Streetwise Professor

Zero Hedge has largely avoided any serious scrutiny for the past several years, after some critical stories in New York magazine and on Felix Salmon’s blog.  I wonder if that’s about to change.

While waiting for serious reporters to subject ZH to the same kind of critical inquiry that ZH routinely aims at its myriad enemies, I have a few questions that might be worth exploring:

1. Do ZH writers have positions in the market?  Any market?
2. Do they disclose positions when they write stories related to their positions, or post tweets related to their positions?
3. Is the SEC at all curious about a hugely influential, and possibly market moving/market influencing site in which someone banned from the securities industry is deeply involved? (Daniel Ivandjiiski, banned from the industry for insider trading denies being a “founder” of ZH, but this sounds weasel-like, depending on the definition of “founder.”  He is the only publicly identified writer for the site.)
4. Is the fear of SEC scrutiny why ZH is registered and hosted in Switzerland? If that’s not the reason-what is?

I have many more questions, but that will do for now.

The Economist just ran a long piece about the unintended, and largely unforeseen, consequences of collateral and clearing mandates.*  And they aren’t all good.  Anything but.

I say largely unforeseen because I’ve been jumping up and down about these consequences here on SWP, in some academic papers (including one to be published in the next issue of the  Journal of Applied Corporate Finance), and numerous presentations.  I have repeatedly emphasized that it was a fallacy that requiring more collateral would necessarily reduce the amount of leverage in the system, make the leverage in the system less fragile, or reduce interconnectedness among financial institutions. I have consistently argued that market participants would substitute alternative forms of leverage and utilize other financing techniques (e.g., collateral transformation and liquidity swaps) as fragile or more fragile than the leverage embedded in derivatives, and that these new forms of financing would just change the topology of the network of connections among firms in the financial markets, and that the new topology would be as or more complex than the pre-mandate topology.

It was always particularly maddening to see regulators and others present pictures of the OTC derivatives market with a spaghetti bowl of interconnections between market participants, and contrast it to a neat and tidy picture of a cleared market with a few neat lines connecting market participants with the CCP.  There was no consideration of how the necessity of funding collateral and making variation margin payments would lead to the creation of financing arrangements among firms that would resemble the spaghetti bowl picture.  No consideration of how the very complex financial system would adjust on the myriad margins available to it.

In some respects, I can make some allowances for the regulators and legislators who imposed this on the world.   Those allowances are mainly a function of low expectations.  I am less forgiving of the academic community.  Many people smarter than I whom I respect have bought into the neat and tidy picture, and have dismissed concerns that the various Frankendodd mandates (and their European cousins) will create a new set of problems that may be worse than the ones that were supposedly fixed.

I think that in large part, this failure to anticipate the real effects of mandates, and the blithe confidence in the efficacy of collateral in particular, reflects the standard partial equilibrium, ceteris paribus way that economists use to approach problems.  This method is very powerful, and I utilize it regularly, but it has its limits.  In particular, it blinds one to the systemic responses to big changes like Frankendodd, to the fact that market actors will respond to these shocks on many dimensions.  As I’ve said repeatedly, there has been a systematic failure to consider how the financial system as a whole would respond to massive interventions designed to reduce systemic risk.

This is a particularly hard problem to analyze mathematically and formally due to its inherent complexity.  The daunting nature of the task, and the fact that formal mathematical modeling is almost required by top tier journals, has, in my opinion, made it unattractive for academics to pursue these issues.  The constraints of the accepted toolset have led to the slighting of an extremely important and interesting issue.

But this is not to say that the problem is immune to analysis that can generate meaningful insights and falsifiable predictions.  Indeed, largely disdained non-formal (“literary”) approaches can do so-and have done so.  I started from a very simple premise, that there were fundamental economic considerations that had led market participants to choose financing arrangements and contracts with certain amounts of leverage and fragility.  Constraining the ability to use those sorts of financing arrangements would induce actors to substitute towards arrangements with similar properties.  Non-formal analysis also shed light on how these mechanisms would operate during periods of systemic stress.

Based on these non-formal approaches, I made predictions about how the markets would evolve under clearing and collateral mandates.  Those predictions can be tested by empirical observation (though again, more descriptive than formally econometric).  That’s as “scientific” (in the Friedman Methodology of Positive Economics sense) as the densest, or most elegant, mathematical model.

And as it turns out, in this instance, some of those predictions are being borne out.  In ways that make me appreciate Cassandra.

I think it is more important to focus on important problems and find the best tools for the job at hand, rather than let narrow conceptions about the appropriate tools define and the problems you work on.  The latter mindset has limited academic economists’ influence on big things like Frankendodd.

The one-eyed man is king in the land of the blind.  Non-formal methods provide sight-and insight-on issues to which formal methods are often quite blind.  Given the incentive structure in academia, however, I am skeptical that the lesson will be learned.

* Link fixed. H/T Phil R.

It is difficult to figure out which commodity induces more mass stupidity-gold or oil. Upon reflection, it seems that the stupidity is price dependent, and given the rise in gasoline prices the oil-related stupidity is taking the lead.

Glibfinder wrote a comment and friend R told me about a particularly distilled example of oil induced insanity-the Bill O’Reilly-Lou Dobbs discussion last Friday.  I am well familiar with O’Reilly’s cluelessness on energy.  Whenever prices are high, he asserts that oil companies can charge whatever they want for oil, and are overcharging: which always raises the question of why they would let prices fall to around $30/bbl (2008-2009) or $10/bbl (1998).

Being a glutton for punishment, I watched.  Or tried to, anyways.  I could take it for only about 3 minutes. O’Reilly spewed his usual story, this time with a bit of a new spin: Prices are “subjective” so companies can charge whatever they want.  Believe me: he wasn’t making a subtle, Austrian-economics based point.  Then he and Dobbs went on crude Mercantilist rants that would have been an embarrassment in 1775.

O’Reilly, while denying he was a socialist, claimed that the government has a legitimate right to control oil prices because it is “our oil.”  I was waiting for him to channel Woody Guthrie, and break out singing “This oil is your oil, this oil is my oil.”

But O’Reilly and Dobbs are just talking (empty) heads. Barack Obama is president of the United States, but he is as idiotic about energy (and economics generally) as they are.  He’s just idiotic in a different way.

He has repeatedly ridiculed increased production of hydrocarbons, saying that it is impossible to drill our way out of dependence.  In Saturday’s radio address, he said that drilling isn’t a plan, “it’s a bumper sticker.”

Typical Obama false choices. Obama says we are already drilling.  The questions are, though, whether restrictions on drilling should be eased, whether more federal lands should be opened for exploration and production.  Obama, in his typical three card monte fashion, attempts to avoid answering those questions by suggesting that since drilling is not the entire solution, it is not worth discussing.

He then demonizes oil companies and their profits, playing on the class warfare theme.  Would he be willing to compare return on capital of oil companies to those of his biggest Silicon Valley donors?

Here’s a laugh:

I’ve directed my administration to look for every single area where we can make an impact and help consumers in the months ahead, from permitting to delivery bottlenecks to what’s going on in the oil markets.

Permitting? Delivery bottlenecks? Really? You mean like Keystone? Looked at the differences between Bakken prices and Cushing prices, or between Gulf prices and Cushing, lately? Plenty of evidence of a bottleneck, which Keystone II and other projects would alleviate.  The biggest bottleneck, arguably, in the world oil industry right now.  One that Obama could have alleviated-but consciously decided not to.  Now that’s chutzpah.

And speaking of bumper stickers, he drones on about a subject on many a bumper sticker plastered to Priuses and Volvos: renewable energy:

It’s time to end taxpayer giveaways to an industry that’s never been more profitable, and use that money to reduce our deficit and double-down on a clean energy industry that’s never been more promising. Because of the investments we’ve already made, the use of wind and solar energy in this country has nearly doubled – and thousands of Americans have jobs because of it.

Uhm, to the extent that the oil industry is profitable, it is because it provides a product that people are willing to pay more for than it costs to produce.  Looking past his risible claim that anything he proposes is to reduce deficits, he proposes to “double-down” on an industry that only survives because of subsidies, because it produces energy that is far less valuable than the cost of producing it. (Actually, “doubling down” is a very appropriate characterization, a phrase usually applied to desperate gamblers trying to dig themselves out of a deep, losing hole.)

Doubling of wind and solar-from nearly infinitesimal to twice infinitesimal.  BFD.  And at what cost?  Regarding jobs-Obama emphasizes the seen jobs supported by subsidies derived from distorting taxes, but what about the unseen lost jobs (and lost wealth) as resources are pushed into uneconomic uses?

Renewables are a colossal waste. Wind. Don’t make me laugh. There is a strong negative correlation between wind and temperature, meaning that wind doesn’t produce power when you need it, and produces power when you don’t-requiring the costly shutdown of conventional plants when the wind is blowing hard (costly, as indicated by negative prices for power). Its unreliability also requires the maintenance of backup thermal generators, and the fact that wind resources are often distant from loads necessitates additional investment in transmission.

Who couldn’t love it?

Insofar as solar is concerned, even the Germans, who went whole hog into dreams of replacing fossil fuels with the sun, have realized it is utter folly.   The Europeans generally, especially the Spaniards and the Germans, have realized that unicorn dreams will not keep the lights on.

But Obama refuses to heed the Ghost of Christmas Future, and insists on repeating the same follies.  One can excuse the Germans and the Spaniards for making the mistake in the first place.  It is inexcusable to repeat the mistake-and glory in it-with their example before his eyes.

Apparently the stupidity is the most renewable part of green energy.

Not to mention that wind or solar don’t address the most pressing energy problem-motor fuels-and the one that does-biofuels-is a disaster in its own special way (apologies to Tolstoy).

Obama also touts fuel economy standards, another fundamentally misguided policy, and one that has wreaked havoc with the US automobile industry for decades.

Milton Friedman said there is no problem government couldn’t make worse. Virtually everyone advancing government solutions to address high energy prices, from O’Reilly to Obama, seem hell bent on proving Friedman correct.

Update: Literally 3 clicks after modifying this post to add the dig at biofuels, via Climateer Investing I came across this post summarizing the views of a Nobel winning chemist: “The Nonsense of Biofuels.”  Hear, hear.

Mary Shapiro weighed in on high frequency trading again.   Well, sort of:

The rules the SEC is contemplating are vague, but could involve fees on high volumes of order cancellations or a minimum time enforced for quotes. “While we haven’t landed on concrete things that we will do next,” Schapiro said, “all these ideas are live and subject for discussion within the agency.”

The WSJ has a little more:

Among the ideas the agency is considering, she said, is the implementation of obligations for certain high-frequency traders to provide quotes near the national best bid and offer prices—the highest buy and lowest sell orders across the market—during a certain percentage of the trading day.

The SEC also is weighing imposing fees on order cancellations, which constitute “a vast majority of orders” submitted by high-frequency firms, Ms. Schapiro said. An estimated 95% to 98% of orders submitted by high-speed traders are canceled as the firms rapidly react to shifts in prices across the stock market, according to Tabb Group, which tracks trends in electronic trading. The possible fee, previously mentioned in a joint advisory committee of the SEC and CFTC, would likely be a tiny fraction of a cent per canceled order, experts say.

Imposing obligations is not costless.  Requiring people to quote when they don’t want to quote means that they will quote poorer prices. With respect to cancellations, yes, some abusive HFT strategies do allegedly involve quote stuffing followed by cancellations.  But many salutary HFT strategies, including the cyber equivalent of scalping-market making-also involve large numbers of cancellations. Market makers are at risk of being picked off, or of trading at stale prices, and hence want to cancel orders, and perhaps submit new ones at different prices, when new information arrives.  And in an electronic environment, new information arrives rapidly.  Locals scalping in futures pits were only obligated to trade at their quotes “as long as their breath was warm” to limit their exposure to these problems: cancellations by HFT traders making markets serve the same purpose. Taxing cancellations could well impair these legitimate uses of cancellations more than the abusive ones, leading to less liquidity and costlier trading.  This is a very blunt tool indeed.

The fundamental issue is that HFT is not one thing.  There are a variety of HFT strategies, some of which are beneficial, others arguably opportunistic.  Moreover, it is quite possible that a given HFT firm uses a variety of strategies, some of which are beneficial, some of which are opportunistic.  The focus should be on trying to identify order submission patterns that are characteristic of opportunistic strategies, and those that are characteristic of beneficial ones (e.g., market making) and develop pricing or enforcement measures that are targeted at the abusive strategies.  Meat axe approaches like taxing cancellations are indiscriminate, and risk doing far more harm than good.

Shapiro doesn’t inspire confidence when she says things like this:

Schapiro expressed concerns of her own Wednesday, lamenting the current volume of trading that is “unrelated to the fundamentals of the company that’s being traded.”

“It’s got very little to do with whether you think IBM’s got a great business plan and solid earnings growth in its future … and a lot more to do with what’s the minuscule aberrational price move that you can take advantage of because you’ve co-located your computer with the exchange and can jump on that in microseconds,” she said.

“And that worries me in some ways.”

There has always been trading unrelated to fundamentals, that has been technical in nature and focused on profiting from minuscule price moves. That’s what most market making is about. Indeed, the existence of that kind of trading produces the liquidity that facilitates long term trading.  And there have always been time and space advantages in trading. Why do you think people paid hundreds of thousands, and sometimes millions, of dollars to be on the exchange floor? The views? The charming company? No.  Because being on the floor gave you an edge.

Shapiro’s testimony suggests that the SEC is befuddled by HFT.  This is understandable, because there’s a lot about it that is not well understood, and because it is surrounded in a fog of mystery and controversy. But her testimony also suggests a deep-seated suspicion of HFT, and preference for indiscriminating solutions that will throw the baby out with the bath.

Not too swift.

For years I have been saying and writing that every spike in energy prices results in a replay of the final scene from Casablanca: “Round up the usual suspects,” with speculators being at the front of the line.   No exception now. With rising gas prices being the main threat to his reelection prospects, Obama and other Democrats are doing their best Captain Renault imitation.  Obama:

Obama sought to deflect growing Republican attacks over rising prices at the pump, blaming recent increases on a mix of factors beyond his control, including tensions with Iran, hot demand from China, India and other emerging economies, and Wall Street speculators taking advantage of the uncertainty.

Noted energy expert, Nancy-natural-gas-is-not-a-fossil-fuel-Pelosi also chimed in:

“Wall Street profiteering, not oil shortages, is the cause of the price spike,” Pelosi said in a statement. “Unfortunately, Republicans have chosen to protect the interests of Wall Street speculators and oil companies instead of the interests of working Americans by obstructing the agencies with the responsibility of enforcing consumer protection laws.”

And, again at the risk of sounding like a broken record (responding to a vast collection of broken records): no theory, no evidence.

With respect to evidence, a heads up: The opponents of the “financialization” of commodity markets have flogged the Singleton paper on oil index trading for all it is worth. I am putting the finishing touches on a far more extensive study, the conclusion of which is quite simple: the Singleton results do not stand up in a broad sample of commodities, or even in oil for a longer sample period.  Watch this space.

In other words: try again, guys.  But that would actually presume, I guess, that evidence matters to these people, anyways.

One thing struck me about the Obama and Pelosi statements: the deliberate inclusion of “Wall Street” in their formulation, as in “Wall Street speculators.”  What, London, Geneva, and Singapore don’t rate?

Which brings another movie image to mind: the scene in Frankenstein in which the villagers storm the castle.  Obama and Pelosi are just following the #OWS-themed, Valerie Jarret-inspired class warfare campaign script. Be prepared to be bombarded with similar rhetoric for the next eight months.  And the shrillness of the attacks will vary directly and exponentially with the price of gasoline.

I don’t have a lot more to say on the subject, primarily because there’s not a lot new to say.  Obama and Pelosi are being good greens, and recycling well-used rhetoric.

I was interviewed on the subject Tuesday for an NPR piece.  It does a pretty good job of summarizing what I said in a 20 minute interview.  A few brief comments:

1. The CFTC claims that it has brought numerous energy enforcement actions and collected large fines.  This is highly disingenuous.  Highly.  These have not been in the oil market (except for the Arcadia case which I criticize in the piece, echoing what I’ve written on SWP).  They have not shown any connection between speculation and manipulation and high oil prices. Virtually all of these cases relate to price reporting fraud and wash trading in the natural gas markets during the merchant energy boom, prior to the demise of Enron and the merchant energy meltdown in 2002.  I was highly involved in efforts designed to prevent these abuses from recurring.  Efforts that did not come to fruition, but which focused on a solution (the creation of transaction data hubs with mandatory reporting) that has now been adopted for the derivatives markets worldwide-not just natural gas in the US.  That is arguably one of the only sensible things in Frankendodd.
2. The piece mentions John Arnold making a billion in speculating.  Yes, he did.  In gas.  The price of natural gas is at near-historic lows, demonstrating that speculative activity does not inevitably cause prices to be high.  Indeed, the disconnect between natural gas prices and oil prices is a huge embarrassment to the anti-speculation mob, especially those who claim that index investing (which results in highly correlated trades in oil and gas) is a dominant force in driving commodity prices.
3. It drives me to distraction that “speculation” and “manipulation” are used interchangeably.  No. No. No.
4. Manipulation definitely occurs in commodity markets, including the energy markets: for instance, manipulations were common in the Brent market in the late-90s and early-00s, and may become more common again as BFOE production continues to diminish.   These manipulations lead to highly temporary and localized price distortions.   Most of the Brent squeezes resulted in elevations in Brent prices for days, or a few weeks, and didn’t push up prices of other types of oil: indeed, the main symptom of these squeezes was the rise in Brent relative to other grades and locations.  As another example, the BP propane squeeze (a case I was involved in) resulted in a spike in TET propane prices for about two weeks.  They don’t explain persistent, global prices spikes.

Hopefully I will have the results on the expanded Singleton analysis available within a few weeks.  Until then, get prepared for a continued onslaught against “Wall Street profiteers and speculators.”  La plus ca change . . .

Last March I noted that in my two previous trips to teach in Geneva, there had been squeezes in the coffee market, and I said I was going to buy coffee spreads before my next trip.  Well, that trip is coming up in about 3 weeks, but somebody in the market (perhaps the Noble Group, according to the FT) beat me to the punch: there is a good squeeze underway in the robusta market, with spreads going from contango to a $182/ton backwardation.  That ain’t a hill of beans.

Note to self: put on the trade earlier next year.

When I was in Geneva last year the Li(e)bor story came to life after having faded from view for several years.  That story has now exploded into prominence, with numerous disclosures over the past several weeks.

Indeed, the story has taken a major turn.  Whereas suspicions as to motive originally focused on the idea that banks were attempting to make themselves look sounder than they were by exaggerating their ability to borrow unsecured, the new stories claim that there is evidence that some traders were manipulating rates specifically to influence the value of derivatives positions tied to Libor.  This is a major development because specific intent to manipulate the price of a derivative is a necessary element of a manipulation case under the Commodity Exchange Act.  If confirmed, these allegations regarding motive dramatically increase the legal stakes for the banks.

Eric Posner and E. Glen Weyl have attracted a lot of attention for their proposal to create an agency that would approve trading of new financial products, in the same way the FDA must approve new drug entities before they can be sold to the public.  Their initiative is fundamentally flawed, both in its diagnosis and its prescription.

There are a variety of problems.  The most basic is their false dichotomy between contracts that are used for speculative purposes, and those that are used for hedging.  In fact, speculation and hedging are highly complementary functions.  The most important function of derivatives markets is to facilitate risk transfer.  This risk transfer often involves a hedger on one side of a transaction, and a speculator on the other.  The speculator may be, as Posner and Weyl claim, trading on the basis of incorrect beliefs.  So be it.  His existence allows the hedger to reduce risk, and makes both parties subjectively better off, although Posner and Weyl seem to suggest that it would be possible to determine objectively that the speculator is acting irrationally.

In other words, much speculation in financial markets facilitates hedging.  To suggest that these activities are antithetical, or unrelated, as Posner-Weyl do, is highly misleading.

Posner and Weyl use mutual funds as an example of a salutary financial innovation.  No disagreement here.  But these can be used for activities that are commonly and properly considered “speculative.”  Moreover, equity and bond futures are widely used to speculate on broad movements in stock and interest rate changes.  But they are also used by pension funds and institutional investors to achieve the same type of objectives as mutual fund investments. So what, really, is the difference between mutual funds and derivatives?

There are indeed well-known problems with speculation.  Much of it (including excessive acquisition of costly information, the development of faster ways to trade) is properly understood as rent seeking.  But these problems are not uniquely associated with particular kinds of instruments, as Posner-Weyl insinuate.  There can be inefficient acquisition of information for speculative purposes in derivatives that are widely used for hedging–including the agricultural futures that Posner-Weyl consider to be salutary. (Although it does not speak highly of their understanding of these markets that they use farmer hedging as their justification of ag futures, though that is hardly the primary hedging use of these instruments.)

Other possible problems highlighted by Posner-Weyl include the use of derivatives for tax avoidance or regulatory arbitrage.  I say “possible problems” because the real problem can be with inefficient regulations or taxes, not the means that are used to mitigate these inefficiencies.  But even abstracting from this difficulty, there is also a fundamental problem distinguishing “bad” derivatives that are used for tax or regulatory avoidance, and “good” derivatives that are used to hedge.

Back in the 1970s and 1980s, simple plain vanilla futures contracts were widely used in a tax reduction strategy called “tax straddles” involving a spread trade (buying one future, selling another with a different delivery day).  The trader would liquidate the losing leg of the trade to generate losses to offset against other gains, or to convert ordinary income into capital gains.  This strategy was eventually disallowed in 1981: the instruments themselves were not banned because they could be used to avoid taxes.

In sum, hedging and speculation are complementary; speculation is not always inefficient;  and inefficient forms of speculation are not confined to specific instruments.  Therefore, regulations designed to impede speculation by requiring the approval of specific products are misguided because impeding speculation interferes with efficient transfer of risk, and because the inefficient uses of derivatives cannot be reduced reliably by preventing the marketing of particular instruments.

This means that charging some financial FDA with the responsibility of choosing which innovations to permit and which to proscribe, based on the goal of eliminating speculation, is basically hopeless.  Such an agency’s choices will be plagued by Type I and Type II errors.

Not to mention that whereas the effects of a drug can be determined with some (though incomplete) precision in clinical trials, there is no comparable way of determining how financial innovations will be used, the volume of their use, or their economic effects (in part because these effects depend on the scale of adoption, and the interaction of these products with other products in the market).  All of these things depend on the choices of myriad individuals, and these choices can change over time: who would have envisioned, in the 19th century when wheat and corn futures were first traded in Chicago, that they would one day be used by index funds to offer diversification opportunities to pension funds?

Drugs are taken by individuals and their effects can be understood by studying individuals who take them: the systemic effects are just the sum of individual effects. Things are very different in financial markets.  The introduction of financial products can lead to very complex responses in the entire system that cannot be understood or quantified in any clinical trial.

When I originally heard of the Posner-Weyl paper, I thought they would focus on how particular instruments can be systemically risky.  They in fact pay very little attention to this issue.  In this regard, it should be noted that the FDA/clinical trial model is completely inapposite.  You cannot study the systemic effect of a financial innovation in an isolated trial: you have to see how it interacts with, and affects, the entire system.

And to try to understand these effects a priori is certainly futile.  The system is too complex, and there is no way to understand how a particular innovation will fare in the market, and how it will affect the entire system.  As a concrete example, no one truly understood the consequences of CDOs on subprime ex ante, just based on the characteristics of the instrument themselves.  The risks embedded in the instruments were not well understood when they were first created, and these risks depended on the scale of their use, which was impossible to predict at the time they were first created.  In the end, there were risks that were not widely understood at the time of introduction, and these risks had systemic import only because these instruments proved very popular and grew to massive proportions completely unanticipated when they were first introduced.

We actually have historical experience with ex ante entry regulations on financial innovation.  Until the 1990s, no exchange could introduce a futures contract unless the CFTC approved it.  The approval was contingent on a CFTC finding that the proposed contract passed an “economic purpose” test, and was designed in a way that would permit it to achieve this purpose.  In some ways, the economic purpose test was analogous to what Posner and Weyl propose today.

This system was costly and reduced competition.  Like many entry barriers, it was exploited by incumbents to hamstring competitors. I am not familiar with any dangerous product that was kept off the market through this procedure, and the introduction of good products was delayed.  All pain, no gain.  Why would we want to repeat that experience.

Maybe Posner and Weyl would disagree with my appraisal of the CFTC precedent.  They don’t seem to be aware of it, in fact.  Before making such sweeping proposals perhaps they should have performed an analysis of a similar system that operated for decades.

Being a Sam Peltzman student, I was never all that impressed with the FDA model in the first place, even in pharmaceuticals.  I am even less impressed with the FDA as a model for the regulation of products that are fundamentally different from drugs.  Especially when those advocating this model make basic errors about the instruments that they believe should be regulated, and the uses to which they are put.

Walter Russell Mead’s excellent blog recently discussed the conflicts over massive natural gas deposits in the eastern Mediterranean:

Naturally, the race to get the gas has reinvigorated old arguments (Cyprus-Turkey) and added fuel to newer disagreements (Israel-Turkey). Israel and Cyprus have been fastest off the blocks, agreeing their common maritime border in 2010 and contracting exploration work to Noble Energy. Turkey, on the other hand, has been slow to react and increasingly confrontational, holding naval exercises and trying to prevent Cyprus from accessing gas that Turkey says belong to Northern Cyprus, which only Ankara recognizes as a country. The confrontation also threatens to further destabilize Israeli relations with Turkey, which appeared to be on the uptick this week when an Israeli delegation arrived in Turkey’s quake-hit Van Province with aid supplies; “You are our true friends” said Van’s vice governor.

The gas reserves in the Levant Basin may be large enough to make Cyprus self-sufficient in energy and turn Israel into a major gas exporter for the next several decades. That, and Israel’s new tilt toward Greece as a way of countering the cold wind in its relations with Turkey, is opening a new era in Israel-Cyprus relations. Netanyahu is on his way to Nicosia this week (the first ever visit of an Israeli PM to the island), and Israel is expected to formally ask to station fighter jets at a southern Cypriot airbase.

Oh joy. Another reason for conflict in a region of the world that counts conflict and strife as its most important export.

Unmentioned in Mead’s post is Russia, the country which has a huge economic stake in the development of a major gas resource right next to its major western European customers.  Eastern Med supplies would far closer to Europe–especially big consumers like Italy–than Russia, and these supplies wouldn’t be subject to the Russian-Ukrainian Punch and Judy routine every winter, or the vicissitudes of Russian domestic considerations.  Meaning that if these resources were developed to their full potential, Gazprom (and Russia) would suffer substantially.  Very substantially.

Which gives Russia a tremendous incentive to foment instability in the region.  Not like that is very hard, either.

It has two major levers in this endeavor.  The first is Cyprus, which is deeply enmeshed with Russia financially and politically.  Russia has been Greek Cyprus’s financial savior, extending it substantial amounts of credit to keep the country from plunging into Greece-like catastrophe.  Even more importantly, Cyprus is the destination or conduit of dirty Russian money, and the location of choice for Russians setting up dodgy shell companies.  (Oh, how entertaining it would be if Cyprus were the target of an invasion by an army of forensic accountants!) (Also recall that the SVR agent who was the money man for the Anna Chapman spy ring miraculously disappeared in Cyprus after being arrested there.)

The second is . . . Syria.  I do not suggest that this is the only for Russian intransigence in that country: that behavior is overdetermined.  But stoking conflict–or standing in the way of resolution of conflict–in Syria does promote Russian interests in the gas business.  Indeed, the economic stakes here are far greater than the oft-cited Russian commercial interests in Syria: some rather shambolic business and infrastructure projects, and arms sales (which appear never to be paid for, at least fully).

Just saying.

I’m sure you’ve noticed that I haven’t written much about clearing lately. (And yes, I can hear the Hallelujah Chorus.)  Simple reason, really.  Most of the clearing related news warrants schadenfreud, and an “I told you so” response.  I enjoy a good Lulz as much as the next guy, but I know it gets old.

But this article hits on so many things at once I have to impose on you all.  It basically gives the lie to all the justifications for the clearing mandates in Frankendodd.

1. The advocates of mandates, notably GiGi and Timmy! asserted repeatedly that clearing would reduce the connectedness of the financial system, and in particular, would reduce the importance of big banks in those connections.  I argued in response that clearing mandates would just change the topology of the network; that it would remain densely connected; big banks would still be tightly connected; and that the new topology was not obviously less systemically risky than the old one.

From the article:

Where do you find the spare $2 trillion needed as collateral for cleared swap trades?

With new regulation in the US and Europe set to move the bulk of the over-the-counter derivatives market towards central clearing from next year, swap buyers and dealers will soon be faced with that very question. Many custody banks believe they could provide the answer.

Already heavily involved in the plumbing of the clearing market, custodians act for almost every major financial services firm without a custody arm – including most dealers and every clearing house.

Most also offer collateral management services, including securities lending and collateral improvement – the process of turning less-liquid securities into eligible collateral to post as surety in transactions.

This experience could prove invaluable with the advent of new swap clearing rules, which come in with the expected implementation of the Dodd-Frank Act in the US from early next year, increasing the demand for collateral transformation services.

David Field, managing director with banking consultancy Rule Financial, said: “The buyside simply doesn’t have enough quality collateral available to lodge for clearing.

Executing brokers are expecting to generate strong post-trade revenues from collateral transformation – but the custody banks are the ones holding the collateral.

This is a huge opportunity for custodians, and several are already investing anywhere between $50m and $100m to position themselves.”

In other words, big custodial banks will be even more tightly connected with all major participants in the derivatives trade because of their comparative advantage in providing collateral transformation, and the strong economies of scope between providing this service and providing other custodial services.

2. The advocates of mandates argued that it would reduce leverage in the system.  I responded repeatedly that this was not at all obvious, and that the most likely effect would be to transform the nature of leverage.  The big move to collateral transformation makes it abundantly clear that this is in fact happening.  I go into this in much more detail in my forthcoming Journal of Applied Corporate Finance article titled “Clearing and Collateral Mandates: The New Liquidity Trap?”

Credit means credit risk.  So the clearing mandate has not eliminated credit risk from the derivatives market, or even reduced it sharply.  It has just transformed it, relocated it.  And it has definitely not eliminated derivatives-related credit risk from big banks.   Indeed, it is moving more risk to some big banks.  BNY-Mellon and JP Morgan are also the most important settlement banks, and play a vital role in the repo market.  This is already a source of systemic risk.  These banks are arguably the most important pieces of the financial infrastructure, and these developments will make them even more important, and also concentrate more risks from disparate markets (e.g., repo and derivatives) in them.

3. The advocates of mandates asserted that it would make the derivatives market less concentrated and more competitive (although nb these are NOT equivalent).  From the article:

Tech-heavy effort

Among the most ambitious to gain business in the swaps market is BNY Mellon, the world’s largest custodian with $25.8 trillion of assets under custody. The bank sees its existing footprint as a springboard towards dominance in the collateral services market for OTC derivatives.

[A director] for collateral management and clearing at BNY Mellon in London, believes it will be a tech-heavy effort. He said: “According to recent Isda Margin Survey figures, roughly 80% of collateral used in the OTC swaps market is cash, with about 15%-20% being fixed-income securities.

If even 20% of the estimated extra $2 trillion of collateral required to clear OTC swaps via central counterparties is in the form of securities, that puts a big onus on the collateral managers to offer smart, quick systems capable of handling huge draws on client collateral daily.”

Rival US custodian State Street has also been boosting its presence in the cleared derivatives markets, launching a swaps clearing operation in September. In a signal of intent, the bank has quietly begun hiring senior futures brokers from established rivals.

Charley Cooper, senior managing director at State Street Global Markets, said: “State Street’s unconflicted approach combined with the operational efficiencies gained from clearing with a custodian, gives us a significant edge in the emerging clearing marketplace.”

A senior derivatives banker said that clients are already looking at custodians as a viable counterparty.
He said: “In the past six months, we’ve seen growing migrations to the custodial clearing business.

Some have a better credit rating than almost every investment bank, and it’s unlikely they will be subject to capital ring-fencing regulations.”

He said that if a major custodian is able to convert even half of its existing custody clients into clearing clients, it could be looking at a share of anywhere between 10% and 20% of the OTC clearing market.”

The incumbents

But existing derivatives flow dealers – especially ones with large custody and treasury businesses – are unlikely to shy away from a revenue-generating opportunity.

Citibank, in particular, is hoping to combine a swaps clearing operation with its custody and treasury services in the US.

Jerome Kemp, global head of exchange-traded derivatives and OTC clearing at Citi, is in no doubt which direction the market is heading.

He said: “We’re looking at a re-dealing of the cards in the derivatives clearing space. Post-Dodd-Frank implementation, clearing will be led by the larger, well-capitalised banks.”

Citi hired aggressively to expand its futures commission merchant business last year, including the hire of Kemp, previously co-head of listed derivatives and clearing at JP Morgan, who arrived with a raft of colleagues.

Kemp thinks the next battleground for the bigger futures commission merchants, which will act as clearers for many firms on the buyside, could hinge on the bundling of services across clearing and asset servicing.

JP Morgan, meanwhile, is also looking to leverage its existing prime services footprint for its hedge fund clients for whom swaps clearing will be a new experience.

The bank has merged its listed and OTC clearing teams, and invested heavily in client roadshows and clearing masterclasses since the Dodd-Frank Act was passed in 2010.

Dale Braithwait, a member of JP Morgan’s OTC clearing team, said: “It’s to our advantage that we’re a big collateral manager too.

For a lot of asset managers, who do not feel they are able to use prime brokerage services, it’s a big benefit to have someone who can act as a custodian and a clearer.”

So there is a big fixed cost to play in this game.  The resulting scale economies tend to increase concentration.  Moreover, there is a strong scope economy across collateral management and transformation services, and other custodial services.  Meaning that the big custodian banks have a strong competitive advantage in providing the new collateral management and transformation services that will become a crucial component of the OTC derivatives markets.

It is particularly ironic that BNY-Mellon will be a major beneficiary of this.  You might recall the execrable NYT piece (written by Louise Story) about the evil derivatives dealer cabal.  One of the most memorable parts of the article was BNY’s whinging about its inability to break into the dealer space.  Read this new piece and you can just imagine BNY execs rubbing their hands together in glee, throwing their heads back, and laughing an evil laugh.  All your cabal belong to us.

So let’s summarize, shall we? Clearing mandates (and requirements to collateralize uncleared swaps) will result in the formation of new links between buyers and sellers of swaps (including dealer banks who do not offer custodial services) and a handful of major custodian banks.  These links will involve the extension of credit, and hence the existence of derivatives-related counterparty risk in which big banks still have substantial exposure.  If anything, the mandates will increase concentration in an important part of the derivatives market.  Moreover, it will arguably increase the concentration of credit risk exposure in a handful of systemically important banks.

Well played!  The actual results of Frankendodd will be the exact opposite of what was claimed by its tireless advocates (And yeah, I’m looking at you, Timmy! and GiGi.  I’m trying not to look at Barney, but that’s a whole other story.)

Unintended consequences, indeed.  Unintended, but predictable–and predicted.

Obama is apparently going to make energy one of the centerpieces of his State of the Union Address (oh for the days when presidents mailed it in–literally).  If it is anything like the gas he emitted at last year’s SOTU, or anything like what is on the WH energy policy page, it will be at best irrelevant and at worst counterproductive.  CAFE is incredibly wrongheaded.  HOMESTAR is an expensive joke.  “Recovery Act Investments”?:

The Administration has invested more than $90 billion in clean energy – the largest clean energy investment in our nation’s history. These critical investments have already created or saved hundreds of thousands of jobs across the country and put the United States on a path to double renewable energy generation from 2008 levels by 2012. In fact, since 2008, more than 20,000 megawatts of new electric generating capacity from wind, solar and geothermal energy have come online, increasing installed capacity by more than 70 percent.

The idea behind investment is not the amount of money you put in, it’s the return you get out.  And these investments by Chu Capital (again, props to Paul Gregory for this felicitous phrase) are generating substantial negative returns.

So again, the Administration That Can’t Tell a Cost From A Benefit. [Also note the typical renewable dodge, focusing on “installed capacity” as opposed to energy generated.  The former number looks much more impressive than the latter: the difference between the two often makes renewables look very bad indeed.]

Renewable energy projects on Federal lands?  Another boondoggle.  And no mention about the fact that vast amounts of conventional energy sources are on public lands, and could be produced cleanly and safely–but are off limits.  And I seriously doubt we’ll hear anything about changing that tonight.

Obama is reportedly going to tout increased domestic production of natural gas.  Here he is playing the familiar role of sprinting to the front of the parade that he had nothing to do with creating, to make it look like he led it all the time.

No, neither he nor his administration nor government more broadly had much at all to do with that which has transformed the gas market, and is in the process of transforming the oil market.  The best thing he can do now is stay the hell out of the way.  The industry is doing quite fine on its own, thank you.

And that would be a good idea more broadly, with respect to energy.  Picking winners, picking technologies, picking fuels.  All things the market can do much better.  The Reagan administration’s best energy policies were to undo the insane energy policies that previous administrations and Congresses had put in place.  In that regard, Obama has a lot to work with: there are scads of insane energy policies currently in place that could use a good junking.  But since many of those are Obama administration brainstorms (or more accurately, brain cramps), that’s not going to happen.

So my bet is you will hear a lot of words about energy tonight.  Constructive action–not so much. Indeed, given past form, more counterproductive initiatives are a better bet.