Streetwise Professor

I’m on my way back from my annual teaching sojourn in Geneva, plus a day in the Netherlands for a speaking engagement.  While I was taking that European non-quite-vacation, a Norwegian power trader, Einar Aas, suffered a massive loss in cleared spread trades between Nordic and German electricity.  The loss was so large that it blew through Aas’ initial margin and default fund contribution to the clearinghouse (Nasdaq), consumed Nasdaq’s €7 million capital contribution to the default fund, and €107 million of the rest of the default fund–a mere 66 percent of the fund.  The members have been ordered to contribute €100 million to top up the fund.

This was bound to happen. In a way, it was good that it happened in a relatively small market.  But it provides a sobering demonstration of what I’ve said for years: clearing doesn’t eliminate losses, but affects the distribution of losses.  Further, financial institutions that back CCPs–the members–are the ultimate backstops.  Thus, clearing does not eliminate contagion or interconnections in the financial network: it just changes the topology of the network, and the channels by which losses can hit the balance sheets of big players.

Happening in the Nordic/European power markets, this is an interesting curiosity.  If it happens in the interest rate or equity markets, it could be a disaster.

We actually know very little about what happened, beyond the broad details.  We know Aas was long Nordic power and short German power, and that the spread widened due to wet weather in Norway (which depresses the price of hydro and reduces demand) and an increase in European prices due to increases in CO2 prices.  But Nasdaq trades daily, weekly, monthly, quarterly, and annual power products: we don’t know which blew up Aas.  Daily spreads are more volatile, and exhibit more extremes (kurtosis), but since margins are scaled to risk (at least theoretically–more on this below) what matters is the market move relative to the estimated risk.  Reports indicate that the spread moved 17x the typical move, but we don’t know what measure of “typical” is used here.  Standard deviation?  Not a very good measure when there is a lot of kurtosis (or skewness).

I also haven’t seen how big Aas’ initial margins were.  The total loss he suffered was bigger than the hit taken by the default fund, because under the loser-pays model, the initial margins would have been in the first loss position.

The big question in my mind relates to Nasdaq’s margin model.  Power price distributions deviate substantially from the Gaussian, and estimating those distributions is challenging in part because they are also conditional on day of the year and hour of the day, and on fundamental supply-demand conditions: one model doesn’t fit every day, every hour, every season, or every weather enviornment.  Moreover, a spread trade has correlation risk–dependence risk would be a better word, given that correlation is a linear measure of dependence and dependencies in power prices are not linear.  How did Nasdaq model this dependence and how did that impact margins?

One possibility is that Nasdaq’s risk/margin model was good, but this was just one of those things.  Margins are set on the basis of the tails, and tail events occur with some probability.

Given the nature of the tails in power prices (and spreads) reliance on a VaR-type model would be especially dangerous here.  Setting margin based on something like expected shortfall would likely be superior here.  Which model does Nasdaq use?

I can also see the possibility that Nasdaq’s margin model was faulty, and that Aas had figured this out.  He then put on trades that he knew were undermargined because Nasdaq’s model was defective, which allowed him to take on more risk than Nasdaq intended.

In my early work on clearing I indicted that this adverse selection problem was a concern in clearing, and would lead CCPs–and those who believe that CCPs make the financial system safer–to underestimate risk and be falsely complacent.  Indeed, I argued that one reason clearing could be a bad idea is that it was more vulnerable to adverse selection problems because the need to model the distribution of gains/losses on cleared positions requires detailed knowledge, especially for more exotic products.  Traders who specialize in these products are likely to have MUCH better understanding about risks than a non-specialist CCP.

Aas cleared for himself, and this has caused some to get the vapors and conclude that Nasdaq was negligent in allowing him to do so.  Self-clearing is just an FCM with a house account, but with no client business: in some respects that’s less risky than a traditional FCM with client business as well as its own trading book.

Nasdaq required Aas to have €70 million in capital to self-clear.  Presumably Nasdaq will get some of that capital in an insolvency proceeding, and use it to repay default fund members–meaning that the €114 million loss is likely an overestimate of the ultimate cost borne by Nasdaq and the clearing members.

Further, that’s probably similar to the amount of capital that an FCM would have had to have to carry a client position as big as Aas’.   That’s not inherently more risky (to the clearinghouse and its default fund) than if Aas had cleared through another firm (or firms).  Again, the issue is whether Nasdaq is assessing risks accurately so as to allow it to set clearing member capital appropriately.

But the point is that Aas had to have skin in the game to self-clear, just as an FCM would have had to clear for him.

Holding Aas’ positions constant, whether he cleared himself or through an FCM really only affected the distribution of losses, but not the magnitude.  If Aas had cleared through someone else, that someone else’s capital would have taken the hit, and the default fund would have been at risk only if that FCM had defaulted.  But the total loss suffered by FCMs would have been exactly the same, just distributed more unevenly.

Indeed, the more even distribution that occurred due to mutualization which spread the default loss among multiple FCMs might actually be preferable to having one FCM bear the brunt.

The real issue here is incentives.  My statement was that holding Aas’ positions constant, who he cleared through or whether he cleared at all affected only the distribution of losses.  Perhaps under different structures Aas might not have been able to take on this much risk.  But that’s an open question.

If he had cleared through another FCM, that FCM would have had an incentive to limit its positions because its capital was at risk.  But Aas’ capital was at risk–he had skin in the game too, and this was necessary for him to self-clear.  It’s by no means obvious that an FCM would have arrived at a different conclusion than Aas, and decided that his position represented a reasonable risk to its capital.

Here again a key issue is information asymmetry: would the FCM know more about the risk of Aas’ position, or less?  Given Aas’ allegedly obsessive behavior, and his long-time success as a trader, I’m pretty sure that Aas knew more about the risk than any FCM would have, and that requiring him to clear through another firm would not have necessarily constrained his position.  He would have also had an incentive to put his business at the dumbest FCM.

Another incentive issue is Nasdaq’s skin in the game–an issue that has exercised FCMs generally, not just on Nasdaq.  The exchange’s/CCP’s relatively thin contribution to the default fund arguably reduces its incentive to get its margin model right.  Evaluating whether Nasdaq’s relatively minor exposure to default risk led it to undermargin requires a more thorough analysis of its margin model, which is a very complex exercise which is impossible to do given what we know about the model.

But this all brings me back to themes I flogged to the collective shrug of many–indeed almost all–of the regulatory and legislative community back in the aftermath of the Crisis, when clearing was the silver bullet for future crises.   Clearing is all about the allocation and pricing of counterparty credit risk.  Evaluation of counterparty credit risk in a derivatives context requires a detailed understanding of the price risks of the cleared products, and dependencies between these price risks and the balance sheet risks of participants in cleared markets.  Classic information problems–adverse selection and moral hazard (too little skin in the game)–make risk sharing costly, and can lead to the mispricing of risk.

The forensics about Aas blowing up real good, and the lessons learned from that experience, should focus on those issues.  Alas, I see little recognition of that in the media coverage of the episode, and betting on form, I would wager that the same is true of regulators as well.

The Aas blow up should be a salutary lesson in how clearing really works, what it can do, and what it can’t.   Cynic that I am, I’m guessing that it won’t be.  And if I’m right, the next time could be far, far worse.

New Jersey senator Corey Booker has introduced legislation to impose “a temporary moratorium on mergers and acquisitions between large farm, food, and grocery companies, and establish a commission to strengthen antitrust enforcement in the agribusiness industry.”  Booker frets about concentration in the industry, noting that the four-firm concentration ratios in pork processing, beef processing, soybean crushing, and wet corn milling are upwards of 70 percent, and four major firms “control” 90 percent of the world grain trade.

My first reaction is: where has Booker been all these years?  This is hardly a new phenomenon.  Exactly a century ago–starting in 1918–in response to concerns about, well, concentration in the meat-packing industry, the Federal Trade Commission published a massive 6 volume study of the industry  The main theme was that the industry was controlled by five major firms.  A representative subject heading in this work is “[m]ethods of the five packers in controlling the meat-packing industry.”  “The five packers” is a recurring refrain.

The consolidation of the packing industry in the United States in the late-19th and early-20th centuries was a direct result of the communications revolution, notably the development of railroads and refrigeration technology that permitted the exploitation of economies of scale in packing.   The industry was not just concentrated in the sense of having a relatively small number of firms–it was geographically concentrated as well, with Chicago assuming a dominant role in the 1870s and later, largely supplanting earlier packing centers like Cincinnati (which at one time was referred to as “Porkopolis”).

In other words, concentration in meat-packing has been the rule for well over a century, and reflects economies of scale.

Personal aside: as a PhD student at Chicago, I was a beneficiary of the legacy of the packing kings of Chicago: I was the Oscar Mayer Fellow, and the fellowship paid my tuition and stipend.  My main regret: I never had a chance to drive the Weinermobile (which should have been a perk!).  My main source of relief: I never had to sing an adaption of the Oscar Mayer Weiner Song: “Oh I wish I were an Oscar Mayer Fellow, that’s what I really want to be.”

Back to the subject at hand!

Booker also frets about vertical integration, and this is indeed a difference between the 2018 meat industry and the 1918 version: as the Union Stockyards in Chicago attested–by the smell, if nothing else–the big packers did not operate their own feedlots, but bought livestock raised in the country and shipped to Chicago for processing.

I am a skeptic about market power-based explanations of vertical integration, and there is no robust economic theory that demonstrates that vertical integration is anti-competitive.  The models that show how vertical integration can be used to reduce competition tend to be highly stylized toys dependent on rather special assumptions, and hence are very fragile and don’t really shed much light on the phenomenon.

Transactions cost-based theories are much more plausible and empirically successful, and I would imagine that vertical integration in meat packing is driven by TCE considerations.  I haven’t delved into the subject, but I would guess that vertical integration enhances quality control and monitoring, and reduces the asymmetric information problems that are present in spot transactions, where a grower has better information about the quality of the cattle, and the care, feeding, and growing conditions than a buyer.

I’d also note that some of the other industries Booker mentions–notably bean and corn processing–have not seen upstream integration at all.

This variation in integration across different types of commodities suggests that transactional differences result in different organizational responses.  Grain and livestock are very different, and these likely give rise to different transactions costs for market vs. non-market transactions in the two sectors.  It is difficult to see how the potential for monopsony power differs across these sectors.

Insofar as the major grain traders are concerned, again–this is hardly news.  It was hardly news 40 years ago when Dan Morgan wrote Merchants of Grain.

Furthermore, Booker’s concerns seem rather quaint in light of the contraction of merchant margins, about which I’ve written a few posts.  Ironically, as my most recent ABCD post noted, downstream vertical integration by farmers into storage and logistics is a major driver of this trend.

To the extent that consolidation is in play in grains (and also in softs, such as sugar), it is a reflection of the industry’s travails, rather than driven by a drive to monopolize the industry.  Consolidation through merger is a time-tested method for squeezing out excess capacity in a static or declining industry.

Booker’s bill almost certainly has no chance of passage.  But it does reflect a common mindset in DC.  This is a mindset that is driven by simplistic understandings of the drivers of industrial structure, and is especially untainted by any familiarity with transactions cost economics and what it has to say about vertical integration.

Scott Sumner rightly skewers this central bankers’/macroeconomists’ angst:

That’s according to a paper presented Saturday by Harvard Business School economist Alberto Cavallo at the Federal Reserve Bank of Kansas City’s annual symposium in Jackson Hole, Wyoming.

Cavallo’s main finding was that competition from Amazon has led to a greater frequency of price changes at more traditional retailers like Walmart Inc., and also to more uniformity in pricing of the same items across different locations. He found that the shift has led to a greater influence of movements in the U.S. dollar exchange rate and gas prices on retail prices.

. . . .

The Cavallo study also showed that from 2008 to 2017, as online purchases accounted for an ever-growing share of total retail sales, the average duration of prices of goods sold at large U.S. retailers like Walmart fell from about 6.5 months to about 3.7 months.

The implications have subtle significance for monetary policy because so-called “sticky prices” — the notion that sellers aren’t able to change prices right away in response to changes in supply and demand — is precisely what gives interest rates power in mainstream models to have any effect on the economy at all. In those models, if prices adjust instantaneously in response to shocks, then there is no role for central bankers to guide supply and demand back into equilibrium.

“For monetary models and empirical work, my results suggest that the focus needs to move beyond traditional nominal rigidities,” Cavallo wrote. “Labor costs, limited information, and even ’decision costs’ (related to inattention and the limited capacity to process data) will tend to disappear as more retailers use algorithms to make pricing decisions.”

Come on.  The right response to Cavallo’s finding is NOT: “OH NOES! Monetary policy will be less effective when prices aren’t as sticky!”  The right response is: “Thank God we won’t need to rely on monetary policy–which can go horribly wrong because central bankers are humans operating with limited information and flawed theoretical understanding–to counteract shocks!”

Sticky prices create a potentially–and I emphasize potentially–beneficial role for monetary policy.  When prices are sticky, monetary shocks–including shocks to the demand for money–can have real effects.  Monetary authorities can in theory–and again I emphasize in theory–counteract these shocks and keep output closer to the optimum level.

However, the actual results often fall far short of the theoretical potential, because (as Sumner argues happened in 2007-2008, and Friedman and Schwartz argued happened regularly in US monetary history from 1867-1960) monetary authorities may misdiagnose economic conditions, and adopt a suboptimal policy, especially when they operate based on flawed heuristics, such as using the level of interest rates as a measure of whether monetary policy is tight or loose.

Thus, having more flexible pricing that allows nominal prices to adjust to shocks to the demand and supply of money makes us less reliant on central banking wizards–a very good thing, when they are often quite like the Wizard of Oz.

As Scott notes, more flexible/less-sticky prices do not eliminate the impact of monetary policy altogether, though for the most part that role should be less interventionist and more rule-based.

One nominal rigidity that more flexible goods prices won’t eliminate is that most debt will be denominated in nominal terms, and thus its real value will change with the prices of goods and services.  More flexible good prices may actually exacerbate the economic impact of nominal debt on real activity.  Although it is possible to imagine financial innovations that lead to more effective indexing or debt, whether the innovation is adopted widely remains to be seen, and there is room for doubt given the coordination issues involved.  Moreover.  there will still be a stock of existing nominal debt to work off even if new debt is indexed in more clever ways.

But even if nominal rigidities disappear, monetary shocks can still cause real fluctuations.  Remember that the Lucasian Rational Expectations models and their successors do not include rigid prices, yet they exhibit real responses to nominal shocks.  Indeed, that was the entire reason why Lucas and his contemporaries devised these models in the first place, as a way of resolving the Friedman conundrum: “money is a veil, but when the veil flutters, the economy stutters.”

In such a world, however, the role of central banks is much more limited.  In such a world, rule-based, rather than discretionary, policies that reduce the frequency and intensity of nominal shocks, are warranted.  That doesn’t leave much for central bankers to do.  They can’t be masters of the universe!

Central bankers no doubt look with dread on such a world.  That dread is implicit in the fretting over more flexible pricing reducing and perhaps eliminating the role of activist central bankers.  But their dread should be our joy.

Elon Musk took to YouTube to make a big announcement about his plans to take Tesla private:

Just kidding.  Like a thief in the night, Elon disclosed that he was not proceeding with his brilliant plan in a blog post that was posted at 11ET last night–Friday night.

Quite the weasel move.  I say when you screw up, man up.  But not our Elon.  He took the coward’s way out with a Friday night–late night–news dump.  Hell, he didn’t even Tweet it.

Of course the statement is filled with argle-bargle rationalizing the decision, and the previous big announcement about funding secured, $420/share, and all that.

He is sticking with the story that there was plenty of funding available.  Really?  Plenty of funding to take out shareholders at $420/share, and allow most of the existing shareholders to remain owners of the private firm in a magical structure never seen before, and almost surely a violation of the securities laws, and allow access to continued funds to fuel Tesla’s cash burn?

Musk of course had an alternative explanation for his U-turn: going private on the terms he had envisioned (or hallucinated) would be “even more time-consuming and distracting than initially anticipated.”

Yes, attempting the impossible usually is pretty time-consuming.

What next? Well, Tesla’s structural financial problems remain.  The company is facing the daunting challenge of navigating between the Scylla of Musk’s promise of no new capital raise and the Charybdis of the incessant cash burn.  Not to mention the problem of a delusional megalomaniac CEO.

Charley Grant of the WSJ has been skeptical of Musk–well, by journalist standards anyways–but he misdiagnoses his and the company’s current predicament.  Grant says that Musk made two mistakes in 2016–buying Solar City, and plunging ahead with the Model 3.  But Musk really had no choice on either: letting SCTY fail or ditching the everyman’s EV would have undermined Musk’s aura in 2016–and that aura is what has kept the capital flowing since.  If he had not done these things, Musk would have faced two years ago the problems he does now.

The other night I watched a BBC documentary about the Wars of the Roses, in which narrator (and historian) Dan Jones argued that Richard III wasn’t evil–the choices he made (killing Lord Rivers, kidnapping and then likely killing the princes in the Tower) weren’t really choices.  If he hadn’t done those things he would have faced immediate doom.  By doing them he bought some time–and delayed his doom.  Richard did what was necessary to survive to fight again another day.

Methinks Musk’s situation is similar.

I was amused that Morgan Stanley had announced Thursday that it was advising Musk on the going private plan, and then Musk pulls the plug about 40 hours later.  Does it really take that long to say “are you out of your fucking mind?”  Or did it take them that long to recover from the giggles? Or maybe Elon just sat on the bad news from MS until he could release it with the least attention possible.

The only real questions remaining are: (a) what caused Elon’s synapses to conceive of this brilliant plan?, and (b) will there be legal consequences?

Insofar as (a) is concerned: LSD? Lack of sleep? Impending mental breakdown? Or was there something more desperately Machiavellian about it?  Regardless, I can’t think of an explanation that bodes well for Tesla.

With regards to (b).  It is so blindingly obvious now (and should have been from word one) that his announcement Tweets were materially false.  They had large impacts on the price of Tesla stock.  They followed years of other dubious announcements, both on Twitter and in SEC filings and investor disclosures. If the SEC lets this slide it will make a mockery of the securities laws, and suggest that there are different standards for some people.

Some have suggested that the SEC is reluctant to take actions that will kill Tesla, or crater its stock price.  Well, why should Tesla be any different than other companies?  SEC actions have cratered other firms. (Dynegy is an example that comes to mind.)   The stock price falls were features, not bugs.  The SEC actions cratered these other firms because they revealed widespread wrongdoing and material falsity in corporate disclosures that had caused stock prices to be greatly inflated.  Why would the SEC want to perpetuate inflation in Tesla’s stock price?  If the stock price can’t handle the truth, well, that would be the problem that the SEC is supposed to be addressing, wouldn’t it?

In “Why Are ABCD Singing the Blues?” I called bull on the claim that ag trading firms were suffering through a rough period because of big crops and low prices.  I instead surmised that gains in capacity, in storage and throughput facilities, had outstripped growth in the amount of grain handled, and that this was pressuring margins.  In yesterday’s WSJ, Jacob Bunge (no relation, apparently, to the grain trading family) had a long and dense article that presents a lot of anecdotal support for that view.  The piece also provides other information that allows me to supplement and expand on it.

In a nutshell, due to increased economies of scale in farming, farms have grown larger.  Many farms have grown to the point that they can achieve efficient scale in storage and logistics to warrant investment in storage facilities and trucks, and thus can vertically integrate into the functions traditionally performed by Cargill and the others.  This has led to an expansion in storage capacity and logistical capacity overall, which has reduced the derived demand for the storage and logistics assets owned and operated by the ABCDs.  Jacob’s article presents a striking example of an Illinois farmer that bought a storage facility from Cargill.

In brief, more integrated farms have invested in capacity that competes with the facilities owned by Cargill, ADM, Bunge, and smaller firms in the industry.  No wonder their profits have fallen.

The other thing that the article illustrates is that scale plus cheaper communication costs have reduced the monopsony power of the grain merchants.  The operation of the farmer profiled in the piece is so large that many merchants, including some from a distance away, are competing for his business.  Furthermore, the ability to store his own production gives the farmer the luxury of time to sell: he doesn’t have to sell at harvest time to the local elevator at whatever price the latter offers–which was historically low-balled due to the cost of hauling to a more distant elevator.  Choosing the time to sell gives the farmer the value of the optionality inherent in storage–and the traditional merchant loses that option.  Further, more time allows the farmer to seek out and negotiate better deals from a wider variety of players.

The traditional country market for grain can be modeled well as a simple spatial economy with fixed costs (the costs of building/operating an elevator).  Fixed costs limit the number of elevators, and transportation costs between spatially separated elevators gave each elevator some market power in its vicinity: more technically, transportation costs meant that the supply of grain to a country elevator was upward sloping, with the nearby farms willing to sell at lower prices than more distant ones closer to competing elevators.  This gave the elevators monopsony power.  (And no doubt, competition was limited even in multi-elevator towns, because the conditions for tacit collusion were ripe.)

Once upon a time, the monopsony power of elevator operators was a hot-button political issue.  One impetus for the farm cooperative movement was to counteract the monopsony power of the line elevator operators.  The middlemen didn’t like this one bit, and that was the reason that they excluded cooperatives from membership of futures exchanges, like the Chicago Board of Trade: this exclusion raised cooperatives’ costs, and was effectively a raising-rivals-cost strategy.  Brokers also supported excluding cooperatives because as members cooperatives could have circumvented broker commission cartels (i.e., the official, exchange-approved and enforced minimum commission rates).  This is why the Commodity Exchange Act contains this language:

No board of trade which has been designated or registered as a contract market or a derivatives transaction execution facility exclude  from membership in, and all privileges on, such board of trade, any association or corporation engaged in cash commodity business having adequate financial responsibility which is organized under the cooperative laws of any State, or which has been recognized as a cooperative association of producers by the United States Government or by any agency thereof, if such association or corporation complies and agrees to comply with such terms and conditions as are or may be imposed lawfully upon other members of such board, and as are or may be imposed lawfully upon a cooperative association of producers engaged in cash commodity business, unless such board of trade is authorized by the commission to exclude such association or corporation from membership and privileges after hearing held upon at least three days’ notice subsequent to the filing of complaint by the board of trade.

Put differently, in the old days the efficient scale of farms was small relative to the efficient scale of midstream assets, so farmers had to cooperate in order to circumvent merchant monopsony power.  Cooperation was hampered by incentive problems and the political nature of cooperative governance.  (See Henry Hansmann’s Ownership of Enterprise for a nice discussion.) The dramatic increase in the efficient scale of farms now means (as the WSJ article shows) that many farmers have operations as large as the efficient scale of some midstream assets, so can circumvent monopsony power through integration.  This pressures merchants; margins.

Jacob Bunge is to be congratulated for not imitating the laziness of most of those who have “reported” on the grain merchant blues, where by “reporting” I mean regurgitating the conventional wisdom that they picked up from some other lazy journalist.  He went out into the field–literally–and shed a good deal of light on what’s really going on.  And what’s going on is competition and entry, driven in large part by economic and technological forces that have increased the efficient scale of grain and oilseed production.  Thus, the grain handlers are in large part indirect victims of technological change, even though the technology of their business has remained static by comparison.

The Elon Magical GoPrivate Mystery Tour gets more magical by the day.  Today Elon tried to do some ‘splainin’, but his explanation was effectively a guilty plea.  He said that he left a late-July meeting with the head of the Saudi investment fund convinced that it would fund the transaction.

Legal memo to Elon: “secured in my mind” is not the same as secured, secured, all legal and such.  Even if–especially if–you are a legend in your own mind.

Musk’s explanation is more of a guilty plea than a defense.  The intersection between “funding secured” and “conversations are ongoing” is a set of measure zero.

Then there’s the magical structure.  As I noted in an earlier post, he wants it all ways.  He wants to be a private firm, but still have a herd of small shareholders.  In other words, he wants a structure that does not exist, most likely because it violates the securities laws.

There’s also another issue that has received no real attention, though it should.  All of the figgerin’ I’ve seen so far just totes up the amount of money required to buy out Tesla shareholders at $420/share.

But that’s just the start!  Tesla has been a cash bleeder for years, and has gone to the secondary offering well again and again to raise the money necessary to fund its operations and capex.  There is no prospect of that ending soon–indeed, one of the reasons I suspect Elon is throwing this Hail Mary is the fundamental inconsistency between his recent assertions that no additional capital raises would be necessary and the need for further funds.

So any sugar daddies will not merely have to stump up as much as $80 billion to buy the outstanding equity–they will have to commit to fund it while it continues to be cash flow negative to the sum of ~$500 million-$1 billion per quarter.

Going private deals are usually done for cash-flow positive companies.  They are levered up and use the cash flows to service the debt.  The PE dealmakers extract cash at the beginning, and definitely don’t plan to inject more cash for the indefinite future. That traditional framework obviously can’t work for Tesla.  So not only is the legal structure that Musk has mooted a figment of his imagination, the economic model is also fantastical.

But other than that, the deal sounds totally great, Elon.

One final note that makes me chuckle.  Elon made his big announcement on Twitter.  He has also blocked a lot of people on Twitter–including me in 2013 or 2014.  Well, selective disclosure of public information–giving it to some people earlier than others–violates Reg FD (“Regulation Fair Disclosure”).  So by (a) blocking me (and many others) on , and (b) running his big brain waves through Twitter, Elon might have committed other securities violations.

Hahahaha.

Two class action lawsuits have been filed against Tesla and Elon Musk, claiming that he artificially inflated the price of Tesla stock through his going private tweets, thereby unleashing a “nuclear attack” that “completely decimated short sellers.”*

It is a plausible claim.  However, the damages here are likely to be minimal.  Tesla’s stock fell below the pre-tweet price within a day, as reality set in.  Therefore, only those who bought during that brief window of tweet-induced euphoria (and inflation)  would have a claim (and this would include shorts who covered).  Not likely a huge class here.

No, the mother of Tesla class actions awaits a big stock price drop, which would likely follow either a disclosure of past mis-statements and fraud, or an SEC announcement of litigation against the firm.  (Hey, has the statute of limitations run out on the 2013 squeezes?)  I think it’s a matter of time, but who knows?

The whole going private thing looks more bizarre by the day, especially given Elon’s odd ideas about what going private means:

Tesla Inc. Chief Executive Officer Elon Musk and advisers are seeking a wide pool of investors to back a potential take-private of the automaker to avoid concentrating ownership among a few new large holders, according to people familiar with the matter.

Tesla is holding early discussions with banks about the feasibility and structure of a possible deal, the people said, asking not to be identified as the details aren’t public. They are canvassing investors including large asset managers, the people said.

Billionaire founder Musk would prefer to amass a group of investors who could each contribute part of the funds because he wants to avoid having one or two large new stakeholders in the company, the people said. Deliberations are at an early stage and the company hasn’t yet formally hired a bank to work on the process or made a final decision on how to proceed, they said.

In other words, Elon wants his cake and to eat it too.  He wants diffuse ownership and total control, and to deny the diffuse owners the investor protections that a public listing brings with it.

Come to think of it, Elon wants to bring the Russian model to the US–think of Rosneft, Gazprom.

The Tesla board of sheep–I mean, directors–is apparently scrambling furiously to try to recover from Elon’s blunder by “investigating” a going private transaction.  A little late!

I really want to know who Tesla’s O&D insurer is, so I can short it.

*Pedantic pet peeve.  You can’t “completely decimate” anything–that’s an oxymoron. Decimate means execute one out of ten.  It was a punishment exacted against mutinous Roman legions.  I think the word the lawyers are looking for is “annihilate.”

The WSJ reports that the CFTC engaged in extraordinary efforts to prevent manipulation of the CDS market by Blackstone Group.  Blackstone had bought about $333 million in protection on homebuilder Hovnanian, and then extended a low-interest loan to the company to induce it to make a technical default on debt the company itself owned (having bought it back).  The CFTC caught wind of this, and put on the full court press and eventually, uhm, persuaded (by intimating that it considered such behavior manipulative) Blackstone to negotiate an exit from the CDS with its counterparties.

In the Allen-Gale taxonomy, this would be best characterized as an “action-based” manipulation, as opposed to trading-based, or information-based.  It is clearly not a market power manipulation.

The conduct at issue is clearly a form of rent seeking–a set of transactions engineered for the purpose of obtaining a wealth transfer.  Unlike a market power manipulation, the direct welfare costs of this activity were probably small, and limited to the costs of negotiating with Hovnanian, and executing the CDS transactions.  However, as in most manipulations, the big costs here were indirect.  Blackstone’s scheme undermines the CDS market as a risk transfer mechanism.  In effect, Blackstone’s stratagem was a form of moral hazard, in that the insured could affect the probability of loss.  Moral hazard raises the cost of insurance, and leads to suboptimal risk transfer.  (Yes, I know that CDS market participants shudder at the use of the word “insurance” to describe CDS, in part because they want to avoid insurance regulation.  I am not using the word in its legal sense, but in an informal way to describe a risk transfer mechanism.)

CDS are particularly prone to moral hazard because individuals (notably, the managers of corporations) can do things to trigger defaults, and CDS can provide them directly or indirectly with an economic incentive to do so.  Further, CDS contracts are incomplete (i.e., not all possible contingencies can be specified) and often as a result contain ambiguities that clever rent seekers can exploit to win a payoff.

The CFTC’s actions are therefore laudable.  What’s particularly curious about this, however, is precisely the fact that it was the CFTC that intervened here.  Under Title VII of Frankendodd, the SEC has jurisdiction “over ‘security-based swaps,’ which are defined as swaps based on a single security or loan or a narrow-based group or index of securities (including any interest therein or the value thereof), or events relating to a single issuer or issuers of securities in a narrow-based security index”–the CFTC has jurisdiction over everything else.

The Hovnanian CDS are clearly in the SEC’s ambit, and not in the CFTC’s.  But in the case of the Hovnanian CDS, the SEC has been conspicuously absent. IIt is not mentioned at all in the WSJ piece.)  Curious, that.  Even more curious given the jealousy with which the SEC (like most government agencies) defends its turf against perceived incursions–especially the CFTC.   Why did the SEC let the CFTC take the lead on this, without a peep of protest?  And why did the CFTC apparently overstep its authority?

Things could have become interesting had Blackstone persisted with its scheme, and the CFTC filed an action against it.  In the event, an obvious legal response by Blackstone would have been to claim that the CFTC had no legal authority to take enforcement action.

Given this legal issue, the CFTC’s intervention may have less of a deterrent effect on future manipulations than an SEC intervention would have.

The SEC does not have the reputation of being a shrinking violet by any means, but it has been noticeably shy in some high profile events, the Hovnanian CDS story being one, and Tesla being another.  Makes me wonder . . .

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

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

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

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

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

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

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

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

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

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

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.