Streetwise Professor

A group of senators from western states, led by Diane Feinstein, have sent Gary Gensler a missive accusing the CFTC of violating the letter and spirit of Frankendodd by failing to register major energy companies (e.g., BP, Shell) as swap dealers.  Each paragraph of the letter is more risible than the one before.

They set the scene by recounting the western electricity crisis of 2000-2001.  This is utterly irrelevant to the swap dealer designation, because swaps had nothing to do with what happened then and there.  Indeed, at its core the crisis was driven by a combination of fundamentals and flawed market design, and even the suspect trading strategies involved physical market transactions rather than swaps.  For instance, none of the Enron strategies like “Fat Boy” or “Ricochet” involved swaps or OTC derivatives generally in any way, shape, or form.  (It’s also rather ironic that one of the things that wreaked havoc with California utilities was that they were precluded by law from engaging in forward transactions to hedge the short position forced upon them by the retail price caps in the restructuring legislation.)

Parts of the letter made me laugh.  Most notably, the senators attack the $8 billion de minimus exemption from the registration requirement.  Their “logic” is that since commodity swaps represent a small fraction (less than one percent) of total OTC derivatives activities, the de minimus level for energy swaps activity should be lower than for financial swaps. Not just lower: “vastly lower.”

They say this “stands to reason.”  Whenever anyone says something “stands to reason” s/he really means: “I can’t give you an actual reason, so I’ll just assert that my conclusion is obvious.”

This gets to the issue of just what the swap dealing designation is intended to achieve.  That’s always been somewhat hazy, but the most charitable interpretation is that swaps dealers are deemed potential sources of systemic risk that require extraordinary regulatory scrutiny.  The risk a particular firm poses to the financial system as a whole depends on its size relative to the entire financial system, rather than to any particular market, so even accepted the premises of Frankendodd the swap dealing designation should not vary by market.  (Indeed, from a systemic perspective, even $8 billion/year on a flow basis is ridiculously small.)

The senators also fret over the possibility that allowing the Shells and BPs of the world to escape the designation will limit the CFTC’s ability to deter manipulation and fraud.  Hardly.  Those things are still illegal, and swap dealing designation will have no impact whatsoever on the CFTC’s ability to detect and deter.  (Which may not be saying much, because all too often the CFTC wouldn’t know a manipulation if it hit the CFTC in the face with a waffle iron.)  (I consider it ironic that these Solons refer to the BP propane manipulation, which was discovered, prosecuted, and punished when the swap dealer designation was not even a twinkle in Barney Frank’s eye.  Bad mental image, I know.)

Relatedly, the senators worry about “transparency”, but all swaps trades will still be reported to central repositories.  The only way the dealer designation matters in this regard is it affects/determines who has to report.  (I shall pass over in silence the fact that the CFTC is at present utterly incapable of utilizing the data reported to the repositories, as Commissioner Scott O’Malia has repeatedly pointed out.)

But most importantly, the senators miss the elephant in the room.  No major energy firm has registered as a swaps dealer because energy firms have shifted trading from swaps to futures.  Another premise (flawed, but there  it is) behind Frankendodd is that swaps are somehow more dangerous to the system than futures.  The legislation and the rules under it imposed more onerous requirements on swaps than futures, in large part to encourage the movement of trading to futures markets.

So if these senators actually applied reason, rather than just hiding behind a stand-in for it, they should be overjoyed that no major energy firm has applied to be a swap dealer.  This should be a feature, not a bug.  It means that market activity has shifted to the venue that these very same senators and others who voted for Frankendodd considered to be the preferred model for trading derivatives: open, transparent, and subject to a rigorous regulatory regime.  Most notably, from a systemic risk perspective, futures are cleared, and one of the major requirements imposed on swap dealers is a clearing requirement.  So the specter of the swap dealing designation, with its associated burdens, has actually led firms to transfer trading activity from the satanic swaps markets to the sainted futures exchanges.  Yay!

But arriving at this understanding would require actual, you know, reasoning.  Not much, but some.

And that is a bridge too far when it comes to the World’s Greatest Deliberative Body.  Which may be a correct description: if so, God save the world.

The term “squeeze” is used rather imprecisely in financial markets.  To me, the term means an exercise of market power in a financial market, usually a derivatives market, like a futures market, options market, or the securities loan market.

One commonly advanced explanation for the runup in Tesla’s stock price is a squeeze of the shorts.  That is, those who short sold the stock by borrowing it and selling it in anticipation of buying back at a lower price.  In this context the term “squeeze” is not usually used to refer to a purposeful exercise of market power, but it is difficult for the liquidation of short positions to affect prices-and distort them-in the absence of the exercise of market power.

Tesla is a heavily shorted stock: In March, about 40 percent of the float was short.  The stock has experienced a big runup, and one widely advanced explanation is that the shorts have been squeezed.  Given that I wrote the book on manipulation (#4,345,667 on Amazon! But now in paperback! Only $275!-of which I see exactly $0.00! Also on Kindle for a mere $220! How can you pass that up?), I thought I would take a rigorous, data-based look at the subject.

In the absence of manipulation, the forward price of a stock should be the current spot price plus the cost of financing the position at the prevailing interest rate until the delivery date on the forward.  In the absence of a squeeze, the cost/fee to borrow the stock should be small.  However, in a squeeze, it is costly to borrow the stock: the bigger the squeeze, the bigger the cost of borrowing.  This borrowing cost depresses the forward price.  Thus, during a squeeze, the forward price is below the spot price plus financing costs.   The differential between these is a measure of the severity of the squeeze.

I can’t observe borrowing costs directly, and there is no explicit forward market for Tesla stock.  But there is an options market that trades fairly actively.  Given put and call prices, and the associated strike prices, I can use put call parity to estimate an implied forward price:

F=(1+rT)(c-p)+K

where c is the call price, p is the put price, K is the strike price, r is the interest rate (I use Libor), and T is the fraction of a year to expiration of the option.  I do this for every strike on Tesla options expiring in May, June, and September: there is one implied forward price for every strike.  I then use the median and average across strikes (for each expiry) to estimate F.  I then compare F to the no-squeeze forward price, which is (1+rT)S where S is the current price on the stock.  (There is little disparity in my estimate of F across strikes, and the mean and median are virtually identical: this gives me confidence that the numbers are solid.)

This figure depicts the spreads between the no-squeeze forward price and the actual forward price: positive values indicate that there is a squeeze:

The figure does provide evidence of the exercise of market power. The spreads widened starting in late-February, and then remained elevated throughout April and into May.  Some of the drift down observed in the spreads derived from the May and June options is a time to expiration effect: the number of days that short has to pay the borrowing cost caused by the squeeze declines as the option nears expiration, leading to a decline in the spread.  This effect is less pronounced for the September options, which is why its spread remains elevated.

On a per day basis, for the June option, the borrowing cost went from about 1.7 cents per day in mid-March and topping out at 4.6 cents/day on 22 April.

Thus, there is pretty compelling evidence of a squeeze during this period.

This can also be illustrated in percentage terms.  That is, the borrowing cost can be converted into an annualized percentage rate, like an interest rate.  This figure illustrates that:

The decline in the May and June percentage rates reflects primarily the increase in Tesla’s stock price. But the numbers are pretty eye-popping.  At the peak, the “interest rate” paid to borrow Tesla stock ranged from between about 25 percent (to borrow until 21 September) and 45 percent (to borrow to 17 May).   Not quite loan-shark levels, but pretty damn high.

This is further evidence of a squeeze. And note particularly the substantial rise in the spreads, measured both absolutely and in annualized percentage terms from late-February through mid-April.  Obviously, the squeeze was building during this time.

The peak of the squeeze, as measured by the spreads (absolute and percentage) was in mid-to-late-April, which corresponds to data on short sales.  Short open interest declined from a peak of 32 million shares on 15 March, and then declined to 27.5 million shares on 30 April.

One other thing stands out.  Note the spike in spreads on 13 May.  Which just happens to be two days before Tesla announced its secondary public offering.

Interesting. Very interesting. I wonder if the SEC is interested.  It should be.

Short squeezes cause the stock to be overpriced.  Squeezed stocks tend to decline subsequently (Jones & Lamont, 2001). The evidence of the squeeze I’ve presented here, and the Jones-Lamont evidence suggests that Tesla’s price should decline.

When?  There’s the rub. Once a squeeze occurs, people are reluctant to short for fear that they may be squeezed again.  In the absence of the countervailing effects of short selling, the fan boys can drive the price to insane levels.  Moreover, as I’ve shown in my academic work, the stock price is increasing in the probability of a squeeze: if (as is plausible) this probability is higher in the aftermath of a squeeze, this means that Tesla’s stock price currently embeds a squeeze premium.

Eventually this squeeze premium will go away, but given the recent experience, in which shorts were squeezed hard, it is possible that this premium will remain in the price for some time.

There is obviously one big question here: Who is doing the squeezing?  I have no idea.  Theories involving obvious suspects, but no evidence to back it up, and no real means to develop that evidence.  The SEC could figure it out, if it had a mind to.  Sadly, based on past experience I’m doubtful it will find the mind, despite the fact that manipulation (including squeezes) is a violation of the securities laws.

And if it bestirs itself, the SEC should look at another Musk company: Solar City.  It has been on a dizzying ride too, and there is evidence of a squeeze here too.  Indeed, the evidence of the squeeze is even more pronounced here.  Note the huge spike in borrowing costs starting at the beginning of the month, after a period of relatively little movement.  Very, very strong evidence of a squeeze:

Very strong.

Is anybody home at the SEC?  I guess we’ll see.

The takeaway from this is that what are sometimes referred to as “technical factors” are present, with a vengeance, in TSLA and SCTY.  Put less euphemistically, both stocks have been squeezed, and pretty hard.  Squeezed, as in manipulated.

The big question: who has the squeeze box?  Anybody home at the SEC who might try to answer that question?

My main issue with Elon Musk and Tesla is government subsidies.  (An issue the WSJ shares, apparently.  Though if commenter David Hoopes is right, they did not arrive at their opinion independently of me, given the echoes between my post and the WSJ’s subsequent oped.  There are definite echoes.)  If Tesla can make it on its own, all power to it.

But I do have my doubts about its ability to deliver, standing on its own two feet.  Though in expressing those doubts, I have to acknowledge that I am in conflict with Mr. Market, who is continuing to push TSLA on its hyperbolic path-up 13.65 freaking percent today.  On what news?  Got me.

My cognitive dissonance is intensified by the litany of bad news coming out about electric autos.  Today Bloomberg ran a long article about the total fail of electric cars in Germany, despite ambitious government targets.  Last Monday, Reuters ran a feature story on how the “road to a greener America is littered with road kill.” And perhaps the biggest news was the liquidation-not bankruptcy mind you, but liquidation-of battery swap innovator Better Place.  This despite $850 million in investment, the support of a major auto company (Renault), and a marketing strategy directed at the most favorable markets (e.g., Denmark, Israel, and Hawaii).

There is a litany of electric car failures.  Perhaps Musk/Tesla can be the exception that proves the rule, but color me skeptical.

Tesla has made waves with its high end Model S.  But Daimler and BMW are about to introduce high end models of their own, and they can certainly beat Tesla on manufacturing cost and quality (given their long history of building luxury vehicles and Tesla’s manufacturing teething problems).  Moreover, the technology is pretty standardized.  People rave about the acceleration of a Tesla, but that’s purely an artifact of electrical motors: the new Daimler vehicle (described in the Bloomberg piece linked above) also has stellar acceleration.

Tesla plans to launch more affordable vehicles, but no one-no one-has succeeded in that space.  The problems inhere in the technology:

“EVs are a really difficult sell today,” the CEO of Toyota’s North American business, Jim Lentz, said in an interview. “Until we see substantial change in battery technology it’s going to be difficult to see EVs really take off.”

Both articles-and many more, to boot-point to a fundamental issue: range and recharging capability.  Here, the failure of Better Place should be truly sobering to the Tesla fan boys.  It was specifically intended to address the range problem through battery switch technology, but sales of electric autos-even in the cherry-picked markets-were too small to make Better Place viable.

And this points out a fundamental chicken-and-egg aspect to electric cars, which in turn helps explain a good part of Musk’s strategy.

The demand for electric cars depends on the availability of charging facilities.  Or, more accurately, the expected availability of charging facilities.  It also depends on the expected speed of recharge, and the expected duration of a charge.

Charging stations seem to be a constant returns to scale technology.  It is easy to expand capacity to reflect demand, just as it was/is easy to expand filling station capacity to accommodate the number of gasoline-powered cars on the road.  Moreover, entry is relatively easy.  That suggests the following simple model.  The number of charging stations will adjust to accommodate the number of electric vehicles.  But this leads to an indeterminacy resulting from a self-fullilling prophecy effect: if a small number of vehicles are sold, there will be a small number of charging stations.  If a large number of vehicles are sold, there will be a large number of stations.  If potential buyers suspect there will be a small number of other buyers, they will anticipate a small number of charging stations, and they will be less likely to purchase (or, more precisely, their reservation price will be low).  If potential buyers think a lot of others will buy, they will anticipate a large number of charging stations, and they will be more likely to purchase (high reservation price).

Thus, there is a bandwagon effect in electric vehicles. The bandwagon works in part through the expected availability of charging services. This has a self-fullfilling element: if a lot of people jump on the electric car bandwagon, it will be profitable for people to invest in recharging facilities.

There are multiple equilibria in these circumstances.  You can have low sales equilibria and high sales equilibria.

This is the perfect situation for a Music Man.  A promoter who gets the bandwagon rolling.  And this is exactly what Musk is trying to do.

Using Twitter in particular, he is trying to convince potential consumers that there will be a huge infrastructure of charging stations, and that these stations will be highly efficient, permitting a recharge in less time than it takes you to fill your SUV with gas.

Several problems here.  The first is that the bandwagon effect may never kick in: it hasn’t so far, despite aggressive efforts by governments to get it started.  The second is that creating a bandwagon is a public good in this instance: even if Musk starts an electric car bandwagon going, given the ability of myriad other auto manufacturers to enter the market, Tesla will only be able to capture a fraction of the sales resulting from the bandwagon.

You might find this analogy a stretch, but I am convinced it is apt: Elon Musk faces the same challenge as Ben Bernanke, and is using the same strategy.  (And hey, the differences aren’t that great.  Without a hair transplant, or plugs, or whatever he did with his pate, by now Musk would be a chrome-dome like Ben!)  Bernanke wants to generate inflation.  His ability to do so depends on his ability to shape inflationary expectations.  There is a self-fulfilling prophecy aspect to this too, and as a result, there are multiple equilibria: you can have low inflation and high inflation equilibria, depending on whether people expect inflation to be low or high. So Bernanke and the Fed have resorted to various public statements to try to shape these expectations.

That is, there is a bandwagon effect in inflationary expectations, just as there is a bandwagon effect in the sales of electric vehicles.  One strategy to get a bandwagon going is the Tinker Bell Strategy: I believe! I believe!  Musk is attempting to get people to Believe! in electric cars through Twitter and other public pronouncements.  Bernanke and the Fed are attempting to get people to Believe! in increasing inflation through public announcements and guidance.

It is a rational strategy for both to follow, given their objectives.  I must say, though, that starting an inflation bandwagon is likely far easier than getting an electric car bandwagon going.  Addressing the recharging issue is a necessary, but not sufficient condition to overcoming consumer reservations about electric cars.  There are so many other limitations on performance that will make people reluctant to adopt.

But I get the strategy.  If you are long Tesla, or contemplating going long, you need to understand what that strategy is and what must happen for it to succeed.  If you buy Tesla, you are essentially buying an option on Musk being able to start a bandwagon, and get the self-fulfilling prophecy to work.

This also explains the need to build a cult of personality around Musk, all the better to enhance his oracle-like status: hence the employment of a Sock Puppet Army, the aggressive attacks on anyone who calls BS on the cars, or the company, etc.

It will either succeed wildly, or crash in humiliating failure.  I think the fundamentals favor the latter, but in a multiple equilibrium world, I can’t rule out the former.

Okay.  I admit it.  I was wrong.

You’re shocked, I’m sure.

About what, you’re asking?

Well, I said that the RFQ provision of the SEF regulation was the worst of the worst of Frankendodd.  After further review, I’ve decided this is incorrect.  Instead, the “available for trade” rule is the worst of the worst.

The basic idea is that a swaps execution facility applies to the CFTC to list a swap contract as “available to trade.”  If the swap meets one (or more) of six rather vague factors, after receiving comments from other market participants, the CFTC will designate the swap as available.

That would be fine, I guess, if market participants had the choice to take advantage of this availability . . . or not.  But no choice is allowed.  (Choice, it is evident, is an anathema in Frankendodd.  DFA is all about making you eat your Brussels sprouts.)

Thus, once the CFTC designates something as available to trade on a SEF, all market participants subject to the SEF rule (i.e., pretty much everyone other than certain end users) must trade the contract on a SEF, or not trade it at all.  Thus, a SEF can effectively force all market participants to trade a particular instrument on a SEF, or eschew trading it altogether.

Great work, if you can get it.  The ability to make people use and buy your services.

This is beyond bizarre. The ultimate transactors internalize most of the costs and benefits of alternative means of executing a transaction.  But under the available to trade rule, they are not able to make the trade-off between these alternative means: once someone else lists a contract as available for trade, they must trade it on a SEF.  Note, moreover, that this someone else-the SEF operator-has an incentive to try to force business his way.  So the entity making the decision does not bear the full costs  and benefits of its action: indeed, it can profit from compelling others to do something that is against their interests.  That’s always a recipe for error.

Of course, the whole theory behind Frankendodd’s SEF mandate is that there is some sort of externality that leads transactors to choose inefficiently to trade bilaterally rather than on a transparent, order driven market. Just what that externality is is not obvious, to say the least: transparency is apparently a big part of that.  But even if you believe that theory, the SEF operator (a) is not going to internalize that externality, and (b) is not going to internalize the other  costs and benefits of forcing the ultimate transactors to use a particular mode of execution.  Thus, the incentives of the party that Frankendodd empowers to make the decision regarding how to trade are not aligned, even remotely, with the interests of the parties its decision affects.

Of course, a SEF must specify contractual terms of what it will make available to trade.  Market participants may try to avoid transacting something ill-suited for trading on a SEF by trading something similar, but with different terms.  But that can fall afoul of the anti-evasion provisions of Dodd-Frank.  Thus, the available to trade provision will result in (a) the coerced trading on SEFs of contracts unsuitable for it, (b) reduced trade (because market participants decide to trade less rather than trade in an inefficient way), (c) regulatory wrangling over whether some market participants are trying to evade the SEF mandate, or (d) all of the above.

Great.  Just great.

The economic justification for the SEF mandate is extremely shaky: that’s why I consider it the worst of DFA.  The implementation details only make it  worse.  These details presume either that (a) market participants don’t know their own interests, or (b) their interests are contrary to broader “social” interests.  (a) is risible, and (b) is highly dubious.  It is even more dubious to delegate to an agent that does not internalize these social interests the power to compel others who certainly bear many of the costs of the agent’s decisions to make choices they would not make voluntarily.

One last thing about the SEF mandate.  It will apparently determine the future leadership of the CFTC.  Gensler will not be reappointed, evidently.  (I shall pass over that in silence.  Need I say anything?) Relative newcomer Mark Wetjen had apparently been the frontrunner to replace him, but Wetjen’s opposition to Gensler’s obsession with RFQ5 has apparently killed his chances at becoming chairman.

My impression is that Wetjen is a serious and conscientious guy who arrived at his opposition to RFQ5 only after serious thought and efforts to determine whether the rule made any sense.  (Of course, since I think the idea made no sense, I believe he made the right call.)  But for some inexplicable reason, the RFQ rule became identified as a blow against banks, so opponents to it have become perceived as tools of the banks.* And that apparently sank Wetjen’s prospects for the chairmanship.

It’s a mad, mad, mad, mad world, folks.   A risible provision of the most inane aspect of Frankendodd will determine the leadership of a regulatory agency that wields incredible powers under that act.

Update: A shout out to Single Dealer Platforms (which is quite generous in linking to SWP), which expressed similar skepticism about available-to-trade before I posted this.

* The episode of my report on commodity trading firms shows pretty clearly that I don’t dance to the tune of big banks: indeed, a reporter told me that the banking group that hired me to do that report is “furious” that my report that contradicts their position has leaked out.  Yet I criticized heavily the RFQ provision.  Thus, being a bank apologist is neither necessary nor sufficient to explain opposition to the RFQ rule.

Last week it looked like the Obama administration had decided to be sensible on at least one energy issue-the export of LNG.  It approved a new license (for Freeport LNG) for export to countries with which the US has no free trade agreement.  But the WSJ reports that new Energy Secretary Ernest Moniz is thinking of putting on the brakes again.  Because we need more studies.  No.  Seriously:

Mr. Moniz showed caution about the existing studies. Speaking to reporters after a speech to an energy-efficiency conference here, he said he was “committed to doing a review of what’s out there in terms of impact analyses” before approving more applications to export U.S. natural gas. Critics have said last year’s study didn’t rely on the best data available.

“Right now we have no plans of commissioning new studies, but everything is on the table until I have done my analysis,” Mr. Moniz told reporters after his first public remarks as energy secretary

Sorry.  We don’t need no steenkin’ studies.  The whole idea smacks of central planning.  The presumption should be that if firms are willing to risk their private capital, the benefits exceed the costs.  Any analysis should be restricted to potential externalities.  Real externalities.  Not pecuniary ones.

But these “impact studies” are all about pecuniary externalities.  Namely, they focus on the effects of exports on prices of natural gas, and the effects of natural gas prices on consuming industries (like petrochemicals).  But these price effects are not true externalities that lead to inefficient allocation of resources.   Indeed, restricting exports because of these effects would cause a misallocation of resources.

Pecuniary effects do have distributive effects.  In the case of LNG exports, they affect the distribution of rents between gas producers in the US and foreign consumers on the one hand, and domestic gas consumers on the other.

And that’s what the need to get an export permit does: it permits the government to affect the distribution of rents.  That, in turn, gives rise to rent seeking.  And corruption.

In this context John Cochrane mentions the Indian “permit raj”: there you need to get a permit for everything.  This gives those with the authority to grant permits incredible power.  Power they use to enrich themselves and secure political support.

That is exactly what can go on here.  Those hoping to get a permit have an incentive to exert influence, through lobbying, campaign contributions, and supporting public campaigns on issues favored by the administration.  They also realize that they face substantial risks if they oppose the administration on other issues: “Nice little LNG terminal proposal you have here.  Would be a tragedy if something happened to it.”

The government has no business being in this business, beyond perhaps-perhaps-addressing real externality issues.  But even there, other mechanisms (e.g., liability for pollution) may be preferable to a permitting process.  (Look at how Russia used environmental regulations to drive Shell out of Sakhalin II: any power to permit can be used to expropriate of hold up the party seeking the permit.)

In the US, energy, and particularly the international trade of energy, is particularly raj-like: Keystone II is another example.  This destroys value in myriad ways.  Beneficial investments are delayed, or not made at all, either because the government stops them directly, or the risks and costs of getting approval undermine the economics.  Real resources are used to influence policy.  Since energy investments involve big dollars, the losses can be big too.

People often lament the lack of an American energy policy.  I disagree.  We do have an energy policy, and the Energy Raj is a big part of that policy.  A better policy, by far, would be no policy at all.  Would that the DOE adopt the motto: “Don’t just do something! Stand there!”

I’m not holding my breath, though.  The benefits of the raj to the rajahs are far too great.

Harry D’Angelo and Rene Stulz have an interesting paper about bank leverage.  It makes a simple point.  Banks’ liabilities-notably, deposits-are someone else’s asset. That asset provides a benefit, namely liquidity, that depositors can’t realize by trading in capital markets, due to some friction.  This intermediation is what makes banks special.  As a result, depositors are willing to hold bank liabilities in exchange for a lower return than bank assets. Banks therefore have an incentive to create these liabilities-that is, to leverage up-to the maximum extent possible, in order to capture as much of this liquidity premium as possible.  This leveraging is a good thing, because it supplies an asset that is highly valued by those who incur high costs to access capital markets directly.

In the D’Angelo-Stulz model, bank equity is the capitalized value of this below market borrowing rate/liquidity premium.  If the liquidity premium is modest, the  supply of liquid claims results in a high debt to assets ratio.  Again, this high leverage is a good thing, because it is the consequence of the efficient supply of intermediation.  Banks access the capital market effectively engage in a form of asset transformation that generates value: those who cannot access the capital markets, or at least not as efficiently, cannot engage in this asset transformation, and they are willing to pay banks who can.  Through diversification and risk management, banks can engage in asset transformation that is valued by depositors.

This paper is most useful as a corrective to the rather annoying Admati et al “Bankers’ New Clothes” arguments that banks are excessively leveraged and should therefore be subjected to far more rigorous capital requirements, e.g., 25 percent equity.   Admati et al rely heavily on Modigliani-Miller type arguments, and D’Angelo-Stulz show that high leverage can be efficient when there is a single deviation from MM assumptions.  Bank debt (at least some forms of it-more on this below) provides a valuable device in the presence of a friction, and therefore issuance of this debt (in lieu of equity) is socially beneficial.

That said, there are some issues with the paper.

First, the formal model is very rudimentary.  It posits that those without access to the capital market are willing to pay an exogenously specified premium for bank liabilities that offer liquidity, i.e., guaranteed purchasing power.  But willingness to pay does not determine the equilibrium price of liquidity.  In a competitive banking market, the equilibrium price of liquidity is determined by the cost of producing it as well.  This is not modeled in the paper.  The marginal cost of engaging in intermediation/asset transformation must be upward sloping in order for banks to earn producer surplus (which, when capitalized, would be the value of bank equity).

Presumably, equity is one of the means by which banks are able to engage in asset transformation that provides reliable liquidity to those holding bank liabilities.  In essence, equity is a means of bonding contractual performance (a point I learned from reading Yoram Barzel years ago).  In the banking context, equity provides a cushion that ensures that depositors will be able to realize the face value of their claims at will-which is the essence of liquidity.  Thus, the reliability of the liquidity banks supply, and hence the premium that depositors are willing to pay, depends on the amount of equity (as well as on the asset side of bank balance sheets).  The paper does not address this interaction, taking equity value as a pure residual value driven by an exogenous liquidity premium that does not depend on bank equity.

Second, although deposits that provide liquidity to investors without ready access to the capital market are one part of bank leverage, banks, and especially systemically important ones, borrow in other ways, and the resulting liabilities do not have the same money-like characteristics as deposits.   The paper does not explain the entire capital structure of banks.  Indeed, it predicts that banks should be financed almost exclusively by the issuance of money-like liabilities.  They aren’t, so the paper doesn’t explain why banks issue debt that does not provide liquidity benefits instead of equity.  (Perhaps it could be argued that banks provide liquidity indirectly, e.g., by issuing corporate paper that is purchased by money market funds which provide money-like claims to investors.  But this still doesn’t explain the issuance of longer term debt.)

Third, this analysis relates primarily to commercial banks that issue deposits.  What about investment banks?  They are highly leveraged, and it’s not so clear that their liabilities offer the kinds of liquidity benefits that drive the results in the paper.  (Theories that argue that banks are too highly leveraged because of deposit insurance subsidies or access to central bank liquidity (at subsidized rates) don’t apply to investment banks either, because those didn’t have access to deposit insurance of central bank liquidity support.)

Fourth, the paper discusses systemic risk, but this discussion is a little glib.  Debt that provides valuable liquidity services under normal circumstances is fragile, and susceptible to runs.  When runs occur, money-like bank liabilities do not provide liquidity.  Presumably, this affects the liquidity premium, which means that it is unclear that banks issue too much debt.  But the paper can’t really address this question because the value of liquidity is specified exogenously.

All this said, the paper is still valuable because it makes an important point.  Existing theories of banks posit that banks are leveraged because debt addresses some sort of agency or information problem.  These are essentially supply-side factors. The D’Angelo-Stulz theory identifies a demand-side driver of bank leverage.

Bank leverage is a big issue now, with Basel III and Brown-Vitter.  Good policy regarding leverage (and hence, capital requirements) requires an understanding of its costs and benefits. Calling attention to the demand for bank liabilities, and the benefits they provide, is an important contribution to such an understanding.

This story is very bizarre, and I can’t figure out what is going on, exactly.  Or put differently, what has put a bee in the CFTC’s bonnet about CME Clearport’s Exchange of Futures for Swaps (EFS) facility after all these years.

The Commodity Futures Trading Commission has issued a “special call” asking Wall Street banks and other traders to provide documents that would prove recent derivatives transactions known as “exchanges of futures for swaps” were legal. Lawyers at the CFTC enforcement division are also scrutinising the trades for possible violations.

. . . .

The new inquiry centres on whether large traders and market-makers used unregulated over-the-counter swaps markets to trade what were in fact futures, strictly regulated contracts that are economically identical to swaps.

Trading futures off an exchange is illegal, and regulators are concerned that traders may have used these deals, known as EFSs, to agree prices that did not reflect the market.

“They’ve made information requests to everybody that’s ever traded an EFS. They’re saying, ‘prove to us that the swap was legitimate’,” said a recipient of a CFTC document request

The only thing that makes sense is that the CFTC believes that market participants engaged in EFS transactions without having a legally binding swap agreement in place first, meaning that the parties would have engaged in futures trades off-exchange.  Or something.

Note that even if the parties had entered a swap, it may have been in effect a very short period of time-just as long as it took to execute the deal and submit it to Clearport for clearing.

I also find it curious that the article mentions that the CFTC is looking only at deals done post-Frankendodd, even though deals have been done this way since the 2002 time frame, if memory serves.  One explanation is that CFTC believes the alleged conduct was permissible under CFMA, but not under DFA.  Another guess on my part.

If there is a violation here, it seems to be a highly technical one.  The end result is pretty much the same if they did or they didn’t execute a binding swap first: each party has futures positions obtained at a privately negotiated price.

CFTC has a lot on its plate already: is this really a priority? Really?

Moreover, the party that usually screams the loudest about off-exchange trading of futures is the futures exchange.  But Clearport is a CME system, and EFS is a CME procedure, and it seems that CME is totally fine with this.  Actually, if the following quote relates to the EFS issue (and it’s not clear that that’s the case from the article), CME is actually hacked at this:

Terry Duffy, CME executive chairman, said in a letter to CFTC last week: “In our view, nothing is served by piling on duplicative reporting mandates.”

For certain, though, CME was perfectly satisfied with the way market participants were doing EFS deals.

So who is the victim here?

It’s actually ironic that EFS was the CME’s way of implementing clearing for energy and metals.  And the CFTC is rah-rah about clearing.  But it is looking askance at the CME’s way of implementing clearing.  I guess it’s a case of that was then, this is now.

CFTC also effectively killed EFS as a mechanism for facilitating OTC clearing by determining that a swap, no longer how short its existence before conversion into futures, counted towards a firm’s annual $8 billion (to be reduced to $3 billion) de minimus swap volume for the purpose of determining whether it is a swap dealer.  As a result, market participants are moving to block futures trades rather than EFS to clear energy transactions: block futures trades that are negotiated away from the central market, just as the allegedly phantom swaps were. So this is last year’s war.  If traders weren’t doing papering officially a swap deal, they were effectively engaging in block futures trades, which is what they are doing now.  If it’s OK now, other than the technical violation, was it so horrible then that it requires a full blown investigation?

So what’s up?  A burdensome, intrusive “Special Call” to investigate a possible technical violation that the exchange that would be hurt by a violation doesn’t seem to care about, and which is of little relevance going forward.

Wow.  That seems like a totally reasonable use of scare resources-resources Gensler claims he doesn’t have nearly enough of.

Javier Blas of the FT just posted an article about a report “written by a leading academic on commodity markets” on whether commodity trading firms (like Cargill or Vitol) are sources of systemic risk.

What, haven’t heard about that report?  Well, that’s the main point of the story.  The report was spiked by the GFMA, a banking trade association, which commissioned it.  According to Javier:

However, the report was never completed and remained in a “draft” status, after its conclusions went against the interest of the lobby group, three people familiar with the matter said.

So yes, perhaps you’ve guessed by now that the academic in question is me (though you have to read 2/3s of the way through the story to get to my name).  And yes, that’s pretty much what I understood to have happened, though I was never told that in so many words.  It’s nice to have it confirmed by “three people familiar with the matter”, even though it was blindingly obvious to me at the time. *

I call them like I see them.  GFMA didn’t like that.  I wouldn’t change the call, so they sat on the report.  So it goes.

I think GFMA handled this badly even from the perspective of its own interests, though I guess I am not really surprised: this is the way organizations like this tend to behave.  I am sure this has given the report more visibility than it ever would have achieved otherwise, and makes GFMA look bad in the bargain, at least in my (probably biased) opinion.  The regulatory body they were trying to influence-the FSB-was briefed on the findings, and had a draft of the report, so deep-sixing the report only signaled to the FSB that GFMA didn’t like the results, which it probably knew anyways.  Spiking the report also serves to validate the independence of the findings-and of the finder of the findings.  That’s definitely an upside for me.

Working on the report helped me learn a good deal more about the global commodity trading firms, so that’s also a good thing.  I look forward to learning and writing more in the future.

*For the record, the copy of the report “seen by the Financial Times” didn’t come from me.

There are reports that the CFTC will vote on the SEF rule next week.  The rule had been in limbo for months due to Gensler’s insistence that the rule require those requesting a quote solicit them from five potential counterparties.  Gensler has apparently relented because he could not get the new Democratic commissioner, Mark Wetjen, to join with Chilton and Gensler to vote out the 5 RFQ rule.

The compromise will require users to solicit two quotes for the next two years, and then three thereafter.

Whatever.

On the 1 year anniversary of the DFA, I named the SEF mandate as The Worst of Frankendodd. I haven’t changed my mind on that, though the competition is fierce.  And the RFQ requirement is the Worst of the Worst.  It is defended as a way of  improving competition.

This is at best paternalistic.  It presumes that those who want to enter into swaps don’t know their own interests.  Perhaps Gensler thinks that the buy side suffers from some sort of Stockholm Syndrome after years of captivity to the dealer banks.

In reality, buy side firms-most of whom are extremely experienced and sophisticated-are making trade-offs between competition and information leakage.  They are trying to minimize cost of execution, and have the information and incentive to do that.  Note too that they are required to do this for every trade, regardless of instrument, size, and other factors that may influence the trade-off.  But nope, one size fits all. They should be allowed to make that trade-off themselves, without any guidance from Gary.

RFQ5?  How about RFQ0?

Here’s an analogy.  How would you like it if the government told you how many stores you had to visit before making a purchase?  You know, to make sure that you get the best price.  Call it the CS5 rule.  You have to comparison shop at five stores before making a purchase.  On everything.   Of course, when deciding on whether to shop at one store or five, you trade-off the potential savings (which will depend on the value of the purchase, the good you are shopping for, and other factors) from shopping around more, against the cost (which will vary with the value of your time, how hurried you are, your income, the price of gas, where you live, etc.)  But none of that matters under the CS5 rule.  Want to buy a quart of milk?  Shop at five stores.  For your own good.

Yeah.  It’s that bad.  CS2 would be bad, but not that bad.

Once the SEF rule goes into effect it will be interesting to see how the structure of the industry involves.  There will be a land rush of new SEFs.  I predict there will be a shakeout, and there may well be only a single dominant SEF for each major instrument.  The SEF rule does not, as I understand it, require a SEF to send an order to another SEF offering a better quote.  Which means that the network effects of liquidity will tend to cause trading activity to “tip” to a single SEF for products big enough to support order book trading.

But the whole SEF landscape will also be shaped by the margin rules, the Bloomberg suit over those rules, block trading rules, and on and on.  The rule is not the beginning of the end, it is barely the end of the beginning.

The FSB is contemplating designating commodity trading firms like Cargill and Glencore as systemically important.  No, not that FSB: The Financial Stability Board, a group of global regulators established in the wake of the financial crisis.

The reason for this is, apparently, that these firms are engaged in shadow banking.  The linked Reuters story mentions two types of activity.

First, commodity trading firms extend trade credit and working capital to their customers.  Second,  some use securitization to raise funding.

The FSB is rightly concerned about shadow banking, but the kinds of activities that commodity trading firms engage in is quite different from some of the activities implicated in the crisis.

Some forms of securitization contributed significantly to the crisis.  Most of the most dangerous forms involved significant maturity transformation, and direct ties to big banks.  SIVs that funded portfolios of mortgage securities with short-maturity corporate paper, that were backed by liquidity puts provided by sponsoring banks are the prime example of this.  When investors began to doubt the value of the underlying assets, there were runs on the SIVs: they could not rollover their paper, and sponsoring banks ended up taking the now toxic assets back onto their balance sheets.  This was a big problem because the banks were highly leveraged; their main business is to provide credit; and they are essential components of the payment system.

The securitizations that commodity trading firms have engaged in, like the Trafigura program mentioned in the Reuters piece, are (a) far more limited, and (b) very different.   In particular, these structures do not involve the kind of maturity mismatch that was the Achilles heel of the SIVs.  Indeed, if anything, to the extent there is maturity transformation it is the opposite of the type that proved problematic in the crisis.  The underlying assets are very short dated (such as receivables) and/or very liquid (like inventories of aluminum in LME warehouses).  The assets typically have shorter maturities than the liabilities issued to fund them.  Indeed, one of the challenges of these structures is to replenish the assets as they mature.  Traditional SIVs had to rollover their liabilities: commodity trade securitizations have to replenish their assets.  The former is far more problematic than the latter because the run risk is far greater.

Moreover, historically the default rates on the trade receivables that are securitized are very, very small.  The extent data are for all trade receivables, not just commodity trade receivables, but the credit losses are trivial.

I also find little reason to be unduly concerned over the  the granting of trade credit and extension of working capital funding through prepayments and other arrangements.  Consider prepays, where a trading firm may provide funding to a refiner, say.  The commodity trader may fund the input (crude oil), and in exchange receive refined products.   The refined product is essentially collateral for the financing provided to buy the input.  Moreover, the value of this collateral can be hedged in most cases, limiting the credit exposure of the commodity firm extending the credit.   This is often quite different than extending credit to fund illiquid, hard to value, long maturity assets that cannot be hedged.

The commodity trading firm has a comparative advantage in marketing the output.  Moreover, due to its knowledge of the industry and the particular firms involved, it likely has information that makes it the most efficient creditor.  It knows more about the market and the particular borrowers than most banks.

The foregoing suggests that the credit risk and maturity transformation risk involved in commodity trading firm shadow banking activities is far less than that involved in the kinds of shadow banking that proved highly problematic during the crisis.  But credit losses are conceivable.  What would happen if commodity trading firms suffered big credit losses?

It’s hard to see how this could seriously threaten the stability of the financial system or the global economy.  Commodity trading firms aren’t that big: if Glencore is too big to fail, so is Kraft, or a similarly sized company.  Their assets are dwarfed by those of the big SIFI banks: they are about as big as many middling banks you’ve probably never heard of.  Moreover, the commodity trading firms are far less leveraged than big banks.  Furthermore, their capital structures are far less fragile, because they involve little maturity transformation: their short term liabilities are largely matched against short term assets, such as hedged commodity inventories.  The firms provide financial intermediation, but unlike banks, that’s not their primary function, so they are not as vital to the credit supply process as banks.  They are not essential elements in the payments infrastructure.

Commodity firms provide valuable logistical services, but the assets, human and physical, that they utilize are readily redeployed.  If one company goes bust, its assets can be redeployed so that the trade in commodities can continue.

Some of the shadow banking activities that commodity firms engage in actually take risk out of the banking system.   A major reason for the development of securitization in commodity markets was that big banks-especially French banks facing difficulties in securing dollar funding-cut their funding to commodity firms.  So the firms turned to securitization and thereby transferred the risk to the capital markets.  And unlike the case with SIVs sponsored by banks, there isn’t a backdoor by which this risk can make its way back to bank balance sheets.

I would also note that commodity trading firms do not benefit from deposit insurance, and so don’t pose the same moral hazard concerns as banks that do.

So I find few parallels between the kinds of shadow banking that proved so dangerous during the crisis, and the kinds of shadow banking that commodity firms engage in.

Commodity firms are first and foremost logistics specialists that engage in financing transactions to facilitate that business. A couple of other historical experiences suggest that such logistical intermediaries are not systemically important.

In 2002, the entire merchant energy sector in the US imploded.  These firms-companies like Enron, Dynegy, Mirant, and Williams-were primarily logistical intermediaries that provided financing and risk management services to their clients, just as global commodity trading firms do.  Not just one of these firms imploded.  The whole industry did: the stock prices of the firms in this business fell by about 90 percent between April and July of 2002.  But gas and power continued to flow. The impact on the US economy was barely measurable.

Furthermore, the experience of the Fukishima earthquake and tsunami suggests that even if the failure of one or more major commodity firms did disrupt commodity logistics for a time, the implications of this for the global economy would likely be small.  The earthquake and tsunami created huge disruptions in supply chains, especially in automobiles and electronics.  Trade was severely disrupted.  But the impact on the global economy was almost immeasurably small.  Studies undertaken by several governments found that the Japanese disaster shaved a tenth of a point or two off global GDP growth.  The financial aftershocks were minimal, even in Japan.  If the world economy can survive such a literal seismic shock that seriously disrupted supply chains in high valued manufacturing, it can almost certainly survive the failure of a big commodity trader.  Or two. Or three.  Especially since the Fukishima disaster destroyed or disrupted physical assets in a way that the financial distress of a commodity firm with redeployable assets would not.

I’d be more persuaded by the FSB’s concerns if it would provide a description of the mechanism by which commodity trading firms can be the source of financial contagion, or the channel through which contagion can be communicated from the financial sector to the real economy.  As those who have read my writings on clearing can attest, I can have a pretty vivid imagination about how contagion can propagate, and despite giving this considerable thought, I haven’t found a plausible mechanism.

In some sense, it seems that the FSB is like Mark Twain’s cat that wouldn’t sit on a hot stove after it had been burned, but it wouldn’t sit on a cold one either.  Once burned by shadow banking of one kind (the kind tightly tied into the banking system), it seems afraid of any kind of shadow banking.

And I have a pretty good idea who is stoking those fears.  I know, as the result of personal experience, that major banks involved in commodity markets are chafing under the restrictions imposed on them, and resent the fact that commodity firms that are their competitors in certain activities are not subject to the same restrictions.  I know they have been importuning the FSB to identify commodity trading firms as systemically important, and to impose bank-like disclosure and capital requirements on them.  All the better to hamstring the competition.

How I know this, I can’t say.  But I’m just sayin’.  You can take it to the bank, as it were.

Too big to fail is a self-fulfilling phenomenon, in large part.  It would be far less of a problem if governments could credibly commit not to bail out certain firms.  It becomes much harder to make such credible commitments when those firms are identified as systemically important.  Therefore, regulators should be very reluctant to confer the “systemically important” label.  Very reluctant.   Objectively, there are few reasons to consider big commodity trading firms-even the biggest ones-systemically important. All the more reason to eschew conferring that designation on them.

In other words, sitting on a cold stove isn’t dangerous.  The FSB should be smarter than the cat in Puddin’ Head Wilson.