Streetwise Professor

Streetwiseprofessor, August 2011:

WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

. . . .

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.

Bloomberg, November 2016:

In the battle for supremacy between the world’s two largest oil exchanges, one of them is enjoying a turbo charge from the U.S. government.

Traders bought and sold an average of almost 1.1 billion barrels of West Texas Intermediate crude futures each day in 2016, a surge of 35 percent from a year earlier. The scale of the gain was partly because of the U.S. government lifting decades-old export limits last year, pushing barrels all over the world, according to CME Group Inc., whose Nymex exchange handles the contracts. By comparison, ICE Futures Europe’s Brent contract climbed by 13 percent.

WTI and Brent have been the oil industry’s two main futures contracts for decades. In the past, the American grade’s global popularity was restrained by the fact that exports were heavily restricted. Now, record U.S. shipments are heading overseas, meaning WTI’s appeal as a hedging instrument is rising, particularly in Asia, where CME has expanded its footprint.

“You have turbo-charged WTI as a truly waterborne global benchmark,” Derek Sammann global head of commodities and options products at CME Group, said in a phone interview regarding the lifting of the ban. “You’re seeing the global market reach out and use WTI — whether that’s traders in Europe, Asia and the U.S.”

This should surprise no one–but the conventional wisdom had largely written off WTI in 2011. Given that economic price signals were providing a strong incentive to invest in infrastructure to ease the bottleneck between the Midcon and the sea, it was inevitable that WTI would become reconnected with the waterborne market.

Once the physical bottleneck was eased, the only remaining bottleneck was the export ban. But whereas the export ban was costless prior to the shale boom (because it banned something that wasn’t happening anyways), it became very costly when US supply (especially of light, sweet crude) ballooned. As Peltzman, Becker and others pointed out long ago, politicians do take deadweight costs into account. In a situation like the US oil market, which pitted two large and concentrated interests (upstream producers and refiners) against one another, reducing deadweight costs probably made the difference (as the distributive politics were basically a push).  Thus, the export ban went the way of the dodo, and the tie between WTI and the seaborne market became all that much tighter.

This all means that it’s not quite right to say that CME’s WTI contract has been “turbocharged by the federal government.” Shale it what has turbocharged everything. The US government just accommodated policy to a new economic reality. It was along for the ride, as are CME and ICE.

ICE’s response was kind of amusing:

“ICE Brent Crude remains the leading global benchmark for oil,” the exchange said in an e-mailed response to questions. “With up to two-thirds of the world’s oil priced off the Brent complex, the Brent crude futures contract is a key hedging mechanism for oil market participants.”

Whatever it takes to get them through the day, I guess. Reading that brought to mind statements that LIFFE made about the loss of market share to Eurex in early-1998.

The fact is that there is hysteresis in the choice of the pricing benchmark. As exiting contracts mature and new contracts are entered, market participants will have an opportunity to revisit their choice of pricing benchmark. With the high volume and liquidity of WTI, and the increasingly tight connection between WTI and world oil flows, more participants will shift to WTI pricing.

Further, as I noted in the 2011 post (and several that preceded it) Brent’s structural problems are far more severe. Brent production is declining, and this decline will likely accelerate in a persistent low oil price environment: not only has shale boosted North American supply, it has contributed to the decline in North Sea supply. Brent’s pricing mechanism is already extremely baroque, and will only become more so as Platts scrambles to find more imaginative ways to tie the contract to new supply sources. It is not hard to imagine that in the medium term Brent will be Brent in name only.

Since WTI will likely rest on a strong and perhaps increasing supply base, Brent’s physical underpinning will become progressively shakier, and more Rube Goldberg-like. These different physical market trajectories will benefit WTI derivatives relative to Brent, and will also induce a shift towards using WTI as a benchmark in physical trades. Meaning that ICE is whistling past the graveyard. Or maybe they are just taking Satchel Paige’s advice: “Don’t look back. Something might be gaining on you.” And in ICE Brent’s case, that’s definitely true, and the gap is closing quickly.

When I give my class on the systemic risks of clearing, I usually joke that I should give the lecture by a campfire, with a flashlight held under my chin. It is therefore appropriate that on this Halloween Risk published Peter Madigan’s take on the effects of Brexiton derivatives clearing: it is a horror story.

Since the clearing mandate was a gleam in Barney Frank’s eye (yes, a scary mental image–so it fits in the theme of the post!) I have warned that the most frightening thing about clearing and clearing mandates is that they transform credit risk into liquidity risk, and that liquidity risk is more systemically threatening than credit risk. This view was born of experience, slightly before Halloween in 1987, when I witnessed the near death experience that the CME clearinghouse, BOTCC, and OCC faced on Black Monday and the following Tuesday. The huge variation margin calls put a tremendous strain on liquidity, and operational issues (notably the shutdown of the FedWire) and the reluctance of banks to extend credit to FCMs and customers needing to meet margin calls came perilously close to causing the CCPs to fail.

The exchange CCPs were pipsqueaks by comparison to what we have today. The clearing mandates have supersized the clearing system, and commensurately increased the amount of liquidity needed to meet margin calls. The experience in the aftermath of the surprise Brexit vote illustrates just how dangerous this is.

As a result of Brexit, US Treasuries rallied by 32bp. The accompanying move in swap yields resulted in huge intra-day margin calls by multiple CCPs (LCH, CME, and Eurex). Madigan estimates that these calls totaled $25-$40 billion, and that some individual banks were asked to pony up multiple billions to meet margin calls from multiple CCPs. And to illustrate another thing I’ve been on about for years, they had to come up with the money in 60 minutes: failure to do so would have resulted in default. This provides a harrowing example of how tightly coupled the system is.

Some other crucial details. Much of the additional margin was to top up initial margin, meaning that the cash was sucked into the CCPs and kept there, rather than paid out to the net gainers, where it could have been recirculated. (Not that recirculating it would have been a panacea. Timing differences between flows of VM into and out of CCPs creates a need for liquidity. Moreover, recirculation by extension of credit is often problematic during periods of market stress, as that’s exactly when those who have liquidity are most likely to hoard it.)

Second, each CCP acted independently and called margin to protect its own interests. With multiple CCPs, there is a non-cooperative game between them. Each has an incentive to demand margin to protect itself, and to demand it before other CCPs do. The equilibrium in this game is inefficient because there is an externality between CCPs, and between CCPs and those who must meet the calls. This is ironic, because one of the alleged justifications for clearing mandates was the externalities present in the OTC derivatives markets. This is another example of how problems have been transformed, rather than truly banished.

This also illustrates another danger that I’ve pointed out for some time: building the levies high around CCPs just forces the floodwaters somewhere else.

Although there were some fraught moments for the banks who needed to stump up the cash on June 24, there were no defaults. But consider this. As I point out in the Risk article, Brexit was a known event and a known risk, and the banks had planned for it. Events like the October ’87 Crash or the September ’98 LTCM crisis are bolts from the blue. How will the system endure a surprise shock–especially one that could well be far larger than the Brexit move?

Horror stories are sometimes harmless ways to communicate real risks. Perhaps the Brexit event will be educational. Churchill once said that “Nothing in life is so exhilarating as to be shot at without result.” The market dodged a bullet on June 24. Will market participants, and crucially regulators, take heed of the lessons of Brexit and take measures to ensure that the next time it isn’t a head shot?

I have my doubts. The clearing mandate is a reality, and is almost certain to remain one. The fundamental transformation of clearing (from credit risk to liquidity risk) is an inherent part of the mechanism. It’s effects can be at most ameliorated, and perhaps the Brexit tremor will provide some guidance on how to do that. But I doubt that whatever is done will make the system able to survive The Big One.

Back when Glencore was in extremis last year, I noted that although the company could do some things on its own (e.g., sell assets, cut dividends, reduce debt) to address its problems, its fate was largely out of its hands. Further, its fate was contingent on what happened to commodity prices–coal and copper in particular–and those prices would depend first and foremost on China, and hence on Chinese policy and politics.

Those prognostications have proven largely correct. The company executed a good turnaround plan, but it has received a huge assist from China. China’s heavy-handed intervention to cut thermal and coking coal output has led to a dramatic spike in coal prices. Whereas the steady decline in those prices had weighed heavily on Glencore’s fortunes in 2014 and 2015, the rapid rise in those prices in 2016 has largely retrieved those fortunes. Thermal coal prices are up almost 100 percent since mid-year, and coking coal has risen 240 percent from its lows.

As a result, Glencore was just able to secure almost $100/ton for a thermal coal contract with a major Japanese buyer–up 50 percent from last year’s contract. It is anticipated that this is a harbinger for other major sales contracts.

The company will not capture the entire rally in prices, because it had hedged about 50 percent of its output for 2016. But that means 50 percent wasn’t hedged, and the price rise on those unhedged tons will provide a substantial profit for the company. (This dependence of the company on flat prices indicates that it is not so much a trader anymore, as an upstream producer married to a big trading operation.) (Given that hedges are presumably marked-to-market and collateralized, and hence require Glencore to make cash payments on its derivatives at the time prices rise, I wonder if the rally has created any cash flow issues due to mismatches in cash flows between physical coal sales and derivatives held as hedges.)

So Chinese policy has been Glencore’s best friend so far in 2016. But don’t get too excited. Now the Chinese are concerned that they might have overdone things. The government has just called an emergency meeting with 20 major coal producers to figure out how to raise output in order to lower prices:

China’s state planner has called another last-minute meeting to discuss with more than 20 coal mines more steps to boost supplies to electric utilities and tame a rally in thermal coal prices, according to two sources and local press.

The National Development and Reform Commission (NDRC) has convened a meeting with 22 coal miners for Tuesday to discuss ways to guarantee supply during the winter while sticking to the government’s long-term goal of removing excess inefficient capacity, according to a document inviting companies to the meeting seen by Reuters.

What China giveth, China might taketh away.

All this policy to-and-fro has, of course is leading to speculation about Chinese government policy. This contributes to considerable price volatility, a classic example of policy-induced volatility, which is far more common that policies that reduce volatility.

Presumably this uncertainty will induce Glencore to try to lock in more customers (which is a form of hedging). It might also increase its paper hedging, because a policy U-turn in China (about which your guess and Glencore’s guess are as good as mine) is always a possibility, and could send prices plunging again.

So when I said last year that Glencore was hostage to coal prices, and hence to Chinese government policy–well, here’s the proof. It’s worked in the company’s favor so far, but given the competing interests (electricity generators, steel firms, banks, etc.) affected by commodity prices, a major policy adjustment is a real possibility. Glencore–and other major commodity producers, especially in coal and ferrous metals–remain hostages to Chinese policy and hence Chinese politics.

If you’ve been paying the slightest attention to financial markets lately, you’ll know that blockchain is The New Big Thing. Entrepreneurs and incumbent financial behemoths alike are claiming it will transform every aspect of financial markets.

The techno-utopianism makes me extremely skeptical. I will lay out the broader case for my skepticism in a forthcoming post. For now, I will discuss a specific example that illustrates odd combination of cluelessness and hype that characterizes many blockchain initiatives.

Titled “Blockchain startup aims to replace clearinghouses,” the article breathlessly states:

Founded by two former traders at Societe Generale, SynSwap is a post-trade start-up based on hyperledger technology designed to disintermediate central counterparties (CCPs) from the clearing process, effectively removing their role in key areas.

“For now we are focusing on interest rate swaps and credit default swaps, and will further develop the platform for other asset classes,” says Sophia Grami, co-founder of SynSwap.

Grami explains that once a trade is captured, SynSwap automatically processes the whole post-trade workflow on its blockchain platform. Through smart contracts, it can perform key post-trade functions such as matching and affirmation, generation of the confirmation, netting, collateral management, compression, default management and settlement.

“CCPs have been created to reduce systemic risk and remove counterparty risk through central clearing. While clearing is key to mitigate risks, the blockchain technology allows us to disintermediate CCPs while providing the same risk mitigation techniques,” Grami adds.

“Central clearing is turned into distributed clearing. There is no central counterparty anymore and no entity is in the middle of a trade anymore.”

The potential disruptive force blockchain technology could have for derivatives clearing could bring back banks that have pulled away from the business due to heightened regulatory costs.

I have often noted that CCPs offer a bundle of many services, and it is possible to considering unbundling some of them. But there are certain core functions of CCP clearing that this blockchain proposal does not offer. Most importantly, CCPs mutualize default risk: this is truly one of the core features of a CCP. This proposal does not, meaning that it provides a fundamentally different service than a CCP. Further, CCPs hedge and manage defaulted positions and port customer positions from a defaulted intermediary to a solvent one: this proposal does not. CCPs also manage liquidity risk. For instance, a defaulter’s collateral may not be immediately convertible into cash to pay winning counterparties, but the CCP maintains liquidity reserves and lines that it can use to intermediate liquidity in these circumstances. The proposal does not. The proposal mentions netting, but I seriously doubt that the blockchain–hyperledger, excuse me–can perform multilateral netting like a CCP.

There are other issues. Who sets the margin levels? Who sets the daily (or intraday) marks which determine variation margin flows and margin calls to top up IM? CCPs do that. Who does it for the hyper ledger?

So the proposal does some of the same things as a CCP, but not all of them, and in fact omits the most important bits that make central clearing central clearing. To the extent that these other CCP services add value–or regulation compels market participants to utilize a CCP that offers these services–market participants will choose to use a CCP, rather than this service. It is not a perfect substitute for central clearing, and will not disintermediate central clearing in cases where the services it does not offer and the functions it does not perform are demanded by market participants, or by regulators.

The co-founder says “[c]entral clearing is turned into distributed clearing.” Er, “distributed clearing”–AKA “bilateral OTC market.” What is being proposed here is not something really new: it is an application of a new technology to a very old, and very common, way of transacting. And by its nature, such a distributed, bilateral system cannot perform some functions that inherently require multilateral cooperation and centralization.

This illustrates one of my general gripes about blockchain hype: blockchain evangelists often claim to offer something new and revolutionary but what they actually describe often involves re-inventing the wheel. Maybe this wheel has advantages over existing wheels, but it’s still a wheel.

Furthermore, I would point out that this wheel may have some serious disadvantages as compared to existing wheels, namely, the bilateral OTC market as we know it. In some respects, it introduces one of the most dangerous features of central clearing into the bilateral market. (H/T Izabella Kaminska for pointing this out.) Specifically, as I’ve been going on about for about 8 years now, the rigid variation margining mechanism inherent in central clearing creates a tight coupling that can lead to catastrophic failure. Operational or financial delays that prevent timely payment of variation margin can force the CCP into default, or force it or its members to take extraordinary measures to access liquidity during times when liquidity is tight. Everything in a cleared system has to perform like clockwork, or an entire CCP can fail. Even slight delays in receiving payments during periods of market stress (when large variation margin flows occur) can bring down a CCP.

In contrast, there is more play in traditional bilateral contracting. It is not nearly so tightly coupled. One party not making a margin call at the precise time does not threaten to bring down the entire system. Furthermore, in the bilateral world, the “FU Option” is often quite systemically stabilizing. During the lead up to the crisis, arguments over marks could stretch on for days and sometimes weeks, giving some breathing room to stump up the cash to meet margin calls, and to negotiate down the size of the calls.

The “smart contracts” aspect of the blockchain proposal jettisons that. Everything is written in the code, the code is the last word, and will be self-executing. This will almost certainly create tight coupling: The Market has moved by X; contract says that means party A has to pay Party B Y by 0800 tomorrow or A is in default. (One could imagine writing really, really smart contracts that embed various conditions that mimic the flexibility and play in face-to-face bilateral markets, but color me skeptical–and this conditionality will create other issues, as I’ll discuss in the future post.)

When I think of these “smart contracts” one image that comes to mind is the magic broomsticks in The Sorcerer’s Apprentice. They do EXACTLY what they are commanded to do by the apprentice (coder?): they tote water, and end up toting so much water that a flood ensues. There is no feedback mechanism to get them to stop when the water gets too high. Again, perhaps it is possible to create really, really smart contracts that embed such feedback mechanisms.

But then one has to consider the potential interactions among a dense network of such really, really smart contracts. How do the feedbacks feed back on one another? Simple agent models show that agents operating subject to pre-programmed rules can generate complex, emergent orders when they interact. Sometimes these orders can be quite efficient. Sometimes they can crash and collapse.

In sum, the proposal for “distributed clearing to disintermediate CCPs” illustrates some of the defects of the blockchain movement. It overhypes what it does. It claims to be something new, when really it is a somewhat new way of doing something quite common. It does not necessarily perform these familiar functions better. It does not consider the systemic implications of what it does.

So why is there so much hype? Well, why was Pets.com a thing? More seriously, I think that there is an interesting sociological dynamic here. All the cool kids are talking about blockchain, and nobody wants to admit to not being cool. Further, when a critical mass of supposed thought leaders are doing something, others imitate for fear of being left behind: if you join and it turns out to be flop, well, you don’t stand out–everybody, including the smartest people, screwed up. You’re in good company! But if you don’t join and it becomes a hit, you look like a Luddite idiot and get left behind. So there is a bias towards joining the fad/jumping on the bandwagon.

I think there will be a role for blockchain. But I also believe that it will not be nearly as revolutionary as its most ardent proponents claim. And I am damn certain that it is not going to disintermediate central clearing, both because central clearing does some things “decentralized clearing” doesn’t (duh!), and because regulators like those things and are forcing their use.

I believe that I am on firm ground saying that I was one of the first to warn of the systemic risks created by the mandating of central clearing on a vast scale, and that CCPs could become the next Too Big to Fail entities. At ISDA events in 2011, moreover, I stated publicly that it was disturbing that the move to mandates was occurring before plans to recover or resolve insolvent clearinghouses were in place. At one of these events, in London, then-CEO of LCH Michael Davie said that it was important to ensure to have plans in place to deal with CCPs in wartime (meaning during crises) as well as in peace.

Well, we are five years on, and well after mandates have been in effect, those resolution and recovery authorities are moving glacially towards implementation. Several outlets report that the European Commission is finalizing legislation on CCP recovery. As Phil Stafford at the FT writes:

The burden of losses could fall on the clearing house or its parent company, its member banks; the banks’ customers, such as pension funds, or the taxpayer.

Brussels is proposing that clearing house members, such as banks, be required to participate in a cash call if the clearing house has exhausted its so-called “waterfall” of default procedures.

The participants would take a share in the clearing house in return, according to drafts seen by the Financial Times.

Authorities would also have the power to reduce the value of payments to the clearing house members, the draft says. In the event of a systemic crisis, regulators could use government money as long as doing so complies with EU rules on state aid.

Powers available to regulators would include tearing up derivatives contracts and applying a “haircut” to the margin or collateral that has been pledged by the clearing house’s end users.

Asset managers have long feared that haircutting margin would be tantamount to expropriating assets that belong to customers.

The draft is circulating in samizdat form, and I have seen a copy. It is rather breathtaking in its assertions of authority. Apropos Michael Davie’s remarks on operating CCPs during wartime, my first thought upon reading Chapters IV and V was “War Communism Comes to Derivatives.” One statement buried in the Executive Summary Sheet, phrased in bland bureaucratic language, is rather stunning in its import: “A recovery and resolution framework for CCPs is likely to involve a public authority taking extraordinary measures in the public interest, possibly overriding normal property rights and allocating losses to specific stakeholders.”

In a nutshell, the proposal says that the resolution authority can do pretty much it damn well pleases, including nullifying normal protections of bankruptcy/insolvency law, transferring assets to whomever it chooses, terminating contracts (not just of those who default, but any contract cleared by a CCP in resolution), bailing in any CCP creditor up to 100 percent, suspending the right to terminate contracts, and haircutting variation margin. The authority also has the power to force CCP members to make additional default fund contributions up to the amount of their original contribution, over and above any additional contribution specified in the CCP member agreement. In brief, the resolution authority has pretty much unlimited discretion to rob Peter to pay Paul, subject to only a few procedural safeguards.

About the only thing that the law doesn’t authorize is initial margin haircutting. Given the audacity of other powers that it confers, this is sort of surprising. It’s also not evident to me that variation margin haircutting is a better alternative. One often overlooked aspect of VM haircuts is that they hit hedgers hardest. Those who are using derivatives to manage risk look to variation margin payments to offset losses on other exposures that they are hedging. VM haircutting deprives them of some of these gains precisely when they are likely to need them most. Put differently, VM haircutting imposes losses on those that are least likely to be able to bear them when it is most costly to bear them. Hedgers are risk averse. One reason they are risk aversion is that losses on their underlying exposures could force them into financial distress. Blowing up their hedges could do just that.

Perhaps one could argue that CCPs are so systemically important and the implications of their insolvency are so ominous that extraordinary measures are necessary–in its Executive Summary, and in the proposal itself, the EC does just that. But this just calls into question the prudence of creating and supersizing entities with such latent destructive potential.

There is also a fundamental tension here. The potential that the resolution authority will impose large costs on members of CCPs, and even their customers, raises the burden of being a member, or trading cleared products. This is a disincentive to membership, and with the economics of supply clearing services already looking rather grim, may lead to further exits from the business. Similarly, bail-ins of creditors and the potential seizure of ownership interests without due process will make it more difficult for CCPs to obtain funding. Thus, mandating expansion of clearing makes necessary exceptional resolution measures that lead to reduced supply of clearing services, and reduced supply of the credit, liquidity, and capital that they need to function.

It must also be recognized that with discretionary power come inefficient selective intervention and influence costs. The resolution body will have extraordinary power to transfer vast sums from some agents to others. This makes it inevitable that the body will be subjected to intense rent seeking activity that will mean that its decisions will be driven as much by political factors as efficiency considerations, and perhaps more so: this is particularly true in Europe, where multiple states will push the interests of their firms and citizens. Rent seeking is costly. Furthermore, it will inevitably inject a degree of arbitrariness into the outcome of resolution. This arbitrariness creates additional uncertainty and risk, precisely at a time when these are already at heightened, and likely extreme, levels. Furthermore, it is likely to create dangerous feedback loops. The prospect of dealing with an arbitrary resolution mechanism will affect the behavior of participants in the clearing process even before a CCP fails, and one result could be to accelerate a crisis, as market participants look to cut their exposure to a teetering CCP, and do so in ways that pushes it over the edge.

To put it simply, if the option to resort to War Communism is necessary to deal with the fallout from a CCP failure in a post-mandate world, maybe you shouldn’t start the war in the first place.

A few years ago, when doing research on the systemic risk (or not) of commodity trading firms, I thought it would be illuminating to compare these firms to major banks, to demonstrate that (a) commodity traders were really not that big, when compared to systemically important financial institutions, and (b) their balance sheets, though leveraged, were not as geared as banks and unlike banks did not involve the maturity and liquidity transformations that make banks subject to destabilizing runs. One thing that jumped out at me was just what a monstrosity Deutsche Bank was, in terms of size and leverage and Byzantine complexity. Its

My review (conducted in 2012 and again in 2013) looked back several years.  For instance, in 2013, the bank’s leverage ratio was around 37 to 1, and its total assets were over $2 trillion.

Since then, Deutsche has reduced its leverage somewhat, but it is still huge, highly leveraged (especially in comparison to its American peers), and deeply interconnected with all other major financial institutions, and a plethora of industrial and service firms.

This makes its current travails a source of concern. The stock price has fallen to record low levels, and its CDS spreads have spiked to post-crisis highs. The CDS curve is also flattening, which is particularly ominous. Last week, Bloomberg reported signs of a mini-run, not by depositors, but by hedge funds and others who were moving collateral and cleared derivatives positions to other FCMs. (I’ve seen no indication that people are looking to novate OTC deals in order to replace Deutsche as a counterparty, which would be a real harbinger of problems.)

Ironically, the current crisis was sparked by chronic indigestion from the last crisis, namely the legal and regulatory issues related to US subprime. The US Department of Justice presented a settlement demand of $14 billion dollars, which if paid, would put the bank at risk of breaching its regulatory capital requirements: the bank has only reserved $5 billion. Deutsche’s stock price and CDS have lurched up and down over the past few days, driven mainly by news regarding how these legal issues would be resolved.

The $14 billion US demand is only one of Deutsche’s sources of legal agita, most of which are also the result of pre-crisis and crisis issues, such as the IBOR cases and charges that it facilitated accounting chicanery at Italian banks.

Deutsche’s problems are political poison in Germany, for Merkel in particular. She is in a difficult situation. Bailouts are no more popular in Europe than in the US, but if anyone is too big to fail, it is Deutsche. Serious problems there could portend another financial crisis, and one in which the epicenter would be Germany. Merkel and virtually all other politicians in Germany have adamantly stated there would be no bailouts: politically, they have to. But such unconditional statements are not credible–that’s the essence of the TBTF problem. If Deutsche teeters, Germany–no doubt aided by the ECB and the Fed–will be forced to act. This would have seismic political effects, particularly in Europe, and especially particularly in southern Europe, which believes that it has been condemned to economic penury to protect German economic interests, not least of which is Deutsche Bank.

No doubt the German government, the Bundesbank, and the ECB are crafting bailouts that don’t look like bailouts–at least if you don’t look too closely. One idea I saw floated was to sell off Deutsche assets to other entities, with the asset values guaranteed. Since direct government guarantees would be too transparent (and perhaps contrary to EU law), no doubt the guarantees will be costumed in some way as well.

The whole mess points out the inherently political nature of banking, and how the political bargain (in the phrase of Calomaris and Haber in Fragile by Design) has changed. As they show quite persuasively (as have others, such as Ragu Rajan), the pre-crisis political bargain was that banks would facilitate income redistribution policy by provide credit to low income individuals. This seeded the crisis (though like any complex event, there were myriad other contributing causal factors), the political aftershocks of which are being felt to this day. Banking became a pariah industry, as the very large legal settlements extracted by governments indicate.

The difficulty, of course, is that banks are still big and systemically important, and as the Deutsche Bank situation demonstrates, punishing for past misdeeds that contributed to the last crisis could, if taken too far, create a new one. This is particularly true in the Brave New World of post-crisis monetary policy, with its zero or negative interest rates, which makes it very difficult for banks to earn a profit by doing business the old fashioned way (borrow at 3, lend at 6, hit the links by 3) as politicians claim that they desire.

It is definitely desirable to have mechanisms to hold financial malfeasors accountable, but the Deutsche episode illustrates several difficulties. The first is that even the biggest entities can be judgment proof, and imposing judgments on them can have disastrous economic externalities. Another is that there is a considerable degree of arbitrariness in the process, and the results of the process. There is little due process here, and the risks and costs of litigation mean that the outcome of attempts to hold bankers accountable is the result of a negotiation between the state and large financial institutions that is carried out in a highly politicized environment in which emotions and narratives are likely to trump facts. There is room for serious doubt about the quality of justice that results from this process. Waving multi-billion dollar scalps may be emotionally and politically satisfying, but arbitrariness in the process and the result means that the law and regulation will not have an appropriate deterrence effect. If it is understood that fines are the result of a political lottery, the link between conduct and penalty is tenuous, at best, meaning that the penalties will be a very poor way of deterring bad conduct.

Further, it must always be remembered that what happened in the 2000s (and what happened prior to every prior banking crisis) was the result of a political bargain. Holding bankers to account for abusing the terms of the bargain is fine, but unless politicians and regulators are held to account, there will be future political bargains that will result in future crises. To have a co-conspirator in the deals that culminated in the financial crisis–the US government–hold itself out as the judge and jury in these matters will not make things better. It is likely to make things worse, because it only increases the politicization of finance. Since that politicization is is at the root of financial crises, that is a disturbing development indeed.

So yes, bankers should be at the bar. But they should not be alone. And they should be joined there by the very institutions who presume to bring them to justice.

CFTC Chair Timothy Massad has come out in support of a one year delay of the lowering of the de minimis swap dealer exemption notional amount from $8 billion to $3 billion. I recall Coase  (or maybe it was Stigler) writing somewhere that an economist could pay for his lifetime compensation by delaying implementation of an inefficient law by even a day. By that reckoning, by delaying the step down of the threshold for a year Mr. Massad has paid for the lifetime compensation of his progeny for generations to come, for the de minimis threshold is a classic analysis of an inefficient law. Mr. Massad (and his successors) could create huge amounts of wealth by delaying its implementation until the day after forever.

There are at least two major flaws with the threshold. The first is that there is a large fixed cost to become a swap dealer. Small to medium-sized swap traders who avoid the obligation of becoming swap dealers under the $8 billion threshold will not avoid it under the lower threshold. Rather than incur the fixed cost, many of those who would be caught with the lower threshold will decide to exit the business. This will reduce competition and increase concentration in the swap market. This is perversely ironic, given that one ostensible purpose of Frankendodd (which was trumpeted repeatedly by its backers) was to increase competition and reduce concentration.

The second major flaw is that the rationale for the swap dealer designation, and the associated obligations, is to reduce risk. Big swap dealers mean big risk, and to reduce that risk, they are obligated to clear, to margin non-cleared swaps, and hold more capital. But notional amount is a truly awful measure of risk. $X billion of vanilla interest rate swaps differ in risk from $X billion of CDS index swaps which differ in risk from $X billion of single name CDS which differ in risk from $X billion of oil swaps. Hell, $X billion of 10 year interest rate swaps differ in risk from $X billion of 2 year interest rate swaps. And let’s not even talk about the variation across diversified portfolios of swaps with the same notional values. So notional does not match up with risk in a discriminating way.  Further, turnover doesn’t measure risk very well either.

But hey! We can measure notional! So notional it is! Yet another example of the regulatory drunk looking for his keys under the lamppost because that’s where the light is.

So bully for Chairman Massad. He has delayed implementation of a regulation that will do the opposite of some of the things it is intended to do, and merely fails to do other things it is supposed to do. Other than that, it’s great!

When I was in Singapore last week I spoke at the FT Asia Commodities Summit. Regardless of whether the subject was ags or energy or metals, China played an outsized role in the discussion. In particular, participants focused on China’s newish “supply side” policy.

There is little doubt that the policy–which focuses on reducing capacity, or at least output in steel, coal, and other primary industries–has had an impact on prices. Consider coking coal:

Coking coal, the material used by steelmakers to fire their blast furnaces, has become the best performing commodity of 2016 after surging more than 80 per cent over the past month on the back of production curbs and flooding in China.

Premium hard Australian coking coal delivered to China hit $180.9 a tonne on Friday, this highest level since price reporting agency Steel Index began publishing assessments in 2013. It has risen 131 per cent since the start of the year, outpacing gold, silver, iron ore and zinc — other top performing commodities.

The main driver of the rally — which has also roiled thermal coal — is Beijing’s decision to restrict the number of working days at domestic mines to 276 days per year from 330 previously.

This policy is aimed at the improving the profitability of producers so they can repay loans to local banks. But it has reduced output and forced traders and steel mills to buy imported material from what is known as the seaborne market.

80 percent. In a month.

Or thermal coal:

Newcastle thermal coal is heading for the first annual gain in six years as China seeks to cut overcapacity and curb pollution. While the timing of the output adjustment is unavailable, it may start in September or October after recent price gains, Citigroup said in the report dated Sept. 8. Bohai-Rim is 26 percent higher from a year ago, when it was 409 yuan, while Newcastle has climbed as much as 40 percent this year.

The phrase “supply side reform” actually fits rather awkwardly here, at least to a Western ear. That phrase connotes the reduction of regulatory and tax burdens as a means of promoting economic growth. But Supply Side Reform With Chinese Characteristics means increasing the government’s role in managing the economy.

A better description would be that this is The New Deal With Chinese Characteristics. FDR’s New Deal was largely a set of measures to cartelize major US industries, in an effort to raise prices. The economic “thinking” behind this was completely wrongheaded, and motivated by the idea that there was “ruinous competition” in product and labor markets that required government intervention to fix. Apparently the higher prices and wages were supposed to increase aggregate demand. Or something. But although the New Deal foundered on Constitutional shoals only a few years after its passage, in its brief existence it had proven to be an economic nightmare rent by contradictions. For instance, if you increase prices in an upstream industry, that is detrimental to the downstream sector for which the upstream industry’s outputs are inputs. According to scholarship dating back to Milton Friedman and Anna Schwartz, and continuing through recent work by Cole and Ohanian,  interference in the price mechanism and forced cartelization slowed the US’s recovery from the monetary shock that caused the Great Depression.

The motivation for the Chinese policy is apparently not so much to facilitate the rationalization of capacity in sectors with too much of it, but to increase revenue of firms in these sectors in order to permit them to pay back debt to banks and the holders of wealth management products (which often turn out to be banks too). Further, the policy is also driven by a need to sustain employment in these industries. Thus, the policies are intended to prop up the financially weakest and least efficient companies, rather than cull them.

So step back for a minute and contemplate what this means. Through a variety of policies, including most notably financial repression (that made capital artificially cheap) and credit stimulus, China encouraged massive investment in the commodities and primary goods sectors. These policies succeeded too well: they encouraged massive over-investment. So to offset that, and to mitigate the financial consequences for lenders, local governments, and workers, China is intervening to restrict output to raise prices. Rather than encouraging the correction of past errors, the new policy is perpetuating them, and creating new ones.

Remind me again how China’s government got the reputation as master economic managers, because I’m not seeing it. This is an example of a wasteful response to wasteful over-investment: waste coming and going. Further, it involves an increase in government intervention, which obviously has those in favor a more liberal (in the Smithian sense) free market policy rather distraught, and which foreshadows even more waste in the future.

The policy is also obviously fraught with tensions, because it pits those consuming primary and intermediate goods against those producing them–and against the banks who are now more likely to get their money back. That is, it is a backdoor bank (and WMP) bailout, the costs of which will be borne by the consumers of the goods produced by industries that were supersized by past government profligacy.

Ironically, the policy also stokes something that the government purports to hate: speculation. Policy volatility encourages speculation on the goods and industries affected by these policies. The large movements in prices in the coal and iron-steel sectors in response to policy changes provide a strong incentive to speculate on future policy changes.

Further, it creates the potential for moral hazard in the future. Future lenders (and purchasers of WMP) will look back on this policy and conclude that the government may well undertake backdoor bailouts if the companies they have lent to run into difficulties. This is hardly conducive to prudent lending and investment.

This is not foresighted policy. It is extemporizing to fix near-term problems, most of which were created by past measures to fix near-term problems. There is a Three Stooges aspect to the entire endeavor.

Of course, it’s an ill wind that blows no one any good. Glencore is no doubt very grateful for Chairman Xi’s heavy-handed policy intervention. It has probably played a larger role in bringing the company back from the brink than did the company’s prudent efforts to cut debt. But it is probably too late, alas, for Peabody Coal, and Arch Coal, and all those “coal people” whom former empathizer in chief Bill Clinton mocked last week. The ingrates!

The bottom line is that China is the 800 pound gorilla of the commodity markets, and shifts in its policies can lead to huge moves in commodity prices. Given that these policy shifts are driven by the crisis du jour (e.g., commodity producer shakiness threatening to make banks and local governments shaky) rather than good economics, and that these policy shifts are difficult to predict given the opacity and centralization of Chinese decision making, they add to substantial additional volatility in commodity prices and commodity markets: who can read the gorilla’s mind (which he changes often)?, and woe to those who read it wrong.

I am on my last day in Singapore, where I participated in the rollout of Trafigura’s Commodities Demystified hosted by IE Singapore.  The event was very well attended (an overflow crowd) and the presentation and new publication (which builds off the conceptual framework of my 2013 white paper The Economics of Commodity Trading Firms) was well-received. It helps fill a yawning gap in knowledge about what commodity traders are and what they do.

In addition to that event, I spoke as a panelist at the FT’s Commodities Asia Summit. One of the main speakers was Charles Li, CEO of Hong Kong Exchanges and Clearing, who laid out his ambitions for plans in mainland China. Things started out well. Whereas expectations were that HKEx would create a modest spot metals trading platform in China (because it doesn’t have and is unlikely to receive a license for trading futures), Li stated that HKEx (which owns the LME) would attempt to create a “lookalike” LME metals warehousing system. In the aftermath of the Qingdao fiasco this could be a very salutary development.

I would suggest caution, however. This may be easier said than done. While Li was describing this, my mind immediately turned to a paper I wrote over 2 decades ago about the successes and failures of commodity exchanges. One of the signal failures occurred when the Chicago Board of Trade attempted to tame the depredations of grain warehouses in the 1860s. Public storage was rife with all sorts of fraud and illicit dealing. The quality and quantity of grain being stored was a mystery, and warehousemen played all sorts of games to exploit their customers. The CBT, acting in the interests of traders who relied on the warehouses, attempted to impose rules and regulations on them, but failed utterly. Eventually the State of Illinois had to pass legislation to rein in some of the warehousemen’s more outrageous actions. Furthermore, larger traders integrated into warehousing, and eventually public storage became primarily ancillary to futures trading (i.e., to facilitate delivery against futures).

The CBT’s problem is that it did not have an adequate stick to beat the warehousemen into compliance. They were kicked out of the exchange, but the gains of being able to trade futures were smaller than the gains from operating warehouses outside the CBT’s rules.

Public warehousing has proved problematic in commodities to the present day. The LME’s travails with aluminum warehousing are just one example, but others abound in commodities including coffee, cocoa, and cotton. In cotton, for instance, even though warehouses are subject to federal regulation, there are chronic complaints that warehousemen do not load out cotton promptly, in order to enhance storage revenues.

So I wish Mr. Li luck. He’ll need it, especially since lacking the ability to deny those violating the warehouse rules from futures trading, he won’t even have the stick that proved inadequate for the CBT. Public warehousemen has long proved to be a very recalcitrant group, over time, place, and commodity.

Li specifically criticized the speculative nature of China’s futures exchanges, and claimed that his new venture would be for physical players, and that it would not be “another financial speculation forum.” But his follow on remarks gave a sense of cognitive dissonance. He said the system would allow banks and hedge funds to participate in the market.

More disconcertingly, he highlighted the effects of financial repression in China (without using the phrase), which leads investors looking for higher returns than are available in the banking sector to turn to alternative investment vehicles. Li specifically mentioned wealth management products, and suggested that metals stored in the warehouses his new venture would oversee could form the basis for such products. I understood him to say that while the warehouses would facilitate the typical function of commodity storage, i.e., filling and emptying in order to accommodate temporary supply and demand shocks, there would also be the possibility that metal would be locked up for long periods to provide the basis for these wealth management products. What I envision is something like physical metal ETFs that have been introduced in the West. These are primarily in precious metals. JP Morgan proposed a similar vehicle for copper, but backed off due to the pressure from Carl Levin and others a couple of summers ago.

In other words, the new warehousing system would be part of the shadow banking system thereby providing a new speculative vehicle for Chinese investors desperate to circumvent financial repression. Hence my cognitive dissonance.

I would also note that even a purely physical spot exchange can be a speculative venue, through buying and selling and borrowing/carrying warehouse receipts. The New York Gold Exchange of Black Friday infamy was hugely speculative, even though it was purely a spot physical exchange.

I also heard Li to say that the venture would guarantee transactions, though I didn’t fully catch what would be guaranteed. Would the exchange be insuring those storing their metal against a Qingdao type event? If so, that’s a pretty audacious plan, and one fraught with risk.

This was just a speech at a conference. It will be interesting to see a fully-fleshed out plan. It will be particularly interesting to see how the enforcement mechanism for the warehouse regulation will work, and it will be especially particularly interesting to see whether this venture is indeed just viewed as a mechanism for improving the efficiency of the physical metals market in China, or whether it will be a clever way to tap into the intense interest of investors large and small in China to speculate and find better returns than those on offer in the banking system. That is, will this be another speculative venue, but one masquerading as a staid market for physical players. Given the way China works, I’d bet on the latter. Pun intended.

Biofuel Renewable Identification Numbers–“RINs”–are back in the news because of a price spike in June and July (which has abated somewhat). This has led refiners to intensify their complaints about the system. The focus of their efforts at present is to shift the compliance obligation from refiners to blenders. Carl Icahn has been quite outspoken on this. Icahn blames everyone, pretty much, including speculators:

“The RIN market is the quintessential example of a ‘rigged’ market where large gas station chains, big oil companies and large speculators are assured to make windfall profits at the expense of small and midsized independent refineries which have been designated the ‘obligated parties’ to deliver RINs,” Icahn wrote.

“As a result, the RIN market has become ‘the mother of all short squeezes,”‘ he added. “It is not too late to fix this problem if the EPA acts quickly.”

Refiners are indeed hurt by renewable fuel mandates, because it reduces the derived demand for the gasoline they produce. The fact that the compliance burden falls on them is largely irrelevant, however. This is analogous to tax-incidence analysis: the total burden of a tax, and the distribution of a tax, doesn’t depend on who formally pays it. In the case of RINs, the total burden of the biofuels mandate and the distribution of that burden through the marketing chain doesn’t depend crucially on whether the compliance obligation falls on refiners, blenders, or your Aunt Sally.

Warning: There will be math!

A few basic equations describing the equilibrium in the gasoline, ethanol, biodiesel and RINs markets will hopefully help structure the analysis*. First consider the case in which the refiners must acquire RINs:

Equation (1) is the equilibrium in the retail gasoline market. The retail price of gasoline, at the quantity of gasoline consumed, must equal the cost of blendstock (“BOB”) plus the price of the ethanol blended with it. The R superscript on the BOB price reflects that this is the price when refiners must buy a RIN. This equation assumes that one gallon of fuel at the pump is 90 percent BOB, and 10 percent ethanol. (I’m essentially assuming away blending costs and transportation costs, and a competitive blending industry.) The price of a RIN does not appear here because either the blender buys ethanol ex-RIN, or buys it with a RIN and then sells that to a refiner.

Equation (2) is the equilibrium in (an assumed competitive) ethanol market. The price an ethanol producer receives is the price of ethanol plus the price of a RIN (because the buyer of ethanol gets a RIN that it can sell, and hence is willing to pay more than the energy value of ethanol to obtain it). In equilibrium, this price equals the the marginal cost of producing ethanol. Crucially, with a binding biofuels mandate, the quantity of ethanol produced is determined by the blendwall, which is 10 percent of the total quantity sold at the pump.

Equation (3) is equilibrium in the biodiesel market. When the blendwall binds, the mandate is met by meeting the shortfall between mandate and the blendwall by purchasing RINs generated from the production of biodiesel. Thus, the RIN price is driven to the difference between the cost of producing the marginal gallon of biodiesel, and the price of biodiesel necessary to induce consumption of sufficient biodiesel to sop up the excess production stimulated by the need to obtain RINs. In essence, the price of biodiesel plus the cost of a RIN generated by production of biodiesel must equal the marginal cost of producing it. The amount of biodiesel needed is given by the difference between the mandate quantity and the quantity of ethanol consumed at the blendwall. The parameter a is the amount of biofuel per unit of fuel consumed required by the Renewable Fuel Standard.

Equation (4) is equilibrium in the market for blendstock–this is the price refiners get. The price of BOB equals the marginal cost of producing it, plus the cost of obtaining RINs necessary to meet the compliance obligation. The marginal cost of production depends on the quantity of gasoline produced for domestic consumption (which is 90 percent of the retail quantity of fuel purchased, given a 10 percent blendwall). The price of a RIN is multiplied by a because that is the number of RINs refiners must buy per gallon of BOB they sell.

Equation (5) just says that the value of ethanol qua ethanol is driven by the relative octane values between it and BOB.

The exogenous variables here are the demand curve for retail gasoline; the marginal cost of producing ethanol; the marginal cost of producing BOB (which depends on the price of crude, among other things); the marginal cost of biodiesel production; the demand for biodiesel; and the mandated quantity of RINs (and also the location of the blendwall). Given these variables, prices of BOB, ethanol, RINs, and biodiesel will adjust to determine retail consumption and exports.

Now consider the case when the blender pays for the RINs:

Equation (6) says that the retail price of fuel is the sum of the value of the BOB and ethanol blended to create it, plus the cost of RINs required to meet the standard. The blender must pay for the RINs, and must be compensated by the price of the fuel. Note that the BOB price has a “B” superscript, which indicates that the BOB price may differ when the blender pays for the RIN from the case where the refiner does.

Without exports, retail consumption, ethanol production, biodiesel production, and BOB production will be the same regardless of where the compliance burden falls. Note that all relevant prices are determined by the equilibrium retail quantity. It is straightforward to show that the same retail quantity will clear the market in both situations, as long as:

That is, when the refiner pays for the RIN, the BOB price will be higher than when the blender does by the cost of the RINs required to meet the mandate.

Intuitively, if the burden is placed on refiners, in equilibrium they will charge a higher price for BOB in order to cover the cost of complying with the mandate. If the burden is placed on blenders, refiners can sell the same quantity at a lower BOB price (because they don’t have to cover the cost of RINs), but blenders have to mark up the fuel by the cost of the RINs to cover their cost of acquiring them. here the analogy with tax incidence analysis is complete, because in essence the RFS is a tax on the consumption of fossil fuel, and the amount of the tax is the cost of a RIN.

This means that retail prices, consumption, production of ethanol, biodiesel and BOB, refiner margins and blender margins are the same regardless of who has the compliance obligation.

The blenders are complete ciphers here. If refiners have the compliance burden, blenders effectively buy RINs from ethanol producers and sell them to refiners. If the blenders have the burden, they buy RINs from ethanol producers and sell them to consumers. Either way, they break even. The marketing chain is just a little more complicated, and there are additional transactions in the RINs market, when refiners shoulder the compliance obligation.

Under either scenario, the producer surplus (profit, crudely speaking) of the refiners is driven by their marginal cost curves and the quantity of gasoline they produce. In the absence of exports, these things will remain the same regardless of where the burden is placed. Thus, Icahn’s rant is totally off-point.

So what explains the intense opposition of refiners to bearing the compliance obligation? One reason may be fixed administrative costs. If there is a fixed cost of compliance, that will not affect any of the prices or quantities, but will reduce the profit of the party with the obligation by the full amount of the fixed cost. This is likely a relevant concern, but the refiners don’t make it centerpiece of their argument, probably because shifting the fixed cost around has no efficiency effects, but purely distributive ones, and purely distributive arguments aren’t politically persuasive. (Redistributive motives are major drivers of attempts to change regulations, but naked cost shifting arguments look self-serving, so rent seekers attempt to dress up their efforts in efficiency arguments: this is one reason why political arguments over regulations are typically so dishonest.) So refiners may feel obliged to come up with some alternative story to justify shifting the administrative cost burden to others.

There may also be differences in variable administrative costs. Fixed administrative costs won’t affect prices or output (unless they are so burdensome as to cause exit), but variable administrative costs will. Further, placing the compliance obligation on those with higher variable administrative costs will lead to a deadweight loss: consumers will pay more, and refiners will get less.

Another reason may be the seen-unseen effect. When refiners bear the compliance burden, the cost of buying RINs is a line item in their income statement. They see directly the cost of the biofuels mandate, and from an accounting perspective they bear that cost, even though from an economic perspective the sharing of the burden between consumers, refiners, and blenders doesn’t depend on where the obligation falls. What they don’t see–in accounting statements anyways–is that the price for their product is higher when the obligation is theirs. If the obligation is shifted to blenders, they won’t see their bottom line rise by the amount they currently spend on RINS, because their top line will fall by the same amount.

My guess is that Icahn looks at the income statements, and mistakes accounting for economics.

Regardless of the true motive for refiners’ discontent, the current compliance setup is not a nefarious conspiracy of integrated producers, blenders, and speculators to screw poor independent refiners. With the exception of administrative cost burdens (which speculators could care less about, since it will not fall on them regardless), shifting the compliance burden will not affect the market prices of RINs or the net of RINs price that refiners get for their output.

With respect to speculation, as I wrote some time ago, the main stimulus to speculation is not where the compliance burden falls (because again, this doesn’t affect anything relevant to those speculating on RINs prices). Instead, one main stimulus is uncertainty about EPA policy–which as I’ve written, can lead to some weird and potentially destabilizing feedback effects. The simple model sheds light on other drivers of speculation–the exogenous variables mentioned above. To consider one example, a fall in crude oil prices reduces the marginal cost of BOB production. All else equal, this encourages retail consumption, which increases the need for RINs generated from biodiesel, which increases the RINs price.

The Renewable Fuels Association has also raised a stink about speculation and the volatility of RINs prices in a recent letter to the CFTC and the EPA. The RFA (acronyms are running wild!) claims that the price rise that began in May cannot be explained by fundamentals, and therefore must have been caused by speculation or manipulation. No theory of manipulation is advanced (corner/squeeze? trade-based? fraud?), making the RFA letter another example of the Clayton Definition of Manipulation: “any practice that doesn’t suit the person speaking at the moment.” Regarding speculation, the RFA notes that supplies of RINs have been increasing. However, as has been shown in academic research (some by me, some by people like Brian Wright)  that inventories of a storable commodity (which a RIN is) can rise along with prices in a variety of circumstances, including a rise in volatility, or an increase in anticipated future demand. (As an example of the latter case, consider what happened in the corn market when the RFS was passed. Corn prices shot up, and inventories increased too, as consumption of corn was deferred to the future to meet the increased future demand for ethanol. The only way of shifting consumption was to reduce current consumption, which required higher prices.)

In a market like RINs, where there is considerable policy uncertainty, and also (as I’ve noted in past posts) complicated two-way feedbacks between prices and policy, the first potential cause is plausible. Further, since a good deal of the uncertainty relates to future policy, the second cause likely operates too, and indeed, these two causes can reinforce one another.

Unlike in the 2013 episode, there have been no breathless (and clueless) NYT articles about Morgan or Goldman or other banks making bank on RIN speculation. Even if they have, that’s not proof of anything nefarious, just an indication that they are better at plumbing the mysteries of EPA policy.

In sum, the recent screeching from Carl Icahn and others about the recent ramp-up in RIN prices is economically inane, and/or unsupported by evidence. Icahn is particularly misguided: RINs are a tax, and the burden of the tax depends not at all on who formally pays the tax. The costs of the tax are passed upstream to consumers and downstream to producers, regardless of whether consumers pay the tax, producers pay the tax, or someone in the middle pays the tax. As for speculation in RINs it is the product of government policy. Obviously, there wouldn’t be speculation in RINs if there aren’t RINs in the first place. But on a deeper level, speculation is rooted in a mandate that does not correspond with the realities of the vast stock of existing internal combustion engines; the EPA’s erratic attempt to reconcile those irreconcilable things; the details of the RFS system (e.g., the ability to meet the ethanol mandate using biodiesel credits); and the normal vicissitudes of the energy supply and demand.  Speculation is largely a creation of government regulation, ironically, so to complain to the government about it (the EPA in particular) is somewhat perverse. But that’s the world we live in now.

* I highly recommend the various analyses of the RINs and ethanol markets in the University of Illinois’ Farm Doc Daily. Here’s one of their posts on the subject, but there are others that can be found by searching the website. Kudos to Scott Irwin and his colleagues.