[Emphasis added.]

Note the huge discretion granted the managers. (“May be issued.” “May be liquidated.” Whenever they fell like it, apparently, as long as there is a vague connection between their actions and “the spot price of crude oil “–and remember there is no such thing as “the” spot price) A much less precise mechanism than in the standard ETF. Also note the shell game aspect here. This refers to “the” price of “a barrel of oil,” but then talks about “diversified holdings” of oil. The document goes back and forth between referring about “reserve barrels” and “barrels of oil on the global market.”

Note further that there is no third party mechanism akin to an Authorized Party that can arb the underlying assets against the OilCoin to make sure that it tracks the price of any particular barrel of oil, or even a portfolio of oil holdings. This means that OilCoin is really more like a closed end fund, but one  that is not subject to the same kind of regulation as closed end funds, and which can apparently invest in things other than securities (e.g., interests in oil producing properties), some of which may be quite illiquid and hard to value and trade. One other crucial difference from a closed end fund is that OilCoin states it may issue new coins, whereas closed end funds typically cannot have secondary offerings of common shares.

Closed end funds can trade at substantial premiums and discounts to the underlying NAV, and I would wager that OilCoin will as well. Relating to the secondary issue point, unlike a closed end fund, OilCoin can issue new coins if they are at a premium–or if the managers feel like it. Again, the amount of discretion possessed by OilCoin’s managers is substantially greater than for a closed end fund or ETF (or an open ended fund for that matter). (There is also no indication that the managers will be precluded from investing the funds in their own “oil producing interests.” That potential for self-dealing is very concerning.)

There is also no indication in the White Paper as to just what an OilCoin gives a claim on, or who has the control rights over the assets, and how these control rights can be obtained. My reading of the White Paper does not find any disclosure, implicit or explicit, that OilCoin owners have any claim on the assets, or that someone could buy 50 percent plus one of the OilCoins, boot the existing management, and get control of the operation of the investments, or any mechanism that would allow acquisition of a controlling interest, and liquidation of the thing’s assets. (I say “thing” because what legal form it takes is not stated in the White Paper.)  These are other differences from a closed end fund or ETF–and mean that OilCoin is not subject to the typical mechanisms that protect investors from the depredations of promoters and managers.

A lot of crypto is all about separating fools from their money. OilCoin certainly has that potential. What is even more insidious about it is that the backers state that it is a different kind of crypto currency because it is backed by something: in the words of the White Paper, OilCoin is “supported” by the “substantial intrinsic value of assets” it holds. The only problem is that there is no indication whatsoever that the holder of the cryptocurrency can actually get their hands on what backs it. The “support” is more chimerical than real.

So my basic take away from this is that OilCoin is a venture that allows the managers to use the issue of cryptocurrency to fund totally unconstrained speculations in oil subject to virtually none of the investor protections extended to the purchasers of securities in corporations, investors of closed end funds, or buyers of ETFs. All sickeningly ironic given the very public participation of a guy who inveighed against speculation in oil and the need for strict regulation of those investing other people’s money.

My suggestion is that if you are really hot for an ICO backed by a blonde, buy whatever Paris Hilton is touting these days, and avoid BartCoin like the plague.

 

 

 

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December 26, 2017

Agency Costs: Washington’s Augean Stables

Filed under: Economics,Politics,Regulation — The Professor @ 6:09 pm

In news that definitely added to my holiday cheer, a gloomy New York Times moaned that “[m]ore than 700 people have left the Environmental Protection Agency since President Trump took office, a wave of departures that puts the administration nearly a quarter of the way toward its goal of shrinking the agency to levels last seen during the Reagan administration.”

Given that the EPA is one of the most malign agencies in DC, every subtraction is an addition to America’s wealth–and no, this will not detract markedly, if at all from environmental quality. Or at least, any loss in environmental quality would not have been worth the cost necessary to achieve it.

The most signal achievement of Trump’s first almost year has been on the regulatory front. (The recent tax law arguably pips that.) The metastasizing regulatory/administrative state under both the Bush and Obama administrations is a detriment to prosperity, and in particular to the dynamism of the American economy. It is the engine of European-like sclerosis, and it badly needs to be brought under control.

Trump has begun–and only that–the task of cleaning this Augean Stables on the Potomac. The bureaucrats are none to happy, and are fighting back, mainly through classic bureaucratic guerrilla warfare. Unfortunately, they have advantages in this form of combat, and any progress will be achieved slowly, and only through unceasing effort. Those appointed to lead the agencies are often at a disadvantage in taming those who work for them even when they have a will to do so, and what’s more, all of the mechanisms of capture are at work here, meaning that agency political appointees are constantly at risk of going native.

The administrative state is a threat to prosperity and liberty, and a Constitutional anomaly, not to say monstrosity. Administrative agencies combine executive, legislative, and judicial functions, thereby threatening the separation of powers and associated checks and balances which are intended to prevent any single branch of government overawing the others. Indeed, in many respects the administrative state has become an independent branch of government, though not one formally established by the Constitution.

Moreover, it is not subject to the normal mechanisms of accountability. Yes, it is formally subject to Congressional oversight and some presidential control, and hence indirectly subject to the electorate, but due in large part to the scope and intricacy of the regulators’ responsibilities, there is a huge principal-agent problem: agency costs (as economists use the term) are a major issue with federal agencies. It is very difficult for Congress or the White House to control regulators. Further, information asymmetries make it inefficient to utilize high-powered incentives to get regulators to implement the wishes of those who formally control them. Civil service protections insulate bureaucrats from personal accountability for all but the most egregious misconduct (and sometimes not even then).

There is also a strong bias towards expanding agencies’ power. Several factors work in this direction, and few in the opposite way. Empire building is one such factor–regulators have a strong preference to expand their power. Congressional committees that oversee agencies also gain political power when the influence of their charges expand. (This shares some similarities with a mafia protection racket.) Government agencies attract people who are ideologically predisposed to expansive exercise of government power.

These asymmetries lead to a ratchet effect. Statist administrations–notably Obama’s, but to a considerable degree Bush’s as well–find allies in the administrative state who eagerly push their agenda. (Look at the CFTC in the Gensler years.) Less statist ones–like Trump’s–face a wearying battle of attrition to undo what had been put in place by previous administrations (and Congresses).

Legal precedents only make things more difficult. The Chevron doctrine (derived from a 33 year old Supreme Court decision) requires federal courts to defer to the judgments (I would not say expertise) of regulatory agencies in matters of statutory ambiguity and interpretation. This exacerbates greatly the agency problems, because since Congressional “contracts” (i.e., laws) are inherently incomplete (they do not specify regulatory actions in every state of the world), such ambiguities and necessities of interpretation are inevitably legion. And under Chevron, the federal courts can do little to rein in an agency. (Justice Gorsuch has criticized Chevron, and hopefully soon there will be an opportunity to reverse it or narrow it substantially.)

The administrative state is a progressive–and Progressive–creation. It reflects deep suspicion and skepticism about private ordering, and a belief in the superior knowledge and moral superiority of an expert class who should be protected from popular whims and passions, as expressed through election results, because those whims and passions are not the reflection of wisdom, knowledge, or dispassionate analysis. (If you want a sick laugh, look at Tom Nichols’ bleatings about expertise at @radiofreetom on Twitter.)  In the progressive worldview, the lack of democratic accountability is a feature, not a bug. Leave these people alone. They know better–and are better–that you!

The strongest case for some insulation of administrative agencies from more intrusive control by the Constitutionally-recognized branches of government is that this facilitates credible commitments: market participants, and citizens generally, know there will be some stability in rules and regulations, and can plan accordingly. But given the tendency to expand the scope of regulations, this translates into stability of overregulation.

There’s also something, well, Russian about a highly bureaucratic state, largely run by an unelected nomenklatura. Read Tocqueville’s descriptions of 19th century Russia and the 19th century US, and you’ll see that the administrative state leans far more towards the former than the latter.  I would also note that the bureaucracy is one of Putin’s strongest political pillars.

So the news that a few bureaucrats at the EPA are so disenchanted by Trump that they’ve up and quit is encouraging, but it’s at most a small victory in a big war. I have been encouraged by few other wins (e.g., on net neutrality), but the most I hope for is an elimination of some of the most egregious excesses of the Obama (and to a lesser degree Bush) years. The overall trend is towards a more powerful, insular, and unaccountable administrative state, much to the detriment of America’s freedom, dynamism, and prosperity.

 

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December 4, 2017

Bitcoin Futures: What? Me Worry?

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

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

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

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

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

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

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

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

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

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

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

Petterfy has expressed worries about weaker FCMs in particular:

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

He has recommended clearing crypto separately from other instruments.

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

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

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

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

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

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

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

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

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

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

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November 22, 2017

Obama Turned the Net Into a Neut: But It’s Getting Better!

Filed under: Economics,Politics,Regulation — The Professor @ 9:52 pm

Few subjects generate such intense reactions as net neutrality. It has become freighted with much emotional baggage, largely because it has been framed–artfully–as a matter of free choice and free speech vs. censorship and control of information by malign interests.

The Trump FCC’s announcement of its plans to reverse the Obama FFC’s 2015 net neutrality rule has led brought the issue–and the Manichean rhetoric–back to the fore.

One would hope that applying some basic economics might shed some light, and cool some of the rhetorical heat. I will give it a go.

The basic economic issue is straightforward. It is basically a matter of price discrimination, a subject that economists have analyzed and understood for years. The crucial feature of net neutrality is its ban on ISPs charging different prices for different types or categories of service. So for example, your Internet provider cannot charge higher prices for more intense consumers of bandwidth (e.g., streaming services).

Although the term “price discrimination” has bad connotations–which net neutrality supporters emphasize–it can be good, and it is difficult to identify conditions in which it is unambiguously bad compared to the real world alternative.

One reason that charging different prices for different types of customers can enhance efficiency–and why suppressing the ability to do so can be inefficient–is that the costs of providing a service can differ between customers. Some customers are more expensive to serve, or demand a differentiated service that is costlier to deliver. Providing the price signals that give the incentive to consume, produce, and invest in capacity efficiently requires price discrimination: higher cost customers should pay more than lower cost customers.

This is an issue in providing Internet services. Some services and users that consume more bandwidth, and impose greater risk of congestion on the system. A pricing structure that does not charge such users/services a higher price to reflect these higher costs induces overconsumption of these services, and imposes costs (e.g., poorer quality of service) on those who do not put such demands on the system. Furthermore, preventing ISPs from charging prices that reflect higher cost distorts their incentives to invest in more capacity, or in technologies and congestion management techniques that ease burdens on the system.

Prohibiting charging prices that vary by type of service or customer therefore results in cross-subsidization (low cost customers subsidize high cost ones), which both transfers wealth and undermines efficient allocation of resources.

Price discrimination can also occur as a result of market power. There are different “degrees” of price discrimination. To keep things simple, the most common kind is “third degree price discrimination”, in which a firm with market power who can segment customers based on their demand elasticities: less price sensitive customers pay higher prices than more elastic demanders.

It is plausible that demand elasticities for Internet services differ, and that elasticity may vary by the type of content, e.g., that the demand for streaming services is less price elastic than the demand for email or cat videos. In this case, charging a different price for streaming services vs. more mundane uses of the Internet could well be a form of 3d degree price discrimination.

It has long been known that the welfare effects of 3d degree discrimination are ambiguous: as compared to a single price for all services/customers charged by a firm facing a downward sloping demand curve, welfare (consumer plus producer surplus) or consumer surplus can be higher of lower with price discrimination. Furthermore, if a firm faces substantial economies of scale, the efficient way of covering fixed costs typically involves 3d degree price discrimination (“Ramsey Pricing”).

So one cannot say a priori that even if price discrimination by ISPs reflects market power, suppressing price discrimination improves welfare: the market power remains, and the ISP might exercise it in a way that causes welfare to be lower than if it exercises it by price discriminating.

Moreover, there is reason to doubt that a predicate for inefficient price discrimination–ISP market power–exists, or is more acute in this market than it is in many other markets where price discrimination is common (and believe me, that is pretty much every market). The days of the “last mile” monopoly are over. A very large fraction of Internet users in the US have access to multiple ISPs. Furthermore, wireless service (4G, and perhaps soon 5G services) competes with traditional cable and DSL service. Between wireless and cable, off the top of my head I can think of 8 providers that I can access. Yes, there is some overlap (e.g., ATT provides both types of service), but the number of choices most Americans have for Internet access is greater than they have for many other goods and services. Meaning that it is unlikely that market power problems are so acute in this market as to justify regulations unheard of in other markets where price discrimination is widely practiced.

I should also note that some kinds of price discrimination can unambiguously improve welfare relative to simple monopoly pricing. First degree (rare in practice) or second degree (e.g., quantity discounts, two part pricing) is superior to simple monopoly pricing. I would wager that some ISPs will adopt such efficiency enhancing price policies if freed from net neutrality restrictions.

Thus, if your concern is that ISPs exercise market power by price discrimination, suppressing price discrimination is not the best way to tackle the problem: attack the market power directly by reducing entry barriers or antitrust actions against ISPs. Furthermore, it is not at all clear that price discrimination in this market is driven primarily by market power, given the competitive conditions in the market. Lastly, and perhaps most importantly, attempting to squelch (at best ambiguously inefficient) market power driven price discrimination also precludes efficiency enhancing price discrimination based on differences in service/customer cost. Doing so imposes substantial costs.

For all these reasons, I conclude that net neutrality is (a) a solution to a non-existent problem, and (b) can do positive harm by preventing the development of efficient pricing systems that give appropriate incentives to consume and invest in system capacity, and to optimize its use.

Another aspect of the net neutrality rule is to prevent ISPs from favoring its content (which it either produces, or buys from others) over that supplied by independent parties.  Again, a necessary condition (but definitely not a sufficient one) for this to be a problem is ISP market power, which as noted above is unlikely to be a particularly serious issue. Furthermore, it is typically not in the interest of a downstream firm with market power to restrict its customers’ access to upstream product. Offering suboptimal product variety reduces the demand for the putative monopolist’s services, which reduces its profit. It is typically more profitable for the monopolist to offer the optimal product variety, and profit by charging a higher monopoly price.

There are some rather contrived models in which vertical restrictions (e.g., tying or exclusive dealing) can be used to lever market power from one good to another: the practical applicability of these models is dubious at best, as some of the modelers themselves acknowledge. But there is also an extensive literature (much of it originating in Chicago in the 1960s, including seminal contributions by my thesis advisor Lester Telser) showing that such vertical restrictions are usually efficiency-enhancing responses to some incompleteness in property rights or information problem. Indeed, in US antitrust law, horizontal restrictions (e.g., cartels) receive far more scrutiny that vertical ones, precisely because academic research on the potential efficiency enhancing effects of vertical restrictions, and the difficulty of using them to increase monopoly power, has informed antitrust policy–under administrations of both parties I might add. (As an aside, this makes the Trump DOJ challenge of the Time Warner-ATT deal somewhat strange, and intellectually at odds with the FCC’s move against net neutrality.)

In sum, I favor jettisoning net neutrality. No, I do not believe that the ISP market is perfectly competitive, but that is a red herring. Even acknowledging the possibility of imperfect competition in that market (although I do believe fear thereof is overblown), net neutrality is not the right way to address it, and indeed, might actually mean that market power is exercised in a way that reduces efficiency. In other words, the Obama FCC wanted to fight ISP market power in the worst way–and it did!

So if net neutrality is an inefficient policy, why did it prevail in the US, at least for a while? That is, what is the political economy of net neutrality?

Well, Chicago has a lot to say about this as well. Indeed, the work of another of my former advisors–Sam Peltzman–is directly on point. Sam’s amazing 1976 JLE article “Towards a More General Theory of Regulation” has an important, but widely overlooked prediction: regulation is likely to occur in industries where there are substantial differences in costs of serving different customers, and that regulated price structures suppress these cost differences. That is, regulated price structures cross-subsidize high cost customers. As Sam put it: “cross—subsidization follows a systematic pattern in which high cost customer groups are subsidized by low cost customers.” And: “The important contribution of politics is to suppress economically important distinctions and substitute for these a common element in all prices.”

That is net neutrality in a nutshell. Put simply, the Obama FCC bought political support Google, Facebook, Amazon, Microsoft, Netflix, et al by implementing a policy that cross subsidized their services. They used the political system to push regulation that suppresses economically important distinctions.

This result is less surprising from a political economy/public choice perspective than the Trump administration’s reversal of net neutrality. My first stab at an explanation is that this reflects the fact that a Trump administration can never expect to obtain political support from these companies, and can doesn’t really have to fear additional opposition: they already hate him with the heat of 1000 suns. So why  not stiff them?

Karma is a bitch, eh?

Now for some laughs!

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