Streetwise Professor

Cheniere Energy is back in the news–and arguably, back from the dead.  Cheniere has been on a roller coaster for about 5 years–right along with the gas market.  In the mid-2000s, when the conventional forecast was that the US was facing gas shortages and persistently high prices, Cheniere was investing in facilities to import liquified natural gas and re-gasify it.  But then the financial crisis and the shale boom caused gas prices to crater, and Cheniere’s import terminal at Sabine Pass looked to be a white elephant.  But prices fell so far in the US relative to the rest of the world that the opposite play appeared promising.  And indeed, a couple of weeks back the company received permission to export LNG.  Its stock price doubled on the news.

Cheniere is looking to configure its facility to be capable of importing or exporting gas.  Like many physical assets, Cheniere’s facility is a real option.  Under the original plan, it was an option to transform foreign gas into domestic gas with a strike price equal to transportation and gasification costs.  With the ability to import or export, it is an option to transform foreign gas into domestic gas, or domestic gas into foreign gas, again with a strike price determined by transportation and transformation costs.

These options can be quite valuable given the volatility of relative prices in the US and elsewhere, with relative price volatility being driven by technology shocks, the development of new fields–and notably, politics.  Developments like Germany’s shutting down of its nukes or the UK’s imposition of punishing taxes on North Sea extraction can have profound effects on relative prices that affect the profitability of real options like those possessed by Cheniere.

Although political developments and uncertainties generate volatility that enhances the value of real options like Cheniere’s facility, politics may also pose its greatest challenge.  Greg Meyer of the FT, who wrote a good article on the company’s change in fortune, pointed out to me this language in the Department of Energy’s decision approving Cheniere’s application to export gas:

We intend to monitor those conditions in the future to ensure that the exports of LNG authorized herein and in any future authorizations of natural gas exports do not subsequently lead to a reduction in the supply of natural gas needed to meet essential domestic needs. The cumulative impact of these export authorizations could pose a threat to the public interest. DOE is authorized, after opportunity for a hearing and for good cause shown, to take action as is necessary or appropriate should circumstances warrant it. Furthermore, DOE/FE will evaluate the cumulative impact of the instant authorization and any future authorizations for export authority when considering any subsequent application for such authority.

This is mercantilist.  No–it is Putinist.  It is a threat to do in the US gas market what Putin did with the Russian grain market–cut off exports in order to depress domestic prices in order to favor particular domestic constituencies.  It is a threat to micromanage trade–transactions undertaken by consenting adults for mutual advantage–through coercion.  It is contrary to free trade principles that the US often piously promotes in lectures to others, but all too often flouts in practice itself.

It is also a piece with this administration’s modus operendi—what Richard Epstein calls “government by waiver” in this typically incisive article.  A government agency arrogates to itself the discretion to permit or disallow individuals and firms to engage in voluntary transactions, with only the vaguest statement of the criteria it will use to make these decisions.  Decisions that can make someone wealthy–or ruin them.  Note that there is not even an assertion–let alone a proof–of a real externality (as opposed to a pecuniary, distributive one) to justify this threat of intervention.  This is purely a threat to use coercion to achieve a politically desirable distribution of wealth between producers and consumers of natural gas.

“Good cause.”  “Threat to the public interest.”  “Essential domestic needs.”  In whose eyes?  Under what criteria?  What public?

All this really means is: we will do what we want when we want for whatever damn reason we want.  It is, as Epstein argues, the antithesis of the rule of law in which general principles are applied uniformly and impersonally; it is a return to the personalized, arbitrary, natural state.  It bears creepy similarities to Putinism.

And as such, it will have–is having–the same consequences.  The DOE’s ominous statement puts Cheniere and any other company thinking about exporting natural gas on notice that a sword of Damocles hangs by a hair over its head.  But this is just one company, one hair, one sword.  There are tens of thousands of swords, tens of thousands of hairs, tens of thousands of companies.  More even: as Epstein notes, Obamacare dangles a sword over every company–and every person–in the US.  Dodd-Frank does the same in financial markets.

The threat of arbitrary government action poses grave risks to every company subject to it.  Which is to say every company, with the risks becoming greater by the day.

This cannot fail to have a depressing effect on investment and hiring.  Given the moribund recovery from the Great Recession–a recovery that was never robust, and which is sputtering noticeably today–it is reasonable to conjecture that there is a link between the hyperactive regulatory policies of this administration and anemic economic performance.  Robert Lucas notes that what made the Great Depression great was not its initial severity, but the failure to recover from it, a failure that persisted for almost a decade.  Lucas conjectures (and he is not alone in this*) that the hyperactivity of the Roosevelt administration–and yes, the Hoover administration before it, conventional wisdom on this score being laughably wrong–prevented recovery from a crash initially caused by faulty monetary policy.  He further conjectures that the eerily similar failure of the US economy to bounce back from the Great Recession is the direct result of “harmful real policies” and “the demonization of business.”

His list of destructive policies, which mirror’s Epstein’s, makes depressing reading:

• Believe it is more accurate to say that the problem is government is doing too much

• Again, I see analogies to the U.S. of the 1930s

• Likelihood of much higher taxes, focused on the “rich”

• Medical legislation that promises large increase in role of government

• Financial legislation that assigns vast, poorly-de?ned responsibilities to Fed, others [this is another example of the Epstein discretion point]

• Are these conditions that foster a revival in business investment, consumer spending?**

Are they indeed.

When every regulator at every government agency has the power–and the active encouragement of the political authorities–to say “Nice little business you got here.  Wouldn’t want anything to happen to it, would you?” one should not be surprised that these businesses are reluctant to invest or hire.  Not in Putin’s Russia.  Not in Obama’s United States.

* Robert Higgs has been the most forceful advocate of this view.  Harold Cole and Lee Ohanian have performed substantial empirical research that supports this contention.  With respect to the L-shaped “recovery” in the US, I argued here on SWP early in the Obama administration that its regulatory onslaught would lead to such an outcome.

** The list could, of course, be expanded dramatically.  It could include, for instance, the flouting of bankruptcy law and the expropriation of creditors as with Chyrsler and GM, and the outrageous decision of the NLRB to prevent Boeing from opening an assembly line in South Carolina.

The deputy governor, financial services of the Bank of England, Paul Taylor, gave a speech warning of the dangers inherent in clearinghouses. All of his major points were raised in my ISDA discussion paper (and which I’ve been flogging in my research and here on SWP for going on 3 years now).  Most notably, he highlighted the dangers of procyclical margins, and the very real possibility of a CCP failure and the devastating consequences such a failure would have. Been there, said that.

Such realism is good to hear, but as I said when Bernanke echoed similar concerns, it would have been a damn sight better had people like Mr. Tucker piped up before the clearing mandate train left the station with Congressional and Parliamentary Casey Joneses at the throttle.

But here’s the truly ironic part.  As I did in my ISDA piece, Tucker grapples with how to resolve a failed CCP:

Two strategies come to mind, which I am airing for debate. The first would be ‘recapitalising’ the CCP so that it can carry on.  The second would be to aim to bring off a more or less smooth unwinding of the CCP’s book of transactions.

On the former route, in the banking sphere the basic strategy is to develop regimes for bondholders to share in the losses after the equity is wiped out; a distressed bank gets ‘recapitalised’ in some way through a reconstruction of its liabilities.  But CCPs do not issue debt, so there is not obviously an economic equivalent of recapitalisation by way of haircutting the debt claims of bondholders.  Recapitalisation would seem to entail an injection of new outside capital.   That should not come from the public sector.  So the only options are the surviving clearing members themselves or a new ‘owner’.  On the face of it, the clearing members would have to be involved, as surely the stricken CCP’s default fund would also need replenishing in order for it to continue.

If the default fund were to be replenished by its surviving clearing members, that could in principle be sorted outat the time or it could be pre programmed.  In practice, making it up at the time must be dangerous.  A pre-programmed allocation of losses would be akin to the old “Down To The Last Drop” rule that used to be employed by a Chicago clearing house [the CME], under which surviving clearing members ultimately had collectively to absorb all losses: mutualisation.  (It was dropped because, as banks became futures-exchange clearing members, bank supervisors didn’t like the unlimited exposure of CMs who were banks.  An example of unjoined-up thinking.) [That’s not the way I heard it explained by those involved in the decisions.] [Emphasis added.]

Breathe deep the irony.  Remember that the primary justification advanced for mandating CCPs was to create a firewall that would limit the exposure of major financial institutions to counterparty losses arising from derivative defaults.  That is, the concern was that the failure of one large financial institution would cause it to default on derivatives trades, imposing losses on other large financial institutions, potentially resulting in their failure.  CCPs were supposed to contain default risks and prevent the from spreading, contagion-like, through the financial system.  But Mr. Tucker argues that for clearing mandates to work, it is necessary to breach the firewall and make big financial institutions the residual claimants of counterparty risk.

Mr. Tucker has just revealed the dirty little secret.  Well not a secret exactly; I’ve been pointing this out for years, notably in my posts on AIG.  Specifically, clearing does not make risks go away.  (No, Gary, there is no magic box.)  It just shifts risk around.  It has to go somewhere.*  Collateralization, by moving derivatives counterparties to the front of the creditor line, shifts risks to other creditors (who may well be large financial institutions, in part).  If collateralization is insufficient, the risks go to the other members of the clearinghouse–which means, it goes to other financial institutions.  Put differently, it vectors the risk right back to the same financial institutions that clearing was intended to protect.

Following the inexorable logic of the situation, namely, that the risk has to go somewhere, Tucker looks for where the risk can go.  Can’t go to bondholders, because a CCP doesn’t have any.  So it must go to clearing members–large financial institutions.**  Which means we’re right back where we started.

Which is another echo.  Several times I’ve predicted that clearing mandates would likely spur a process similar to that in the apocryphal story of the Indian village infested by mice, that brought in cats to eliminate the mice, that brought in dogs to deal with the proliferation of cats, that brought in elephants to drive out the hordes of dogs . . . and then brought back the mice to rid themselves of the rampaging elephants.  Clearing mandates were predicated on the chimerical belief that it was possible to make risk go away, when in fact, its primary effect is to shift risk around.  Which raises the question of where it has to go.  The BOE’s Mr. Tucker has apparently concluded, quite logically, that ultimately it has to rest with large financial institutions where it was in the first place.

In other words, bring back the mice.

* As I’ve noted repeatedly, clearing also affects incentives and therefore can affect the level of risk in the system.  There are a variety of reasons why CCPs may lead to an increase in total risk exposure, mainly by creating moral hazard, and increasing capital efficiency through netting.

** An important caveat here.  The nature of clearing members is not exogenous, and independent of the sharing rule.  Imposing good to the last drop is likely to make big banks reluctant to be clearing members with effectively unlimited exposure to other members.  Instead, GTTLD would likely lead to the creation of affiliates with limited capitalization.  By not recognizing this likelihood, Mr. Tucker is guilty of some “unjoined-up thinking” of his own.

Update.  Whoops.  In my hurry, wrote “Taylor” instead of Tucker.  Thanks MDC.

Western European utilities are pressuring Russia and Qatar to eliminate long term gas supply contracts with prices tied to crude oil in favor of a spot market mechanism:

Russia and Qatar are under growing pressure from Europe’s biggest utilities to scrap a 40-year-old system that links natural-gas prices to oil after Brent crude’s 23 percent surge this year.

As delegates from countries that hold two-thirds of the world’s reserves gather in Cairo tomorrow for a one-day meeting of the Gas Exporting Countries Forum, customers from France’s GDF Suez SA to EON AG of Germany are urging producers to link prices to spot markets instead of insisting on long-term contracts that shadow the fluctuations of oil. Contract prices will rise about 15 percent in the next quarter alone, according to Wood Mackenzie Ltd., an Edinburgh-based energy consultant.

“The European contract price of gas is going up,” said Thierry Bros, a senior analyst at Societe Generale SA in Paris. “Utilities won’t sign new oil-linked contracts.”

But Gazprom says nyet, no, never!:

Spot markets don’t have enough trading to ensure adequate supply, Alexander Medvedev, deputy chief executive officer of Russia’s OAO Gazprom, the world’s biggest producer, said May 13.

“There has never been any transition to spot-priced market structure, and never will be, because spot market liquidity is insufficient,” Medvedev said in Slovakia’s capital, Bratislava. As soon as economies began to recover from the financial crisis, “it became clear that the market will work as before.”

The Other Medvedev is either an ignoramus or a liar.  Check that–he’s probably both.  Regardless of the explanation, his “analysis” is bunk.

First, there has been an extremely successful transition to a spot market structure: in the US, in the 1990s.

Second, the liquidity of the spot market is endogenous.  Believe me, the elimination or even phasing out of oil-linked contract terms would lead in very short order to the development of a robust spot pricing mechanism.  The ability to trade gas spot, and the reliance on spot prices to index contracts will initiate a virtuous cycle that will result in spiraling liquidity.  Just as occurred in the US with the elimination and phase-out of take-or-pay contracts and the elimination of gas price controls.  Just as occurred in oil in the late-1970s when OPEC abrogated oil equity contracts: there was no spot market in oil to speak of before that, but once OPEC transitioned to a different pricing mechanism, the oil spot market developed quickly.  (Note the launch of the NYMEX crude contract followed the elimination of equity contracts in oil by less than three years.)

There is no reason why, in the current environment, with current technology, that a robust spot price in gas cannot and will not develop in Europe.  The existing pricing mechanism is an anachronism rooted in a very different legal and regulatory environment, and one that is plainly unnecessary in light of the development of vibrant spot markets in myriad types of energy since the late-1970s.

Gazprom–surprise, surprise–is just talking its book.  Oil and gas prices have diverged, with oil prices rising and gas prices remaining stagnant or even falling since the end of the financial crisis.  Thus, the pricing mechanism provides a windfall to Gazprom in the existing environment.  Note TOM’s linking of “the market will work as before” to the end of the crisis.  Oil prices plummeted during the crisis, making the linking mechanism less profitable for Gazprom, but with the rise of oil prices, that mechanism works very well for the company.

But very poorly for its customers.  The linked article mentions the woes of E.ON, RWE, and GDF Suez.  Those woes will only become worse with the craven decision of the Merkel government in Germany to shutter the country’s nuclear power plants.  Merkel will soon be in a difficult position, between the Russians she habitually appeases (often at the behest of German companies, including, ironically, E.ON and RWE) and German companies, notably the just-mentioned utilities.   She has jumped from the greenie frying pan into the energy fire.

The current situation is not sustainable.   Wide divergences between prices and values like those seen between the contract price of gas and the spot price of gas cause contract disputes and market breakdowns.  Something will have to give.  Gazprom insists it won’t.  But if the divergences remain wide or even widen, it may find itself without customers and forced to give.

Here’s hoping.

LCH.Clearnet has announced that three exchanges have expressed an interest in buying the heretofore independent CCP.  Why does stuff like this happen on my vacation?  I’ll just make a brief comment, and leave more for later.

Jeremy Grant posits that LCH is in play because of cross margining efficiencies.  This conjecture is understandable, but fundamentally flawed.  Yes, there are definitely cross margining efficiencies.  More generally, there are economies of scope due to diversification effects that make it less costly to consolidate clearing for multiple asset classes in a single CCP.  But this does not explain why exchanges would want to vertically integrate clearing and execution.  Ownership is not necessary to exploit scope economies.  Indeed, the two things are often in tension–and are in this instance.

Scope economies do not explain integration.  Indeed, things cut the other way.  To the extent that there are more scope economies in clearing than execution (which is quite plausible), in the absence of transactions costs the most efficient way to organize the business would be to form a single clearinghouse, with which multiple execution exchanges would contract to obtain clearing services.  In fact, one of the costs of integration is that it often entails the sacrifice of scope economies in clearing.

Put differently, scope economies do not explain the pattern of ownership: the relevant question is why do exchanges find it optimal to own their own clearing facilities, rather than obtaining clearing services by contract.  That would be the way to optimize cross margining, netting, and diversification economies.   Such economies would be exploited maximally by having, say, LCH, clear just about everything, and sell its clearing services to myriad exchanges that offer execution services in different product classes.  But that’s not the way the market is moving.

Thus, the fact that many exchanges are already integrated, and why more exchanges are seeking to integrate, must arise from some other economic force than scope economies.  The most plausible explanation–and one that I advanced more than 5 years ago–is transactions costs.  Due to double marginalization problems and the transactions costs that arise when complementary activities are supplied by single firms (or by a small number of firms that do not compete vigorously), it is often efficient to integrate these complementary activities.  That is a basic lesson of Williamsonian Transactions Cost Economics (TCE).

In my view, that’s why exchanges like CME and DB have integrated, and why other exchanges have or are in the process of doing the same thing.  This drives regulators and legislators nuts: they see such integration as a nefarious scheme to leverage monopoly.  That’s bad economics–and it’s been known to be bad economics for going on 50 years.  Instead, it is all about transactions cost economization.  Regulators can try and fight it, and they will.  If they succeed in their quest, however, they will only succeed at raising costs and reducing efficiency.

Insofar as the potential LCH deals with exchanges are concerned, SwapClear is presumably a major target in any deal, but also a major obstacle.  I can’t see the banks that dominate SwapClear going along with a merger of LCH into NYSE-EuroNext or NASDAQ or LSE.  Or if that happens, I would expect them to leave SwapClear and set up their own CCP, perhaps through ICE Trust or through a new, freestanding interest rate swap and repo CCP.  (Going through ICETrust would exploit scale economies, so that would be a likely approach.)

I have more to say on this, and probably will.  But it’s been a long day in the sun, so it will just have to wait.

The CFTC made all the front pages by filing manipulation charges against Parnon Energy, Arcadia Petroleum LTD and Arcadia Energy (Suisse), all affiliates of the trading firm Arcadia.

Let me say at the outset that I am in favor of addressing manipulation by ex post actions like those filed by the CFTC, and have long made that argument.  Let me also say that in 2002, Arcadia was accused of manipulation of Brent crude, and price patterns at the time were symptomatic of a corner, and per public reports, Arcadia’s trading was consistent with an attempt to corner.  Thus, I have no objection to the type of action the CFTC has brought, and don’t put it beyond Arcadia or a company like Arcadia to engage in manipulative conduct.  Indeed, I wish that the CFTC would rely more on ex post actions and less on things like position limits or ex ante jawboning to reduce the frequency and severity of market manipulation.

That said, based on the complaint, I conclude that the CFTC case is a tenuous one.  It is tenuous because of the novel nature of the claim, and the weak support for that claim provided by the price and trading data cited in the complaint.

The CFTC does not allege a corner.  Instead, it claims that Arcadia engaged in deceptive conduct.  It bought cash WTI forward contracts it did not need, then sold those contracts in the last three trading days of the WTI “cash window.”  The CFTC alleges that the buying deceived the market by suggesting buying interest that was not there, creating a false perception of market tightness.  This perception of increased tightness caused backwardation to increase.

Arcadia’s subsequent sales allegedly disabused the market of its (allegedly false) belief, causing backwardation to fall.  Arcadia allegedly lost money on these cash WTI purchases and sales, but made up for it through first buying and selling nearby spreads, and once the front month contract stopped trading on NYMEX, shorting the (new) nearby spread.  The creation of the perception and subsequent destruction of the perception of tightness, the CFTC alleges, generated profits for those spread positions.

Thus, the CFTC alleges a trade impact manipulation, rather than a corner.  These are always a greater challenge to prove, and the proof the CFTC adduces is hardly convincing.

In particular, the price data do not provide strong support for the allegation.  Consider the first alleged episode, in January, 2008.  Per the complaint, Arcadia bought 4.1 million barrels of February WTI cash crude.  During this period, it was also buying the February-March spread.  But in the 3 January-8 January period, when this trading–notably the cash trading, per the complaint–was allegedly creating an artificial perception of tightness in the market, (a) front month cash WTI fell by about $3.30/bbl, (b) the February-March (GH8) backwardation actually fell by 4 cents, and (c) front month WTI fell relative to front month WTS and LLS.  The spread did jump up 25 cents between the 8th and the 10th, and the WTI-LLS front month spread jumped by over a dollar, but this is after Arcadia’s purchase of the cash WTI contracts, and the purchase of the bulk of the GH8 spreads.  So to believe the CFTC, one has to believe that the market only became aware of the impending tightness with a lag–which is hard to reconcile with its assertion that it became aware that the demand was chimerical immediately on the sale of Arcadia’s cash position.

Moreover, by 15 January the GH8 spread had fallen to a level below its value prior to the commencement of Arcadia’s buying.  Then, when Arcadia began to sell the GH8 spread, the spread actually began to widen, going from 17 cents to 64 cents during the period that Arcadia was selling it. February WTI actually rose relative to February WTS during these days of selling February WTI as well.

This is all very hard to square with any assertion that the market was responding to Arcadia’s trading activity.  After all, NYMEX February futures and WTI cash forwards are effectively perfect substitutes, both allowing the buyer to take delivery of 1000 barrels of WTI in Cushing during February, 2008.  The market was showing greater signs of tightness at the very time Arcadia was reducing its demand for February WTI.  It will be devilish hard for CFTC to argue that purchases of near perfect substitutes have different price impacts, and for it to argue that the market was very sensitive to Arcadia’s trading of February WTI when its sales are associated with rising backwardation and its purchases are associated with falling backwardation.

The GH8 cash WTI spread did indeed go from backwardation to contango during the cash window of 25-28 January, when Arcadia was doing its selling of Feb cash WTI.  But February WTI actually rose during this period, and indeed rose on 28 January when Arcadia did most of its selling.  Again, this is not symptomatic of a market that was suddenly convinced that demand tightness had declined.

It must also be noted that the collapse in the February-March cash spread was equally large for LLS ($.985), and more than twice as large for WTS ($2.335).  Thus, the spread collapse was not limited to the product that Arcadia was trading.

Perhaps CFTC will argue that Arcadia’s deceptive buying had lifted and then crushed LLS and WTS spreads as well, but any manipulative buying should have a larger impact on the commodity actually bought, and the 25 January-28 January spread moves are not consistent with that.

What’s more, making this argument would present the CFTC with an acute problem.  It defines “market dominance” based on the size of Arcadia’s position relative to the WTI market.  If LLS and WTS are such close substitutes for WTI that buying one impacts the prices of the others because they are effectively one market, then for the purpose of determining market dominance Arcadia’s position must be measured relative to that market–WTI, WTS, and LLS, plus any other close substitutes.  It would be much harder to prove market dominance under such an expanded market definition.

In brief, the price and trading patterns for the January episode are not consistent with the CFTC allegations.  Prices fell throughout, even after Arcadia allegedly fooled the market into believing that conditions were tight.  Prices and backwardation did not rise when Arcadia was buying.  Backwardation was rising when Arcadia was actually selling the spread.  The spread collapse during the cash window that the CFTC apparently believes is its “Gotcha” piece of evidence was mirrored by collapses as large or larger in other types of oil.

I also note that the CFTC has provide no evidence that any of the price and spread moves were statistically significant.

The spread and trading co-movements are more equivocal during the March, 2008 episode.  The April-May (JK8) spread did rise when Arcadia bought it, and during the period it commenced buying April cash WTI.  But the biggest move in the spread, from $1.16 to $1.94 occurred when Arcadia sold its JK8 NYMEX spreads.  It was buying 3.5 mm bbl of April cash during this 14-19 March period,  but it was selling 14.4 mm bbl of JK8 spreads–meaning that it sold 10.9 million more barrels of April WTI than it bought during this period–so how could this contribute to an explosion in the perceived tightness of WTI–as indicated by the 78 cent increase in the backwardation? Note too that the WTI April cash flat price was falling $5.73 during the period it was buying the 3.5 mm bbl of April cash crude–another thing that is hard to square with a perception of increased tightness.

Furthermore, the April-May LLS spread fell by more during the cash window ($2.29) than did the WTI spread ($2.015).  This is very hard to square with any coherent manipulative theory, and as noted before, any story in which sales of WTI cause declines in the price of LLS would require a market definition under which it would likely be very hard for CFTC to prove market dominance.

I should also mention that even ignoring this problem, the CFTC’s market definition is suspect.  It compares Arcadia’s position to the company’s estimate of flows of WTI in Cushing during the delivery month.  But this ignores stocks of oil in Cushing, which were about 17 mm bbl during this period.  Now some of these barrels were not WTI, but some if not most of these barrels should be included in any calculation of the size of Arcadia’s purchases relative to the size of the market.

Corner manipulation cases are hard: the CFTC has never won one.  Trade impact manipulation cases in which it is alleged that buying or selling created false perceptions of demand are even harder to analyze and prove.  Thus, just based on the nature of the allegation alone, the CFTC has filed a very challenging case.  When one looks at the evidence the CFTC presents in its complaint, the odds become even higher.  For the January episode in particular, the most straightforward interpretation of the evidence cuts squarely against the allegations.  This will be a very difficult case for the agency to win.

There’s another lesson here that has been lost in all of the hue and cry over the filing of the complaint.  CFTC has been examining the oil market with a fine tooth comb going back to 2005 if memory serves.  If this is the best case they can find after all that, the oil market must be pretty damn clean.

Really?:

Lawmakers in the Parliament voted that clearinghouses should have to hold capital of at least 10 million euros ($14.1 million) to absorb possible losses.

Yeah. That will prevent the next financial crisis.

FT Alphaville reports that the UK Parliament’s Science and Technology Committee is all hot and bothered about bank ownership, and particularly JP Morgan’s ownership, of LME delivery warehouses:

79. We heard that there were large companies dealing metals within the UK and an allegation was made by the MMTA that a company through a subsidiary may be behaving in an anti-competitive manner: on the London Metal Exchange there are four very large companies that own the very warehouses that people deliver metal into, J.P. Morgan is one of them.

They own a company called Henry Bath. They are, therefore, a ring-dealing member of the exchange and they also own the warehouse. That is restrictive. They were also reported, at one point, to have had 50% of the stock of the metal on the London Metal Exchange.[113] 80.

We would be concerned if the ownership of metals storage warehouses by a dominant dealer on the London Metals Exchange were to be anti-competitive. We would also be concerned if a dealer who had the resources to own over 50% of stock on the London Metals Exchange impeded the correct functioning of the market.

81. We use this report to bring the alleged activities of large dealers on the London Metals Exchange to the attention of the Office of Fair Trading. We would be concerned if a dealer were undermining the effective functioning of the market and we look for assurance that the market is functioning satisfactorily.

The confusion about the anti-competitive effects–or, more correctly, the lack thereof–of vertical integration is pervasive.  This is just another example.   JPM ownership of a delivery warehouse is not per se anti-competitive, and indeed, it is difficult to see how it could be a way of leveraging market power as the Committee insinuates.

Insofar as ownership of 50% plus of deliverable supply is concerned, that is a completely separate issue.  Sumitomo never owned any delivery warehouses, but it (and its pilot fish) cornered the market with abandon in the 1990s.  To my knowledge, none of the other frequent squeezes on the LME in recent years have been facilitated by ownership of warehouses.  What’s more, it’s most effective to attack corners and squeezes directly, rather than through restrictions on asset ownership.

I’ve also written from time to time on how ownership of physical assets is an important part of many commodity trading firms’ strategies.  In particular, commodity trading firms can optimize use of physical assets based on their access to information and their ability to exploit the option value of these assets.

With respect to delivery warehouses in particular, come on.  In the grain markets in Chicago, big merchants like Cargill, Continental, and ADM long owned delivery houses.  They did so for the exact same reason that many energy and metals traders today own physical assets like storage.

Where ownership of physical assets may be somewhat problematic is when it gives the owners privileged access to information.  By trading on that information, the asset owners create an adverse selection problem that reduces market liquidity.

Perhaps the most famous example of this occurred in the Chicago grain markets in the 1860s.  At that time, there was a veritable war between grain brokers and traders and the owners of the grain elevators in Chicago.  The Chicago Board of Trade was the representative of the interests of the brokers and traders, and fought hammer and tong against the “piratical” elevators.

The elevator operators had information about the quantity and quality of grain in store.  This information advantage allowed them to trade profitably.  For instance, elevator operators from time to time learned that grain was getting out of condition–“heating.”  Given this knowledge, they would go short, and cover their positions at a profit when news of the spoilage became public.

This is akin to inside trading, and has deleterious effects on market liquidity: it transfers wealth from the uninformed to the informed.

The elevator operators also allegedly operated a cartel that fixed storage rates at supercompetitive levels.  This again harmed grain merchants–and also farmers.   Elevators also took advantage of their ability to mix grain down to the minimum required to meet grade.  This effectively transferred wealth from those who stored above average quality grain into the warehousemen’s pockets.

The CBOT tried mightily to get the elevator operators to report information about the quality and quantity of grain in their facilities, and to charge reasonable rates.  The elevators basically told them to pound sand.  The CBOT had little leverage over the elevators: the brokers and merchants needed the elevators, but the elevators didn’t need to the CBOT, so threats of expulsion had little effect.

Eventually, the CBOT prevailed on the legislature of Illinois to regulate grain warehouses.  This is actually an extremely important event in American legal and regulatory history, for one of the elevator operators, Ira Munn, challenged the Illinois regulation.  He appealed all the way to the Supreme Court, which decided in favor of the state, thereby establishing the power of states–and the federal government–to regulate business “in the public interest.”  The regulatory state in the US traces its roots to that decision in Munn v. Illinois.

One of my favorite papers discusses this episode in more detail.  You can find it here.

Going back to the hyperventilating Parliamentary Science and Technology Committee and JP Morgan’s ownership of a delivery warehouse, the things that were arguably inefficient in 1867 Chicago are completely absent in 2011 Bath.  The LME announces stocks held in warehouses on a daily basis, meaning that elevator operators don’t have privileged information on quantities in store.  Quality is monitored by independent inspectors.  The fears of vertical integration resulting in a leveraging of market power are neurotic.  Merchant ownership of delivery and storage facilities is a virtually universal feature of the commodity landscape.

In other words: Move along.  Nothing to see here.

The International Swaps and Derivatives Association, ISDA, has now officially released my Discussion Paper on central clearing of derivatives.  (This is what I’ve been referring to as my white paper.)  It is the inaugural paper in the ISDA Discussion Paper series.

The link to the press release is here, and the press release contains a link to the PDF.

Any comments would be appreciated.  The paper focuses on most of the hot button issues relating to clearing, and to many of the pending regulatory issues.  Hopefully it will contribute constructively to policy, and more broadly to understanding of the issue.

I’m grateful to ISDA, and in particular ISDA CEO Conrad Voldstad, for providing this opportunity and this platform.  I also appreciate the insights and input of David Murphy, ISDA’s Global Head of Risk and Research.

*Said tongue in cheek, of course.

Chicago finance prof Luigi Zingales has written a short oped on OTC derivatives markets.  Considering the source, it is very disappointing, not to say embarrassing.

Indeed, it seems that Luigi is on the same frequency as Kenneth Griffin of Citadel: their arguments, such as they are, are virtually indistinguishable.

Zingales’s basic argument is that the OTC derivatives market is oligopolistic, and that all sorts of bad things flow from that structure:

Indeed, today the market for derivatives is oligopolistic, with a few banks running huge profit margins. And, regardless of whatever political motivations might lie behind the latest investigations, this market concentration is a real problem. According to a 2009 study by the European Central Bank, the five largest CDS dealers were party to almost half of the total outstanding notional amounts, while the 10 largest CDS dealers accounted for 72% of the trades. The markets for other derivatives are not much better.

As is usual in assertions of dealer oligopoly, there is seldom any comparison to other markets.  The concentration figures Zingales cites are hardly exceptional when compared to other industries, and I daresay to the markets for groceries or gasoline in Chicago.

But worse, Luigi’s argument is very anti-Chicago.  Long, long ago, dating back to the 1960s and 1970s, Chicago eviscerated the structure-conduct-performance paradigm associated with Harvard (and Joe Bain in particular).  Folks like Harold Demsetz and Sam Peltzman pointed out that market structure is endogenous, that concentration can result from the exploitation of cost advantages, that prices can be close to marginal cost even in concentrated markets, and that large profits in such markets are not prima facie evidence of weak or absent competition.

This means that rather than taking the concentration data (as benign as they are by comparison with other industries) and making the leap that this concentration indicates a lack of competition, Zingales should ask why the structure is what it is, what forces generated it, and whether concentration is actually symptomatic of an inefficient, non-competitive market structure.  Put differently, concentration is neither sufficient nor necessary condition for a non-competitive outcome. Regurgitating concentration statistics and proclaiming “QED” is bad economics.

That’s all bad enough, but then he really goes off the rails:

A high degree of concentration distorts the market in several ways. First, when they transact among themselves, large players do not insist on an adequate amount of collateral, relying on the counterparty’s generic creditworthiness (and on the implicit guarantees that governments provided to large firms). Not only does this severely undermine the ability of small firms to compete, but it also contributes to systemic instability of the type that we experienced in 2008, thus increasing the likelihood that taxpayers will have to step in. Market concentration renders mostly illusory the beneficent risk-spreading role that is claimed for derivatives, because the bulk of the risk is borne by very few players.

The point about implicit guarantees is fine–but that’s a policy error that can’t be fixed by jiggering with the market structure.  But the criticism that banks don’t collateralize trades but rely on generalized creditworthiness is wide of the mark for many reasons.  For one, under standard credit support annexes, dealers don’t post independent amounts with one another, but do collateralize via variation margins on a daily basis.  Hence, inter-dealer credit is limited to one-day moves.

For another, Zingales is overlooking the fungibility of credit: initial margins/independent amounts could be funded by borrowing–and banks kind of have access to a lot of borrowing channels.  And since dealers typically rehypothecate collateral, what’s the point of interdealer independent amounts anyways?: with hypothecation A can give collateral to B who can effectively turn around and give it back to A; the actual money flows are a little more complicated, but rehypothecation effectively allows banks to lend each other the collateral that they post with one another.  What’s the point of that?

For yet another, regarding the “undermining the ability of small firms to compete”–can he be serious?  Because of the borrowing point I just made, no doubt if independent amounts on all inter-dealer trades were somehow mandated, who do you think would have the lower cost of funding these margins, the big incumbent banks, or small firms?  I would wager that mandated collateralization would actually favor bigger, more creditworthy firms.

Moreover, Zingales also overlooks other potential scale and scope advantages in derivatives dealing: yes, some of these may be artificial because they arise from TBTF subsidies, but again, that is a problem that needs to be tackled directly.

Zingales then trots out the conventional arguments regarding opacity:

Over-the-counter trading also contributes to the opacity of derivatives markets, further reducing competition and increasing the margin enjoyed by the traders – and the prices that final users (mostly industrial firms) must pay. The combined profits of the key players in this market total $80 billion, which represents a massive tax on the real economy.

To fix this problem, we need to move the bulk of derivative trading onto organized exchanges, where daily collateral requirements would guarantee systemic stability, and price transparency would force competition, reduce margins, and increase the market’s depth. In the United States, the Dodd-Frank Act moves some of the way in this direction, and similar efforts are underway in Europe.

I’ve been over this ground so many times, so I’ll try to keep it brief (for me, anyways).  Zingales presents no evidence that margins are excessive.  End users have choices, including very close exchange-traded substitutes for many OTC derivatives, but they choose to trade OTC instead: like others who have made similar criticisms, Zingales apparently believes that end users are suffering from Stockholm Syndrome or Battered Spouse Syndrome.  When touting exchanges as an alternative, he also overlooks the very real possibility that face-to-face OTC dealings reduce adverse selection costs that end users incur, but would incur on anonymous exchanges.

Moreover, apropos the earlier point about anti-Chicago, if margins are so wide and profits are so fat, why doesn’t entry occur?  Why doesn’t competition work to erode margins and profits here, like in other markets?  Perhaps there’s a story, but Luigi sure doesn’t tell one–and he is far from alone in this.  The statement about profits being a tax is so embarrassing I will pass over it in silence.  The profit number itself is completely contextless; his statements about profits based on absolute magnitude (“boy, that’s big”) remind me of the periodic attacks on oil industry profits that are similarly without any context, or attempt to control for capital deployed, risk, etc.  Given that he alludes to the concentrated riskiness of derivatives positions, perhaps he should at least entertain the possibility that the profits are in fact compensation for risk:  indeed, large profits in “normal” times interspersed with periods of big losses is characteristic of the risk-reward profile associated with tail risk.

As for his proposed “solution,” I can only stand and wonder.  The hook for the entire piece is the EC’s antitrust investigation of the OTC market:

the existence of political motivations does not undermine the legitimacy of the new EU investigations, which will be conducted alongside an ongoing inquiry by the United States Justice Department into anti-competitive practices in the trading, clearing, and pricing of CDS in the US

He starts out his critique of the OTC market by focusing on concentration in the OTC market, and concludes that high concentration is symptomatic of a lack of competition.

Uhm, has he looked at concentration in the exchange space? Is he aware that virtually every major exchange-traded derivatives contract is a monopoly?  Has he looked at concentration trends in exchanges?  Has he noticed the major consolidation wave that has been going on in exchanges since about 2005, and which as picked up again after tailing off during the crisis?

To go on: Is he aware that OTC markets also engage in “daily collateralization”, particularly among dealers?  Is he aware that such daily collateralization is not necessarily stability enhancing, as he asserts? Is he aware that “price transparency” already exists, though in a different form, on OTC markets?  Is he aware that the price transparency on exchanges is accompanied by counterparty opacity that can actually increase trading costs for the uninformed end user due to adverse selection?  And again: if the advantages of exchange trading are so great for end users, why haven’t exchanges made greater inroads in attracting their business, and why have end users in fact gravitated more towards OTC markets where he claims they are getting shafted?

Luigi is a very accomplished economist.  He can do much better than uncritically recycling stale and unpersuasive conventional wisdom.

Please, Luigi: adjust the frequency on your receiver.

Derivatives Reform Proving Difficult.

Regulatory arbitrage raises its ugly head.

‘ET’ [Extraterritoriality] stokes fears about sweeping swap rules.

Clearinghouses Would Not Have Prevented the Financial Crisis.

I’m Shocked! Shocked! to hear that reforming complex markets based on complex contracts among numerous complex financial firms that span myriad jurisdictions around the globe is actually like complicated or something.  I thought Chrissy and Barney and Timmy!  and various Euro-types could rearrange these markets at a whim and make everything all better.

Not really.  I’ve seen a train-wreck from the get go.

Take clearing in particular.  If you’ve spent any time on this at all, you know that the details are incredibly complex.  The economics are challenging, the legal aspects daunting.  My white paper* goes into this in some detail.  This paper does a nice job at explaining some of the legal issues–but still only scratches the surface. If you think you can rearrange something so intricate and have it all work out just swell, you’re in for a rude surprise.  The problem is that you don’t learn what the problems are until they appear, completely unanticipated.

Mark my words.  Re-engineering these markets will lay the foundation for a future crisis.  If only people had heeded Hayek’s aphorism: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

* The white paper is done, and approved.  It should be released formally this week–maybe tomorrow.  Apparently the PR folks at the organization that commissioned the study wanted a few days with it to figure out how to distribute and market it optimally.