Streetwise Professor

The primary reason for my deep skepticism about the wisdom of clearing mandates was liquidity risk. As I said repeatedly, in order to reduce counterparty risk, clearing necessarily increased liquidity risk through the variation margining mechanism. Further, it was–and is–my opinion that liquidity risk is a far graver systemic concern that counterparty risk.

A major liquidity event has occurred in the last couple of days: rates in the repurchase market–the major source of short term funding for vast amounts of trading activity–shot up to levels (around 5 percent) nearly double the Fed’s target ceiling for that rate. Some trades took place at far higher rates than that (e.g., 9.25 percent).

Market participants have advanced several explanations, including big cash demands due to corporate tax payments coming due. Izabella Kaminska at FTAlphavile offered this provocative alternative, which resonates with my clearing story: the large price movements in oil and fixed income markets in the aftermath of the attack on the Saudi resulted in large margin calls in futures and cleared OTC markets that increased stresses on the funding markets.

To which one might say: I sure as hell hope that’s not it, because although there was a lot of price action yesterday, it wasn’t The Big One. (The fact that Fred Sanford’s palpitations occurred because he couldn’t get his hands on cash makes that bit particularly apropos!)

I did some quick back-of-the-envelope calculations. WTI and Brent variation margin flows (futures and options) were on the order of $35 billion. Treasuries on CME maybe $10 billion. S&P futures, about $1 billion. About $2 billion on Eurodollar futures.

The Eurodollar numbers can help give a rough idea of margin flows on cleared interest rate swaps. Eurodollar futures open interest is about $12 trillion. Cleared OTC notional volume (not just USD, but all IRS) is around $80 trillion. But $1mm in notional of a 5 year swap is equivalent to 20 Eurodollar futures with notional amount of $20 trillion. So, as a rough estimate, variation margin flows in the cleared IRS market are on the order of 100x for Eurodollars. That represents a non-trivial $200 billion.

Yes, there are potentials for offsets, so these numbers are not additive. For example, a firm might have offsetting positions in EDF and cleared IRS. Or be short oil and long Treasuries. But variation margin flows on the order of $300 billion are not unrealistic. And since market moves were relatively large yesterday, that represents an increment over the typical day.

So we are talking real money, which could certainly contribute to an increased demand for liquidity. But again, yesterday was not remotely a truly epic day that one could readily imagine happening.

A couple of points deserve emphasis. The first is that perhaps it was coincidence or bad luck, but the big variation margin flows coincided with other sources of increased demand for liquidity. But hey, stuff happens, and sometimes stuff happens all at once. The system has to be able to withstand such simultaneous stuff.

The second is related, and very concerning. The spikes in rates observed periodically in the repo market (not just here, but notoriously in China) suggest that this market can go non-linear. Thus, even if the increased funding needs caused by the post Abqaiq fallout wasn’t The Big One, in a non-linear market, even modest increases in funding needs can have huge impacts on funding costs.

This highlights another concern: inter-market feedback. A shock in one market (e.g., crude) puts stress on the funding market that leads to spikes in repo rates. But these spikes can feedback into prices in other markets. For example, if the inability to fund positions causes fire sales that cause big price moves that cause big variation margin flows which put further stress on the funding markets.

Yeah. This is what I was talking about.

Today’s events nicely illustrate another concern I raised years ago. Clearing/margining make markets more tightly coupled: the need to meet margin calls within hours increases the potential stress on the funding markets. As I tell my classes, unlike in the pre-Frankendodd days, there is no “fuck you” option when your counterparty calls for margin. You don’t pay, you are in default.

This tight coupling makes the market more vulnerable to operational failings. On Black Monday, 1987, for example, the FedWire went down a couple of times and this contributed to the chaos and the potential for catastrophic failure.

And guess what? There was a (Fed-related!) operational problem today. The NY Fed announced that it would hold a repo operation to supply $75 billion of liquidity . . . then had to cancel it due to “technical difficulties.”

I hate it when that happens! But that’s exactly the point: It happens. And the corollary is: when it happens, it happens at the worst time.

The WSJ article also contains other sobering information. Specifically, post-crisis regulatory “reforms” have made the funding markets more rigid/less-flexible and supple. This would tend to exacerbate non-linearities in the market.

We’re from the government and we’re here to help you! The law of unintended (but predictable) consequences strikes again.

Hopefully things will normalize quickly. But the events of the last two days should be a serious wake-up call. The funding markets going non-linear is the biggest systemic risk. By far. And to the extent that regulatory changes–such as mandated clearing–have increased the potential for demand surges in those markets, and have reduced the ability of those markets to respond to those surges, in their attempt to reduce systemic risks, they have increased them.

I have often been asked what would cause the next financial crisis. My answer has always been: the regulations intended to prevent a recurrence of the last one. Today may be a case in point.

ICE is on the verge of launching Bitcoin futures. The official start date is 23 September.

The ICE contract is distinctive in a couple of ways.

First, it is a delivery settled contract. Indeed, this feature is what made the ICE product so long in coming. The exchange had to set up a depository, the Bakkt Warehouse. This required careful infrastructure design and jumping through regulatory hoops to establish the Bakkt Trust Company, and get approval from the NY Department of Financial Services.

Second, the structure of the contracts offered is similar to that of the London Metal Exchange. There are daily contracts extending 70 days into the future, as well as more conventional monthly contracts. (LME offers daily contracts going out three months, then 3-, 15-, and 27-month contracts). The daily contracts settle two days after expiration, again similar to LME.

The whole initiative is quite fascinating, as it represents a dual competitive strategy: Bakkt is simultaneously competing in the futures space (against CME in particular), and against spot crypto exchanges.

What are its prospects? I would have to say that Bakkt is a better mousetrap.

It certainly offers many advantages as a spot platform over the plethora of existing Bitcoin/crypto exchanges. These advantages include ICE’s reputation, the creation of a warehouse with substantial capital backing, and regulatory protections. Here is a case in which regulation can be a feature, not a bug.

Furthermore, for decades–over a quarter-century, in fact–I have argued that physical delivery is a far superior mechanism for price discovery and ensuring convergence than cash settlement. The myriad issues that were uncovered in natural gas when rocks were overturned in the post-Enron era, the chronic controversies over Platts windows, and the IBORs have demonstrated the frailty, and vulnerability to manipulation of cash settlement mechanisms.

Crypto is somewhat different–or at least, has the potential to be–because the CME’s cash settlement mechanism is based off prices determined on several BTC exchanges, in much the same way as the S&P500 settlement mechanism is based on prices determined at centralized auction markets.

But the crypto exchanges are not the NYSE or Nasdaq. They are a rather dodgy lot, and there is some evidence of manipulation and inflated volumes on these exchanges.

It’s also something of a puzzle that so many crypto exchanges survive. The centripetal forces of liquidity tend to cause trading in a particular instrument to gravitate to a single platform. The fact that this hasn’t happened in crypto is anomalous, and suggests that normal economic forces are not operating in this market. This raises some concerns.

Bakkt potentially represents a double-barrel threat to CME. Not only is it competing in futures, if it attracts a considerable amount of spot trading activity (due to a superior trading, clearing, settlement and custodial platform, reputational capital, and regulatory safeguards) this will undermine the reliability of CME’s cash settlement mechanism by attracting volume away from the markets CME uses to determine final settlement prices. This could make these market prices less reliable, and more subject to manipulation. Indeed, some–and maybe all–of these exchanges could disappear if ICE’s cash market dominates. CME would be up a creek then.

That said, one of the lessons of inter-exchange competition is that the best mousetrap doesn’t always win. In particular, CME has already established liquidity in the futures market, and as even as formidable competitor as Eurex found out in Treasuries in the early-oughties, it is difficult to induce a shift of liquidity to a competitor.

There are differences between crypto and other more traditional financial products (cash and derivatives) that may make that liquidity-based first mover advantage less decisive. For one thing, as I noted earlier, heretofore cash crypto has proved an exception to the winner-takes-all rule. Maybe the same will hold true for crypto futures: since I don’t understand why cash has been an exception to the rule, I’d be reluctant to say that futures won’t be (although CBOE’s exit suggests it might). For another, the complementarity between cash and futures in this case (which ICE is cleverly exploiting in its LME-like contract structure) could prove decisive. If ICE can get traction in the fragmented cash market, that would bode well for its prospects in futures.

Entry into a derivatives or cash market in competition with an incumbent is always a highly leveraged bet. Odds are that you fail, but if you win it can prove enormously lucrative. That’s essentially the bet that ICE is taking in BTC.

The ICE/Bakkt initiative will prove to be a fascinating case study in inter-exchange competition. Crypto is sufficiently distinctive, and the double-barrel ICE initiative sufficiently innovative, that the traditional betting form (go with the incumbent) could well fail. I will watch with interest.

In the aftermath of the El Paso and Dayton shootings, “red flag” rules are all the rage. Identify people who are at high risk of committing such atrocities, and prevent them from buying weapons.

Most of the arguments in favor of this rely on statements like “many mass shooters have characteristic X (e.g., mental illness), so let’s prevent those with characteristic X from buying guns.” As appealing as these arguments sound, they founder due to a failure to understand fundamental probability concepts which imply that for extremely rare events like mass shootings, red flags are extremely unreliable.

Most of the arguments in favor of red flags rely on estimates of P(X|M), i.e., the probability that someone who committed a mass murder (“M“) had characteristic X. For example, “70 percent of mass shooters present evidence of mental illness.” Or Y percent play violent video games or post racist rants online.

But what we really need to know in order to implement red flags that do not stigmatize, and deny the rights of, people who present a low risk of committing a mass shooting is P(M|X): “what is the probability that someone with characteristic X will commit a mass shooting?” Although most people argue as if P(X|M) and P(M|X) are interchangeable, they are not, as Thomas Bayes demonstrated in the 18th century when he demonstrated something now called Bayes’ Theorem.

As Bayes showed, P(M|X)=P(X|M)P(M)/P(X) where P(M) is the unconditional probability someone is a mass shooter, and P(X) is the unconditional probability that someone has characteristic X.

The problem with attempting to determine whether someone with X poses a risk is that mass shooters are extremely rare, and hence P(M) is extremely small.

USA Today estimated there were 270 odd mass shootings between 2005 and 2017. A Michael Bloomberg-funded anti-gun group counts 110. Given a population of around 300 million, even using the higher number a rough estimate of P(M) is 9e-7: a 9 with six zeros in front of it. Therefore, even if P(X|M)=1 (i.e., all mass shooters share some characteristic X) , for any characteristic X that occurs fairly frequently in the population P(M|X) is extremely small.

Consider a characteristic where there is fairly good data on on P(X): schizophrenia. It is estimated that 1 percent of the population is schizophrenic. Plugging .01 for P(X) gives a value of P(M|X) of 9e-5, or about 1 out of 10,000. Meaning that the likelihood a random schizophrenic will commit a mass shooting is .001 percent.

This actually overstates matters, because P(X|M)<1. Indeed, since mass shootings are in fact quite heterogeneous, P(X|M) is likely to be far less than one for most characteristics.

Things get even worse if one broadens the scope of the characteristic used to define the red flag. If instead of using schizophrenia, one uses serious mental illness, by some measures P(X)=.2. Well, if you increase the denominator by a factor of 20, P(M|X) falls by a factor of 20. So instead of a probability of .001 percent, the probability is .00005 percent.

And again, that is an exaggeration because it assumes P(X|M)=1.

Meaning that putting a red flag on schizophrenics or those who have experienced some mental illness will be vastly overinclusive.

Of course, life is a matter of trade-offs. One must weigh the costs imposed on those who are wrongly stigmatized (“false positives”) with the benefit of reducing mass shootings by imposing restrictions based on an overinclusive, but at least somewhat informative signal (i.e., a signal with P(X|M)>0).

For some there is no trade-off at all. For those primarily on the left who believe that guns are an anathema and have no benefit whatsoever, even a 99.99995 percent false positive rate is not at all costly. However, a very large number of Americans do think bearing arms is beneficial, these false positives come at a high cost.

That’s where the debate should really focus: the rate of false positives and the cost of those false positives vs. the benefits of true positives (which would represent mass shootings avoided). What Bayes’ Theorem implies is that for an act that someone is extremely unlikely to commit, that false positive rate is likely to be extremely high. It also implies that debating in terms of P(X|M) provides very little insight. P(M) is small, and for any fairly common characteristic, P(X) is fairly large, so P(X|M) has relatively little impact on the rate of false positives.

Again, what Bayes’ Theorem tells us is that for a rare event like mass shooting, vastly more innocent people than true risks will be red flagged. The costs of restricting those who pose no risk must be weighed against the benefits of reducing modestly the risk of a very rare event. Further, it must be recognized that implementing red flag rules are costly, and in these costs should be included the invasions of privacy that they inevitably entail. Yet further, red flag rules are certain to be abused by those with a grudge. And yet further, many of those with characteristic X will escape detection, or will be able to evade the legal restrictions (and indeed have a high motivation to do so).

In the aftermath of mass shootings, there is a hue and cry to do something. The hard lesson taught by Parson Bayes is that there is not a lot we can do. Or put more precisely, those things that we can do will inevitably stigmatize and restrict vastly more innocent people than constrain malign ones.

I’m sure you’ve read articles claiming that the cost of renewables electricity generation is approaching that (or even lower than) the cost of traditional thermal generation. I am deeply skeptical of these claims even when evaluated on their own terms (which focus on generation costs alone), but find them particularly misleading because they ignore other costs attributable to the facts that renewables are intermittent and diffuse, and that the siting of renewables generation is sharply constrained because they are energy limited resources; the distribution of energy is dictated by nature; and typically is not closely related to the distribution of load.

In other words, renewables are costly because you can’t stick them where the sun don’t shine (or the wind don’t blow).

Case in point: Australia. As even Bloomberg (a tiresome renewables fanzine) reports:

Australia’s financing of cleaner power is slowing because the country’s aging grid isn’t being upgraded quick enough to accept new, intermittent generation and transport it efficiently to demand centers.

Although Bloomberg attempts to blame an old, creaky transmission system, this is misleading in the extreme. It would be far cheaper to upgrade Australia’s transmission system to accommodate thermal generation than it will be to build transmission to increase the fraction of generation coming from renewables.

This is true for at least a couple of reasons.

First, the energy-limited nature of renewables means that you have to site them where the energy is available–sunny or windy places. This imposes a constraint on the location of generation resources that is not relevant for thermal generation. With traditional fossil-fueled generation, you have more flexibility in trading off transmission costs with generation costs (including the cost of brining fuel to plants) than is the case with wind. This flexibility means that all else (notably the spatial distribution of load) equal, transmission costs are lower with thermal generation than renewable power.

Second, the intermittent and inherently more volatile nature of renewables generation increases the variance in the spatial distribution of generation. This variability in the spatial distribution of generation necessarily requires more transmission capacity per unit of load. This, in turn implies a lower average rate of utilization of transmission resources.

The basic idea here can be illustrated relatively simply. Consider a system with two generation resources. One is highly volatile (e.g., a renewable resource). The other is controllable. There is one load location. The transmission capacity from the volatile location to load must be high enough to carry the power when output is high (because the energy input is high due to the vicissitudes of sun or wind). The transmission capacity from the location with controllable generation must also be high enough to transmit enough power to fill the gap left when the renewable output is low.

Note that when renewable output is high, controllable output will be low and the transmission lines from the latter will operate at low capacity. When renewable output is low, the lines serving it will be operating at low capacity.

It’s possible to expand the example to include multiple variable, energy limited, but imperfectly correlated renewables resources, but the outcome is the same. You need more transmission capacity to deal with the spatial volatility in generation, and given load, higher capacity translates into lower average capacity utilization.

Thus, the problem that Australia is confronting isn’t a function of an old grid: it arises from the fact that increased reliance on renewables requires investment in new transmission capacity even in a system where transmission is optimized relative to (thermal) generation and load.

The need to maintain relatively underutilized transmission capacity to deal with the inherent volatility of renewables generation is mirrored by the need to maintain underutilized thermal generation capacity:

While new clean energy projects struggle to gain access to a congested grid, aging coal and gas-fired generators are being kept running for longer to maintain system stability. AGL Energy Ltd. said Friday it would delay the planned closure of its Liddell and Torrens A plants, both around 50 years old, to help the national energy market cope with peak summer demand, which has seen blackouts in parts of southeastern Australia in recent years.

Who knew?

Yet the renewables industry/lobby continues to flog the dogma that they will inevitably be more efficient:

Despite the challenges facing the industry, it’s not all doom and gloom. A number of coal-fired plants will be retired over the next decade and they will only be replaced by the cheapest cost of energy, which is renewables, Clean Energy Finance Corp. Chief Executive Ian Learmonth said in an interview.
“I’m hoping once some of these issues around the grid and regulations are settled that we’ll see another significant uptick in the renewable energy pipeline,” he said.

What costs is Mr. Learmonth including in his assertion that renewables are the “cheapest” source of energy? His statement that settling “issues around the grid” will lead to increased renewables investment suggests that he is ignoring crucial costs, because settling these issues doesn’t come for free.

It’s not as if the transmission issue is unique to Australia. It is present in every locale that has force-fed renewables. Germany is a prominent example. Wind energy is abundant in the North Sea, but believe it or not, there aren’t a lot of electricity consumers there (despite my ardent wish that Merkel and her ilk get into the sea). Major sources of load are in central and southern Germany, so bringing North Sea wind power to load requires massive transmission investments, which inevitably are not just costly, but politically difficult (Der NIMBY, anyone?). These difficulties inflate the cost.

Renewables boosterism operates in an atmosphere of serious unreality because it consistently glosses over–or ignores altogether–the costs arising from intermittency, diffusiveness, the energy-limited nature of wind and solar, and the caprices of nature that cause a mismatch between where the energy exists and where it is needed. When these facts are considered, sticking renewables where the sun don’t shine makes perfect sense.

In my recent post on position limits, I suggested that at most spot month limits are justified as a means of constraining market power manipulation. It is important to note, however, that setting spot month limits at levels that approximate stocks in deliverable position may not be sufficient to prevent the exercise of market power during the delivery period, with the resultant deleterious effects on prices.

The basic motivation for position limits equal to stocks is predicated on a model of manipulation that makes particular assumptions about market participants’ beliefs. I pointed out the importance of this assumption in my 1993 Journal of Business article on market power manipulation. In one model of that paper, I assume that market participants believe that a large long who takes delivery will resell what is delivered, and will not consume it. In the other model, market participants believe that the large long will consume (or otherwise withhold from the market) some fraction of what shorts deliver to him.

Under the first set of beliefs, it is indeed a necessary condition for profitable manipulation that a long’s position exceed inventories in deliverable position. It is this kind of manipulation that spot month limits pegged to inventories can prevent.

However, under the second set of beliefs, a large long with a position smaller than inventories in deliverable position can exercise market power and inflate prices. Spot month limits based on inventories cannot prevent this type of manipulation.

I recently completed a paper that incorporates this insight into a standard signalling model. In the model, there are two kinds of longs: (a) “strong stoppers,” who have a real demand for the deliverable commodity, place a higher value on it than others, and who will consume at least some of what is delivered to them, and (b) manipulators, who have no real demand for the deliverable and who will resell what is delivered. Shorts do not know which type is standing for delivery.

In the model, a long submits an offer to sell his futures position at a specified price prior to expiration. The strong stopper submits an offer above the price that would prevail in the absence of a strong stopper (reflecting his high valuation of the commodity). I show that under different out-of-equilibrium beliefs there is a pooling equilibrium in with the manipulator mimics a strong stopper, and submits a high offer price at which he is willing to liquidate.

In the pooling equilibrium, the shorts deliver a quantity that exceeds the quantity that they would deliver if they knew the long was a strong stopper: this reflects the fact that they realize that the manipulator will resell what is delivered, and the shorts can repurchase it at a depressed price. However, in this equilibrium the manipulator sells some of his futures position at a supercompetitive price, and earns a supercompetitive profit even though he has to “bury the corpse” of a manipulation.

Crucially, the manipulation can succeed even if the long’s position is smaller than inventories, as long as the flow supply curve is upward sloping at such quantities. The flow supply curve can be upward sloping merely due to the theory of storage: an anticipated depletion of stocks increases the value of the remaining inventory. Therefore, if shorts anticipate a positive probability that a long will consume what is delivered, the theory of storage implies that the supply of deliveries is an increasing function of the futures price at expiration.

Thus, a futures position in excess of inventories in deliverable position may be a sufficient condition to exercise market power, but it is not a necessary one. If shorts are uncertain about a long’s motive for taking delivery, and some longs are strong stoppers who will consume what is delivered and thereby deplete inventories, manipulators can mimic strong stoppers and extract a supercompetitive price even with a position smaller than inventories.

One implication of this analysis is that reliance on spot month position limits is not sufficient to prevent market power manipulations. Additional measures, what I have called “ex post deterrence” since my 1996 Washington and Lee Law Review article, are also necessary. In my earlier work I argued that they are necessary because it was unlikely that position limits could adjust to reflect inevitable changes in inventories. This new paper shows that even if they could so adjust limits, they would be inadequate. Market power manipulation facilitated by fraud (i.e., falsely pretending to have a real demand for the commodity) can occur even if position limits prevent a long from obtaining a position during the delivery period that exceeds stocks in deliverable position.

This analysis also implies that equating “deliverable supply” with “inventory in deliverable position” is wrong. The supply available at the competitive price may be smaller than inventories–and indeed, far smaller than inventories–when shorts do not know the “type” of long standing for delivery.

The traditional model of deliverable supply is predicated on a view of manipulation shaped by the big corners of history, in which there was little doubt about the motivations of a large long. But as the court in the Cargill case noted, “[t]he methods and techniques of manipulation are limited only by the ingenuity of man.” Exploiting shorts’ ignorance about his motive for taking delivery, a long can ingeniously exercise market power even with a position smaller than deliverable supply.

This is a possibility that is only dimly recognized in the existing regulatory structure in the US. Most importantly, it implies that a reliance on preventative measures like position limits alone is inadequate to reduce efficiently the frequency and severity of market power manipulation. Ex post measures are required as well.

To huge fanfare, Facebook announced the impending release of a new cryptocurrency, “Libra.” Except it isn’t–a crypto, that is. Whereas real cryptocurrencies are decentralized, anonymous, unpermissioned, and lack trusted intermediaries, Libra is centralized, permissioned, non-anomymous and chock-full o’ intermediaries in addition to Facebook. It doesn’t really utilize a blockchain either.

Other than that . . .

For the best (IMO) take on the “Zuck Buck”, I heartily recommend FT Alphaville’s extended take–and takedown. I’ll just add a few comments.

First, when it comes to finance, there is little (if anything) new under the sun, and that is clearly true of Libra. The Alphaville stories provide several historical precedents, to which I’ll just add another. It is basically like pre-National Bank Act banking system in which banks issued bank notes that circulated as hand-to-hand media of exchange, and which were theoretically convertible into currency (gold prior to the Civil War) on demand. Libra is functionally equivalent to such bank notes, with the main distinction that it is represented by bytes rather than pieces of paper.

Facebook attempts to allay concerns about such a system by requiring 100 percent backing by bank deposits or low-default-risk government bonds, but as historical experience (some as recent as 2008) demonstrates, although such systems are less subject to runs than liabilities issued by entities that invest the proceeds in illiquid assets, they are not necessarily run-proof.

Furthermore, the economic model here isn’t that different from the 19th century bank model because the issuer can profit by investing the proceeds from the issue of the currency in interest bearing assets, and pocketing the interest. Those buying the currency forego interest income, and presumably are willing to do so because of it reduces the costs of engaging in various kinds of transactions.

This type of system faces different kinds of difficulties in low and high interest rate environments. In high rate environments, the opportunity cost of holding the currency is high, which leads to lower quantity demanded. In low rate environments, the revenue stream may be insufficient to cover the costs incurred by the intermediaries. This creates an incentive for asset substitution, i.e., to allow backing the currency with higher risk assets (with higher yields) thereby increasing insolvency and run risks.

I note in passing that low interest rates destroyed the traditional FCM model which relied on interest income from customer margins as a major revenue stream (as Facebook is proposing here). Ask John Corzine about that, and look to the experience of MF Global.

Why introduce this in a low interest rate environment? Maybe this is a kind of loss-leader strategy. The opportunity cost of holding Libra is low now (given low rates), so maybe a lot of people will buy in now. Even though the benefits to the issuers/intermediaries may be low now (because the interest income is low), they may be counting on customer stickiness once there is widespread adoption. That is, those who hold Libra when the cost of doing so is low may stick around even when the cost goes up substantially. That is, Facebook and its partners in this endeavor may be counting on some sort of switching cost or some behavioral irrationality to reduce the interest-rate sensitivity of demand for Libra.

Good luck with that. (For another example of nothing new under the sun, read up on disintermediation of traditional banks when interest bearing money market mutual funds came on the scene.)

I would also suggest that Libra has some disadvantages as a medium of exchange. For one thing, since assets will be held in multiple currencies, it creates currency risk for virtually everyone who uses it. For another, it involves additional cost to move from fiat into Libra and from Libra into fiat. This reduces the value of the Libra as a medium of exchange because of the resulting difference in cost in using it for within-network and off-network uses.

This last point relates to something else in the Libra white paper, namely, the claims that the currency will be a boon to the “unbanked.” This makes zero sense.

The reason that some people don’t have bank accounts is that the cost of servicing them (reflected in fees that banks charge) is above the willingness/ability of those people to pay for those services. There is no reason to believe that Libra reduces the cost of servicing the currently unbanked. Furthermore, the value of the services provided is likely to be lower, and substantially so because inter alia (a) the lack of brick an mortar facilities that low income people need for check cashing/depositing and cash depositing, (b) the restricted network of people with whom they can transact, and (c) currency risk.  Relatedly, it’s hard to see how one can move funds into our out of Libra without having access to banking services. I see the unbanked rhetoric as mere SJW eyewash attempting to make this look like some progressive social project.

The arrogance of Facebook is also rather astounding. Again, this is not crypto–it is banking. Yet Facebook presumes that it can do this without the panoply of licenses that banks must have, and without being subject to the same kinds of regulation as banks.

Because why? Trust me? Suuuurrreee, Mark.

Along these lines, note that the most benign interpretation behind Libra is that it is a narrow bank (100 percent reserve banking). But remember the Fed recently denied approval to TNB (“The Narrow Bank”) USA NA even though it was only going to offer deposits to “the most financially secure institutions” and explicitly eschewed providing retail banking services. Yet Marky et al expect the Fed (not to mention banking regulators in every other jurisdiction on the planet) to stand aside and let Facebook offer maybe (but maybe not) narrow banking services (with added currency risk!) to the great unwashed?

On what planet?

Note the furious government reactions to this, not just in the US but in Europe. Zuckerberg et al were totally delusional if they expected anything different, especially in light of Facebooks serial privacy, free-speech, and antitrust controversies.

In sum, in my opinion Libra faces serious economic and political/regulatory obstacles. Having politicians and regulators hate you isn’t bad per se in my book–it can actually represent an endorsement! But the economics of this are incredibly dodgy. My skepticism is only increased by the misleading packaging (crypto! a boon to the unbanked!) and the congenitally misleading packager.

I have known CFTC Commissioner Dan Berkovitz for almost 20 years, when he was a senior staffer on the Senate Permanent Subcommittee on Investigations, and he reached out to me for guidance on market manipulation issues. I think it’s fair to say that we disagree on most important issues. He supports many regulations I strongly oppose, but despite that our relationship has been cordial and mutually respectful.

Dan’s recent speech at the FIA Commodities Symposium in Houston focuses on issues that we happen to disagree on, and needless to say, I am unpersuaded. Indeed, I think his remarks demonstrate quite clearly the fundamental intellectual failings with the regulatory measures he favors.

He focuses on two issues: competition in OTC derivatives, and speculative position limits. With respect to OTC derivatives, he says

There are now 105 swap dealers and 23 swap execution facilities registered with the Commission. Almost 89% of interest rate swaps and 96% of broad index credit default swaps are cleared through a central clearinghouse. Nearly 98% of all swap transactions involve at least one registered swap dealer. The CFTC’s swap trading rules have led to more competition, more electronic trading, better price transparency, and lower spreads for swaps traded on regulated platforms

But then he contradicts himself on competition:

Despite this progress, we have seen an increase in concentration in the trading and clearing of swaps among the bank swap dealers.  [Emphasis added.] Although we have more competition in the swaps market since the passage of Dodd-Frank, in the form of tighter bid-ask spreads and lower transaction costs, we have fewer competitors.  [Which makes me question whether the tighter spreads are the result of more competition, or other factors.] High levels of concentration present systemic risks and provide fewer choices for end-users.  [But wasn’t the point of DFA to reduce systemic risk by reducing concentration? GiGi sure said so.] One of the purposes of the Commodity Exchange Act (“Act” or “CEA”) is to promote fair competition.  The Commission therefore has an obligation to address this issue.

How concentrated are our derivative markets?  For swaps trading, five registered bank swap dealers are party to 70% of all swaps and 80% of the total notional amount traded. And for clearing services, the five largest FCMs—all affiliated with large banks—clear about 80% of cleared swaps.[  The eight largest firms clear 96% of cleared swaps.  I am concerned about what could happen if one of those providers fails.  I am also concerned about the impact on the price of derivatives for end users.

Even prior to Frankendodd, I predicted that the regulations would lead to greater concentration, precisely because regulatory burdens create fixed costs, which favor scale. The concentration among FCMs is particularly worrisome from a systemic risk perspective, and has been exacerbated by the way clearing regulations have been implemented. Not all of these are the CFTC’s fault: it has attempted to push back on the Fed’s implementation of the liquidity ratio, which creates unnecessary capital charges associated with segregated margins. Dan alludes to that issue thus: “We must find ways to increase bank capital standards without discouraging the availability of clearing and other risk-management tools available to end users.” But the basic conclusion remains: measures intended to reduce concentration in order to reduce systemic risk have not achieved that objective, and have in fact likely increased concentration.

The biggest weakness in Dan’s speech is his valiant, but tellingly and painfully strained, justification for position limits.

The CFTC has a long history with speculative position limits, and their benefits to the market are well established.  Section 3 of the Act identifies risk management and price discovery as fundamental purposes of U.S. derivatives markets. Meaningful position limits coupled with appropriate hedge exemptions are crucial to advancing those purposes.  Position limits help prevent corners, squeezes, and other forms of manipulation.  They prevent distortions in the prices of many major commodities in interstate commerce—ranging, for example, from wheat to gold to coffee to oil.  The Hunt brothers’ attempts to corner the silver market, the Ferruzzi squeeze of the soybean market, and the Amaranth hedge fund’s excessively large positions in the natural gas futures and swaps markets are clear examples of why position limits are needed to prevent the price distortions and real-world impacts that can result from excessive speculation.  Episodes such as these validate Congress’ and the CFTC’s long-held view that position limits are “necessary as a prophylactic measure” to deter sudden or unreasonable price fluctuations and preserve the integrity of price discovery and risk mitigation on U.S. derivatives markets.

Insofar as prevention of market power manipulations (squeezes and corners) are concerned, this can be achieved through spot month limits and does not require restrictions on the positions held prior to the delivery month, and across all months, as the Commission’s previous proposals would impose. Meaning that the proposed regulations are over-inclusive and an unduly restrictive means of achieving their stated objective.

Further, insofar as the examples are concerned, they provide no support for the types of expansive limits that have been proposed. None.

As I’ve said repeatedly about the Hunt episode (the CFTC’s favorite go-to example): when do we get to the Trojan War? That episode is ancient history, and is more the exception that proves the rule than a warning of a clear and present danger. I have said this repeatedly only because the CFTC brings up the example repeatedly. If they stop, I will!

Ferruzzi is interesting, because Ferruzzi cornered a market with position limits, from which the company had an exemption. Indeed, it was the CFTC’s and CBOT’s revocation of Ferruzzi’s hedge exemption during the spot month that broke the company’s corner (and launched my academic career in commodities!–thanks to all!) I can think of other examples in which long hedgers with exemptions executed market power manipulations, and indeed, long hedgers with exemptions are the most dangerous manipulators. Meaning that position limits on speculators are beside the point when it comes to addressing market power manipulation.

With regards to Amaranth, Dan states

The Amaranth episode provides another clear example of how large speculative positions can distort market prices.  At one point, Amaranth held 100,000 natural gas contracts, or approximately 5% of all natural gas used in the U.S. in a year. “Amaranth accumulated such large positions and traded such large volumes of natural gas futures that it distorted market prices, widened the spreads, and increased price volatility.”

The quotations are to a Senate Permanent Subcommittee report (which Dan was an author) . I can say definitively that the analysis underlying those conclusions is completely unpersuasive, and would fail to pass muster in any manipulation litigation. The analysis lacks statistical rigor, and demonstrates neither “artificial” prices or that Amaranth caused these artificial prices (intentionally or otherwise).

Indeed, the CFTC did not pursue Amaranth for distorting natural gas prices through its immense OTC derivatives positions (the 100,000 contracts Dan refers to) outside the delivery month. Instead, it (and FERC) went after the fund and its head trader Brian Hunter for three “bang the close” manipulations in 2006. (Full disclosure: I was an expert for plaintiffs on those manipulations in a private lawsuit.) Position limit regulations would not have prevented those manipulations.

Indeed, other manipulation cases the CFTC has pursued, including bang the settle type cases against Optiver and Parnon and Moore Capital (which I was also an expert in in related private litigation) also would not have been impacted by position limits. That is, limits would not have prevented them. In another recent CFTC case (just settled, and again, I am an expert in related private litigation), the party accused by the CFTC (Kraft) was a long hedger with a hedge exemption.

In brief, neither Dan nor anyone else has presented an example of a post-Trojan War alleged manipulation that position limits would have prevented.

So what’s the point? Can position limits reduce the risk of distortion arising from something non-manipulative?

Dan has an answer, and the answer is “no!” (though he says “record before us demonstrates that the answer is ‘yes.'”)

What speculative position limits are intended to do is to prevent a single market participant from moving markets away from fundamentals of supply and demand through the accumulation of large speculative positions.  [Emphasis added.] In this regard, it’s important to note that speculative position limits focus on the positions held by a single trader or trading entity, not on the overall level of speculation in a market.  The Commission’s task in setting speculative position limits is not to determine how the collective level of speculation in a market might affect prices.  [Emphasis added.] Nor is it to try to determine the “correct” level of speculation that should be permitted in a market.  Instead, the Commission must focus on the single speculator and the impact of large speculative positions on the market.

But this demolishes the argument for limits that was made with increasing intensity around 2006, and peaking (along with oil prices) in mid-2008. Those advocating position limits then could point to no single large trader that was distorting prices. Instead, they blamed (to use Dan’s phrase) “the collective level of speculation” to justify limits–which is exactly what Dan (rightly) says the limits won’t and can’t constrain. Meaning that the CFTC’s proposed limits represent a bait-and-switch: by a limit supporting CFTC commissioner’s own admission, the proposed limits won’t address the supposed ill that led Congress to legislate them in the first place.

To summarize: Position limits outside the spot month are unnecessary to prevent market power manipulations (and other deterrent measures can enhance spot month limits); position limits won’t prevent other kinds of manipulation (e.g., bang the settlement); there are no examples in decades of distortions that position limits of the type proposed might have mitigated; the examples that have been proposed are wrong; the most likely market power manipulators (long hedgers) would be exempted from limits; limits would not have prevented the specific manipulations the CFTC has alleged in recent years; and the limits the CFTC has proposed would not touch the kinds of allegedly multi-trader “collective” excess speculation that caused Congress to mandate position limits in the first place.

Other than that, the case for position limits is rock solid!

Dan Berkovitz manfully attempts justify limits but achieves just the opposite. The arguments and evidence he brings to bear demonstrate how bankrupt the case for limits truly is.

Given that limits will involve substantial compliance costs, and bring no benefits, the song remains the same: position limits are all pain, no gain.

The Supreme Court made something of a splash recently in its Apple v. Pepper antitrust decision, which some have interpreted as undermining the limitation in the Illinois Brick case that only direct purchasers can sue for antitrust damages. The majority decision claims that it is adhering to the “bright line” of Illinois Brick. Apple demonstrates, however, that any blanket limitation on who has antitrust standing can lead to perverse outcomes.

The facts in Apple are that Apple’s App Store is allegedly a monopoly that it can exploit to raise the price of apps sold through the store. Apple collected its fee (in the form of a commission) from app sellers, and collected no fee from buyers using the store. Apple claimed that app buyers have no standing to sue because they bought the apps from the app sellers, not Apple, meaning that they were indirect purchasers, and hence no standing to sue under Illinois Brick. A 5-4 majority decided otherwise.

The economics of this are straightforward. It is basically a version of tax incidence analysis, which says that the distribution of the burden of a tax is the same, regardless of whether the government collects the tax from sellers, or from buyers. In the present instance, the burden of Apple’s supercompetitive charge would be the same regardless of whether Apple charges app suppliers or consumers for access to the App Store.

That fact alone should raise alarms about the efficiency (and fairness) of a blanket denial of antitrust standing, depending on who is the “first purchaser” or who the putative monopolist charges the supercompetitive price.

A simple supply-demand diagram illustrates the point.

The blue line is the demand for apps. The red line is the supply of apps. The demand for the App Store is a derived demand: it is derived from the supply and demand for apps, and equals the vertical distance between the supply and demand curves. In the diagram, App Store Demand is the gray line. It is downward sloping, indicating that the App Store has market power. It chooses a quantity such that its marginal revenue (the yellow line) equals marginal cost (assumed to be zero).

Given the supply and demand for apps, the profit maximizing quantity is 25, which is half the competitive quantity of 50 (given by the intersection of the supply and demand curves). Apple collects 50 per app sold.

The only prices that clear the market involve consumers paying 75 per app, and sellers receiving 25 for app. This outcome can be obtained in several ways. Apple could charge suppliers a commission of 50, which they would pass on, collecting 75 from consumers and netting 25. Or, apple could charge buyers a fee of 50, which would mean that they would only pay developers 25 per unit for the 25 units they buy.

So who pays what and who gets what depends not a whit on whom Apple charges.

This means that prohibiting one or the other users of the App Store for suing for damages means that they will be uncompensated: the party that can sue can be either overcompensated, or perhaps undercompensated too.

In the example, the competitive price is 50, meaning that the buyers overpay by 25. If they can’t sue, they are SOL and suffer a loss greater than the overcharge (25) times the number of units (25). Their loss is greater because of the deadweight loss: there are 25 units that consumers would have bought absent the monopoly, but don’t purchase when it exists. This deadweight loss (the “welfare triangle”) is one-half times the units not consumed (25) times the markup paid by consumers (25).

If only the sellers have antitrust standing, because they pay Apple the 50/unit, they are overcompensated if they are awarded their unit sales (25) times the full Apple overcharge of 50. The 1250 in compensation exceeds their loss in surplus which is their share of the overcharge (25) times the units sold (25) plus the deadweight loss (25*25/2) (for a total of 937.5). If the sellers are awarded only their share of the overcharge (25) on the units they sell (25) they would be undercompensated like the buyers.

Therefore, since the losses due to monopoly power are shared between the App Store sellers and buyers, restricting compensation to only one of them results in undercompensation to the party that can’t sue for damages, and (depending on how the damages to the party with standing are calculated) can overcompensate or undercompensate the party with standing. This mismatch between harm and compensation potentially undermines the deterrent effect of private antitrust actions, and also means that the antitrust law has largely arbitrary distributive effects, especially since there is no necessary connection between who suffers the most harm and who has standing to sue: who suffers the most harm depends on supply and demand elasticities, and if unlike the simple analysis above demand is much less elastic than supply, consumers are harmed more.

This is likely an important consideration in Apple. It is basic econ (it drops out of the Slutsky equation) that demand tends to be inelastic for goods that represent a small fraction of a consumer’s expenditures: that’s likely the case for apps, which typically cost just a few bucks. Furthermore, given low entry barriers on the app developer side, I would surmise that the supply of apps is highly elastic. Inelastic demand and elastic supply means that consumers bear most of the overcharge. In this case, the misalignment between economic harm and standing to sue based on who pays the fee to Apple is likely acute.

The rationale for Illinois Brick is that parsing out harm when both buyers and sellers are damaged is just too damn hard, and costly. In the context of the simple example, knowing perfectly the distribution of losses from market power requires knowing the supply and demand curves. So fuggedaboutit, and just give everything to the one who writes the check to the monopolist, even though who writes the check has jack all to do with who actually pays the price.

Litigation costs are a legitimate consideration, but not the only consideration. Undermining the efficiency and distributive purposes of the antitrust laws is costly too.

Apple v. Pepper has the virtue of looking past the economically irrelevant issue of privity to the substantive economic effects of the alleged antitrust violation that is before the bar. The Apple majority claims that it is faithfully implementing Illinois Brick, but by looking at the economic substance the decision will prove, in my opinion, the camel’s nose under the tent that will substantially broaden the categories of market participant eligible for antitrust standing.

I’ve written often about the economic nightmare that are renewables, specifically wind and solar power. They are terribly inefficient because they are intermittent, and they are diffuse. The intermittency requires maintaining substantial backup capacity. Their diffuse nature means that they are incredibly land intensive. I should also add that renewable energy sources are not miraculously located where loads are. Indeed, they are often located far, far away from load, and therefore necessitate substantial investment in transmission.

How inefficient? This recent University of Chicago study documents that the difference in cost between renewable and conventional generation dwarfs any possible benefit from CO2 reduction. To reprise the old joke: governments that subsidize renewables want to reduce CO2 emissions in the worst way, and they have.

Heretofore the Germans have been the world’s leader in renewable idiocy, with their Energiewende debacle, which has raised power costs to among the world’s highest, and not led to decreases in CO2 emissions (due mainly to the intermittency problem mentioned above). Well played! So how are the Germans going to deal with this? Perhaps by making electricity MORE expensive, by adding a CO2 tax on top of the CO2 cap and trade scheme.

I would say that will be hard to top Germany’s leading position in the ranks of renewables retards, but the Swedes are giving it a gallant try. So get this. The Swedes are replacing cheap zero carbon power (from four nuclear plants) located near load centers like Stockholm with expensive zero carbon power produced my windmills in the frozen back of buggery in the far north of Sweden. One big problem, they are woefully short of transmission capacity from back of buggery to the places where Swedes actually live and work.

This will make power more expensive, and is already constraining economic activity in Sweden. Moreover, it is raising the risk of blackouts.

So the Swedes may be replacing reliable carbon free electricity with electricity free electricity. That will be fun in the winters, eh?

Realistic people who believe that it is necessary to reduce carbon emissions understand that nuclear power is the efficient way to do so, and will become even more efficient with the development of new reactor technologies. It would be far more economical to invest in improvements in nukes than vast wind and solar projects.

But the Swedes appear to still be in the thrall of post-Three Mile Island hysteria (note that the decision to close the plants was made in 1980, a year after TMI) just as the Germans responded to post-Fukushima hysteria by deciding to close all their nukes.

That is, the energy policies of supposedly sophisticated societies are being driven by bugbears and bogeymen–a morbid obsession with CO2, and a view of nuclear power shaped by a nearly 40 year old Jane Fonda movie. This is leading them to force people to rely energy sources that are monstrously inefficient, making said people poorer. (Not to mention that a monomaniacal focus on CO2 leads them to overlook the total environmental impact of wind and solar, which is not a pretty picture.)

The Swedes are also leaders in a modern-day Children’s Crusade (that worked out great the first time, right?) to impose their climate bogeymen on the rest of the world. A rather unfortunate Swedish teenager is going around lecturing the world on the need for drastic action on CO2 now. This is an emotionally manipulative use of children as a substitute for actual argument and analysis and facts. Cynically, it exploits the reluctance of people to criticize children (even though they know nothing, or next to it), especially ones (in the words of the immortal Hank Hill) that ain’t right.

And behold what policies the Swedes want to visit on the rest of us. What they do in Sweden is their business, but they should keep their noses out of everyone else’s.

Makes me more glad than ever that my ancestors bugged out for Minnesota 140 odd years ago. But recent research suggests that they are to blame for Sweden’s current idiocies! I’ve long hypothesized that more independent souls are far more likely to emigrate, leaving the conformists behind. And recent research focusing on Scandinavia provides support for this hypothesis:

The researchers suggest the migration flows, which were small relative to the native population of America but equivalent to about 25 per cent of the total population of Scandinavia, changed the character of Norwegian and Swedish society by removing the most ambitious and independently-minded people.

So Scandinavia’s loss was America’s gain. And if their energy policies are any indication, they are still paying the price today.

Trump just departed from Ellington Joint Reserve Base here in Houston, ending a quick trip to Texas which included a rally in Houston. The focus of Trump’s visit was the US energy sector (In Texas? Go figure!). As part of that, he announced and signed an executive order limiting the power of states to block or obstruct the construction of interstate oil and gas pipelines.

Overall, I’m not a fan of executive orders, as they tend to be used to override or circumvent normal Constitutional procedures and purposes. There is a strong argument, however, that this order is an exception.

The very genesis of the Constitution traces to commercial disputes between states under the Articles of Confederation. Contention between Virginia and Maryland over navigation of the Potomac and the Chesapeake resulted in the calling of the Annapolis Convention (formally The Meeting of Commissioners to Remedy Defects of the Federal Government) in 1786. Although the Convention itself was something of a damp squid, it did result in the calling of the Philadelphia Convention of 1787, which wrote the Constitution that continues to be the law of the land to this day, 232 years later.

Of course, one part of that document is the Commerce Clause (Article I, Section 8, Clause 3) which grants to the Federal government the power to regulate commerce between the states. This was not an accident, comrades. Preventing protectionism by the states against each other was one of the main reasons for creating a more powerful central government.

State governments always have the temptation and incentive to favor their own constituents at the expense of people in other states. Letting that impulse operate freely would result in a Balkanized country with myriad wasteful restrictions, taxes, tolls, and regulations that would sap wealth. (Consider pre-Revolutionary France, with its oppressive system of local tolls on the movement of goods.) Anticipating that, the Founders expressly sought to limit the protectionist powers of states.

In Gibbons v. Ogden (1824) the Marshall court forcefully exerted the Commerce Clause. Things have likely gone too far since: for example, the Commerce Clause’s delegation of authority over navigable waters to the US government has been pushed to the extreme by using it to impose Federal environmental regulation on an intermittent wet spot on your back 40.

But what Trump is ordering is clearly within the four corners of the Clause as originally conceived. Oil and gas are produced in some states, and consumed in others. Interstate movement is necessary to connect producers and consumers. Further, for myriad motives many states have attempted to obstruct that movement. That is not, and has not been since the formation of the Republic, their prerogative.

The case can be made that the Commerce Clause has proved a Trojan Horse that has facilitated an expansion of Federal power beyond that what the Founders envisioned. But what Trump is ordering is squarely within the intent of the Clause, as drafted and intended.

The dramatic growth in US energy production is being hampered by infrastructure constraints. For many, that is a feature, not a bug: the hostility towards fossil fuel energy in particular by many in the US, especially on the left, makes such infrastructure a schwerpunkt for environmentalists. Knock out the transit links between producers and consumers, and energy will be neither produced nor consumed. They often find it easier to focus their efforts on state and local governments because (a) they are often more biddable, and (b) since you only need to prevail in one or two to delay or derail altogether a pipeline moving across many, the odds of success are higher. (If there are N jurisdictions crossed by a pipeline, and the probability of getting a jurisdiction to block it is P, the probability that it will go through is (1-P)^N, which decreases with N.)

Yes, local communities do have concerns. The question is what is the appropriate remedy for them. A properly applied Takings Clause (with payment of true value for taken property) is one: it prevents subsidization through expropriation. Insofar as environmental issues are concerned, the question is whether ex ante restrictions (i.e., imposing high standards to permit construction) are better than ex post penalties for damage imposed (which provide an incentive for infrastructure operators to take precautions against damage).

Since infrastructure operators are well-capitalized, and unlikely to be judgment proof, and since there are armies of class action attorneys waiting in the wings salivating at the opportunity to sue for damages, ex post penalties are likely to be more efficient than ex ante restrictions, especially ex ante restrictions imposed by state and local governments who internalize the benefits they obtain for their constituents, but who do not internalize the costs that they impose on producers upstream or consumers downstream.

And this is not to say that the Federal government is inevitably predisposed to efficient outcomes. Look no further than the previous administration, which largely embraced the environmentalist hostility to domestic energy development, and which as a consequence used its powers to thwart some important infrastructure developments (e.g., Keystone, which would have proven especially valuable in light of the loss of heavy crude production in Venezuela and to a lesser degree Mexico). So Federal power can be exercised for good or ill when it comes to energy infrastructure. Trump’s order is an example of it being exercised for the good of energy consumers and producers.