Streetwise Professor

May 2, 2016

Zero Hedge: Zero Class

Filed under: Economics,Politics — The Professor @ 8:13 pm

Bloomberg’s Tracy Alloway and Jake Kawa wrote an expose on Zero Hedge last week. There was not a tremendous amount of new material here. I was disappointed that they didn’t have anything about Daniel Ivandjiiski’s father: I am convinced there is a Warsaw Pact intelligence connection there. The story focused on the revelations of an ex-Tyler Durden, Colin Lokey. Looked provided information that supports what I’d written almost five years ago, namely, that ZH is a Russian information operation:

Lokey, who said he wrote much of the site’s political content, claimed there was pressure to frame issues in a way he felt was disingenuous. “I tried to inject as much truth as I could into my posts, but there’s no room for it. “Russia=good. Obama=idiot. Bashar al-Assad=benevolent leader. John Kerry= dunce. Vladimir Putin=greatest leader in the history of statecraft,” Lokey wrote, describing his take on the website’s politics. Ivandjiiski countered that Lokey could write “anything and everything he wanted directly without anyone writing over it.”

The remaining Tyler Turkeys responded in their typically classy way. I am very proud to be featured in their lead:

Others, such as “academics who defend Wall Street to reap rewards” had taken on a different approach, accusing the website of being a “Russian information operation”, supporting pro-Russian interests, which allegedly involved KGB and even Putin ties, simply because we refused to follow the pro-US script. We are certainly ok with being the object of other’s conspiracy theories, in this case completely false ones since we have never been in contact with anyone in Russia, or the US, or any government for that matter. We have also never accepted a dollar of outside funding from either public or private organization – we have prided ourselves in our financial independence because we have been profitable since inception.

Hilarious. Hey guys: next time use my name!

And seriously. There’s a lot more behind what I wrote than “simply because we refused to follow the pro-US script.” Such a disingenuous non-responsive response is as much as a confirmation as I could imagine.

The Tylers continue to strike their pose as courageous battlers against the corrupt capitalism. Ironically, given that they recycle the laughable NYT bullshit story labeling me a tool of Wall Street, I have inflicted far more real pain on those that ZH claims to fight than they have. Whereas they are all talk, by my rough estimate I have contributed materially to cases in which banks, traders and others have paid in the mid-to-high nine figures to settle. The figure could realistically exceed ten figures in the near future.

After taking a swipe at me, the remaining Tylers turn their attention to Lokey. They quote extensively from his text messages (more class!) and label him as a drug addict and drug dealer, and claim that this discredits him as a source.

Um, he wrote for them for a year while he knowing about his past and his alleged instabilities. Doesn’t that kind of discredit what they published for a year?

Based on Lokey’s account, the Bloomberg piece describes ZH as the web equivalent of a sweat shop. This makes it highly unlikely that the remaining two named Durdens, Ivaandjiiski and Tim Backshall, carried the load prior to Lokey’s arrival. Thus, there are probably other ex-Durdens out there with tales to tell.

ZH is a dodgy operation. Bloomberg has turned over the rock a little. But there is much more to learn. Let’s hope Bloomberg, or someone else, turn over a few more.

November 20, 2014

How Do You Know That Zero Hedge is a Russian Information Operation? Here’s How

Filed under: History,Military,Politics,Russia — The Professor @ 9:41 pm

I have frequently written that Zero Hedge has the MO of a Soviet agitprop operation, that it reliably peddles Russian propaganda: my first post on this, almost exactly three years ago, noted the parallels between Zero Hedge and Russia Today.

A few days ago ZH ran a post that illustrates perfectly how it spews Russian propaganda that slanders the United States and other enemies of Russia, such as Ukraine: “Ukraine Admits Its Gold Is Gone: “There Is Almost No Gold Left In The Central Bank Vault.”

The lurid post highlights a statement by the head of Ukraine’s Central Bank, to the effect that almost all the gold in Ukraine’s official reserve is gone. It states that this is news, a stunning revelation, which confirms a story that ZH reported a few weeks after the triumph of Maidan: that soon after Yanukovych fled, the gold had been spirited out of the country in the dead of night by airplane. It closes by stating the the disappearance of the gold occurred at the time that US State Department official Victoria Nuland was in Kiev. The implication is obvious. The US stole it:

In any event, now that the disappearance of Ukraine’s gold has been confirmed, perhaps it is time to refresh the “unconfirmed” story that a little after the current Ukraine regime took power the bulk of Ukraine’s gold was taken to the United States.

Wow. Quite a tale.

And one that overlooks crucial details. Most importantly, the Ukrainian CB’s “admission” of that the vaults are empty is not news. At all. A mere few days after Yanukovych fled, Ukrainian Prime Minister Yatsenuk disclosed that the country’s gold reserves had been looted:

Speaking in parliament, Yatsenyuk said that the former government had left the country with $75bn of debts. “Over $20bn of gold reserve were embezzled. They took $37bn of loans that disappeared,” Yatsenyuk said. “Around $70bn was moved to offshore accounts from Ukraine’s financial system in the last three years,” he claimed. [Emphasis added.]

The US dispatched  FBI and Treasury investigators to assist Ukraine in an investigation.

Funny how ZH left out that history, which appeared in virtually every mainstream publication at the time, and made it seem for all the world like the Ukrainian Central Bank’s revelation hit the world like a thunderbolt, nine months after Yanukovych’s flight. That distortion of history makes it plain that the ZH story is not information, but an information operation.

Shortly after Yatsenuk disclosed the theft of the gold, stories started appearing on the web, first on a Russian website, claiming that the gold had been spirited out the country: including on ZH, which quoted the Russian web story. This obviously serves a Russian purpose: it presents a counter-narrative that blames the theft of the gold not on Yanukovych, or the Russians, but on the new Ukrainian government and the United States.

This is the classic Soviet/Russian agitprop MO that I noted 3 years ago. A story appears in an obscure publication, typically outside the US or Europe, where it has been planted by Soviet/Russian intelligence. It is then picked up by another, more widely read publication, in Europe or the West. Maybe it works its way through several additional media sources. It then gets disseminated more widely in the west, sometimes making it to prestige publications like the NYT.

In the era of the web, the information weapon needn’t make it that far. Getting into a widely-read web publication like Zero Hedge which is then linked by numerous other sources and tweeted widely ensures that the lie goes viral.

ZH is an important transmission belt moving the story from Russian propagandists/information warriors to western news consumers. It happens a lot. This is a particularly egregious example, but the transmission belt runs almost daily. ZH is as much a part of Putin’s information warfare as RT. If you follow closely enough, it’s as plain as the nose on your face.

So why does anyone take Zero Hedge seriously? And believe me, many do. Many people who should know better.

And what is the US’s counterstrategy? Marie Harf’s Twitter account. I say again: we are so screwed.


May 1, 2014

Zero Hedge Reveals Its True Colors. Again.

Filed under: Military,Politics,Russia — The Professor @ 7:50 pm

Every sentient being not in the tank for Russia recognizes that the Television Channel Formerly Known as Russia Today (i.e.,  RT) is spewing Kremlin agitprop 24/7. Heck, even the borderline sentient, like our Secretary of State, recognize this.

There is another widely followed outlet, this one online, that is vying with RT for the dubious honor of flacking most shamelessly for Putin: Zero Hedge. There are numerous posts daily that flog the Russian view, but few are more egregious than this one. The part comparing Crimea to the Falklands was rather amusing. As was the statement about Chevron being part of the Rockefeller empire. Yeah. Back in 1910. When it was Standard Oil of California. There was a lot of venting about the Rothschilds, and Jews generally. And WTF about the Yellowstone caldera?

You might say: “but that post is from another source.” But as I pointed out two-and-a-half years ago, this is a classic Soviet influence operation technique.

In that post I also noted the close affinity between RT and Zero Hedge. Some things don’t change.

To say I am not surprised is an understatement. Recall that Zero Hedge is run by Daniel Ivandjiiski, the son of an obvious Soviet bloc (Bulgarian, specifically) intelligence operative.

I’ve thought for years that ZH is a Kremlin influence operation. It is doing nothing now to disabuse me of that notion. To the contrary. It is cementing it.


March 13, 2014

Putin Channels Zero Hedge

Filed under: Economics,Politics,Russia — The Professor @ 3:37 pm

@libertylynx reminded me of one of the whoppers that went unnoticed because of all the even bigger whoppers in Putin’s presser 10 days back:

Now, the stock market. As you may know, the stock market was jumpy even before the situation in Ukraine deteriorated. This is primarily linked to the policy of the US Federal Reserve, whose recent decisions enhanced the attractiveness of investing in the US economy and investors began moving their funds from the developing markets to the American market. This is a general trend and it has nothing to do with Ukraine. I believe it was India that suffered most, as well as the other BRICS states. Russia was hit as well, not as hard as India, but it was. This is the fundamental reason.

Some simple facts.  Since the beginning of March, the Russian market is down 13.74 percent.  The largest decline, of over 10 percent, occurred on the Monday after the upper chamber of the Duma authorized an invasion of Ukraine.  In the same time, the MSCI Emerging Market Index was down 2.55 percent: since Russia is included, non-Russian EM stocks were down less than 2.55 percent.  The MSCI EM Index also includes Turkey, which is lurching into chaos. As for India, it is up about 6 percent, and was down less than 1 percent on the day the Russian market crashed 10 percent.

So who you gonna believe?  VVP or those lying charts? Obviously what has hit the Russian markets is not a Fed-driven phenomenon common to BRICs or emerging markets.  This was a Russia-specific phenomenon.  Which means it’s all about Putin and Ukraine.

But the most revealing thing is that Putin can say such readily falsified things with such confidence and panache.  Has he convinced himself it’s true?  Or does he know that his real target audiences, Russians dependent on TV for news, and useful idiots in the West, will just swallow his swill as Gospel and won’t bother to check?

I’m guessing the latter, but I can’t rule out the former.

December 10, 2012

The Wages of a Zero Sum Mindset, Russo-Syrian Edition

Filed under: Military,Politics,Russia — The Professor @ 3:50 pm

Russia’s defense of Syria’s Assad is overdetermined.  (And don’t believe for a minute its claims that it is not protecting Assad: walks like a duck, quacks like a duck, flies like a duck-it’s a duck.)

There are military-diplomatic reasons.  Syria is a long-term ally in the region-Russia’s last one.  Syria provides Russia with its only port in the Med.  Russia has legitimate fears of another jihadi outpost, this one at the heart of the Middle East.

There are domestic political reasons: in a reprise of its role in the Holy Alliance, Russia’s extreme fear of an popular overthrow of the government leads it support any regime facing popular opposition, no matter how odious that regime might be.

But a big reason can only be described as psychological, and rooted in Russia’s obsession with the Cold War, and in particular its loss in the Cold War to the US,.   Recent Russian squealing about the US’s alleged lapsing into a Cold War mentality (e.g., the Magnitsky Act) is so much projection that reveals just who really thinks about the Cold War non-stop. More generally, Russia is obsessed with respect, and regaining its great power status.

Putin for one marinates in these obsessions.

One effect of this obsession is the pronounced tendency to oppose reflexively anything that the United States supports, or that Russia even suspects it might support.  Hence, the fact that the US is attempting to orchestrate Assad’s ouster is sufficient for Putin and Lavrov and the rest of the gang to oppose it.

Ironically, in so doing they are jeopardizing Russia’s more objectively-based reasons for wanting to maintain a foothold in Syria.  By creating obstacles to every attempt for the UN or NATO to get rid of Assad and transition to some other government, Russia (assisted by China) has ensured that the conflict has become a protracted war to the knife in which the most radical forces-jihadi forces, in particular-have decisive advantages.  Given its longstanding relationship with all aspects of the Syrian military and security forces, and its connection with Assad, if anyone could have brokered an outcome that would have avoided the bloodshed and chaos that have occurred in the last two years, and which will almost get worse when the inevitable comes to pass, it was Russia.  But it dug in its heels, permitting Assad to hang on, and to escalate, and to make a cataclysmic end almost certain.

When this end occurs, Russia’s influence in Syria will be nil, and its image in Syria and the Middle East generally will be deeply blackened.  It can kiss Tartus good bye.  There will be a major jihadi enclave that much closer to Chechnya.

If it had not responded so reflexively to western initiatives to find some way of getting Assad out, and indeed, if it had utilized its connections and influence, it could have preserved something.  Instead it will lose everything.  Even overlooking the humanitarian catastrophe that is unfolding, and the dangers that a post-civil war Syria will pose to its people and the region, and just looking from a purely self-interested Russian perspective, Putin and Lavrov played this badly.  The opposite game will prove very expensive for Russia.  Yes, the US would have gained from Assad’s departure, especially at the outset (not so clear now, given how things have gone, but his eventual departure is inevitable).  In the Russian zero sum world view, given the salience of the US in the Russian mind, that was sufficient reason to fight for Assad to the bitter end.   But it will prove to be a grievous wound, and an entirely self-inflicted one

February 27, 2012

Some Zero Hedge Questions

Filed under: Politics,Regulation — The Professor @ 9:37 pm

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.

November 7, 2011

Peas in a Pod: Occupy, RT, and Zero Hedge

Filed under: Economics,Politics,Russia — The Professor @ 5:34 pm

The American and Western media have been fawning in their coverage of the Occupy movement, but for please-get-a-room Tiger Beat coverage they cannot hold a candle to the “News” Organization Formerly Known As Russia Today, which now goes by the more innocuous moniker RT: Gee, I wonder why they dropped the explicit Russia reference.  ‘Tis a puzzler.

RT is a creature of the Russian government, part of its widespread information operations.  It is widely recognized as a means by which the Russian government peddles outlandish, anti-Western, and particularly anti-American conspiracy theories; a haven for loons and wackos; a fine inheritor of the “in America they lynch negroes” school of journalism.

And RT’s current obsession is Occupy. You can test your gag reflexes by Googling “Russia Today OWS” and following a few links to RT stories about the Occupy movement.  RT could be OWS’s press agent: maybe it is.  This piece–done very early in the OWS protests–is gruesomely representative.

So just why would Russia Today–pardon me, RT–be so enamored with Occupy?  Do I need to draw you a map?

Vladimir Putin and the siloviki who run Russia are unrepentant Cold Warriors who harbor intense resentment at the fall of the Soviet Union: they ache for revenge, or at least a replay.  They were weaned on anti-Americanism, and subsist on it as they move into their senior years.  Putin and his most important minions were intelligence operatives who spent their formative years in dirty operations against the US.  It is in their DNA.

Putin’s intense hatred for the US seethes below the surface, and quite frequently bubbles over in tirades against the country.  Indeed, just today he ranted about the “arrogant powers.”

Of late, much of his vitriol has been directed precisely at the American financial system, which he refers to using a word often applied to enemies of the state during Soviet times–parasitical.  It is quite clear that he blames the western financial crisis for inflicting the existential economic plight that has plagued Russia since 2008.

So OWS and Putin/siloviki are a match made in heaven.  Both share a common enemy, and a common diagnosis of what is wrong in the world.  No surprise, then, that Putin is marshalling Russia’s propaganda apparatus to flack for OWS.

For those of a certain age, and who have a passing familiarity with the way the world worked before 1991, might also wonder what other Russian support is flowing to elements within OWS.  OWS, and the sheltering media fog that blankets it, brings to mind the various peace movements of the Cold War era, perhaps most notably the Nuclear Freeze movement.  Said movement was thoroughly penetrated by the Soviets and their allied intelligence services.  No, not everyone who marched was a commie: very few were, in fact.  But more than a few leading lights were Soviet assets.  Given the coalitional, fragmented nature of Occupy, it would strain credulity to believe that something similar is not going on today.  There are useful idiots and Leninist vanguards.  That’s the way these things work, and they no doubt work that way in Occupy.

Interestingly, RT is a favorite source for the conspiratorial/paranoid tribes of the polygot assemblage that claims the libertarian label.  This is an interesting historical phenomenon in itself: these tribes can trace their lineage to agrarian populists, Jacksonian anti-bankers, Jeffersonian agrarians, and Anti-Federalists.  They believe that finance is antithetical to liberty.  Hence their affinity for OWS–and RT.

Another favorite of these folks is the Zero Hedge website.  I have often mentioned that Zero Hedge is aptly named.  One hedges to reduce variance, and the extreme variability of the content on ZH makes it plain that they don’t hedge at all.

The site links quickly to breaking finance stories from major news sources, reports data on prices from sometimes obscure markets in response to breaking news, and often excerpts research from reputable analysts and firms. Hence, ZH can be useful as a de facto news aggregator.

When it comes to the editorial content spewed out under the pseudonym “Tyler Durden,” however—oi.  What a farrago of paranoid, conspiratorial nonsense.  ZH is obsessed with HFT—and utterly warped and delusional in its ravings on the subject.  Ditto for derivatives.  And the Fed.  And especially Goldman and Wall Street generally.  Look, I’ve been critical of all of the above at times, but ZH coverage of them is unhinged and indiscriminate.

ZH’s editorial line on the US and European economies parallels almost exactly that of RT.   Moreover, although ZH is unsparing in its criticism of virtually every Western government leader, it never whispers the slightest word of reproach about Vladimir Putin or Russia.   Indeed, a tweet mentioning that fact almost immediately drew a response from ZH: a link to a ZH piece spouting a common line of Russian propaganda argument about the superior fiscal foundation of Russia as compared to the US.

And like RT, ZH could be an OWS echo chamber.

Apropos the certain-kind-of-libertarian-RT-ZH nexus, a certain commenter on this site has been linking to ZH with some regularity in the comments, all with the intent of mocking my supposed shilling for The Banks and The Man.   A friend of mine remarked on this the other day, which led to a conversation about ZH generally.  We were trying to make sense of it, when a thought struck me: ZH is like a Soviet-bloc influence operation.  These operations would plant disinformation in publications around the world.  Most of the publications were obscure, often in Third World countries.  The disinformation would be mixed in with legitimate reporting.  The goal of these operations was to put disinformation into circulation via more obscure publications, knowing that more reputable publications higher up the media food chain would frequently pick up the planted stories and run them.  Some of the stories would work their way to the very top of the food chain, winding up in publications like the NYT and the WaPo and particularly in major European newspapers.

That comports perfectly with the ZH MO.   Provocative and poorly sourced allegations with a particular slant are scattered among legitimate news and data.  The solid news stories attract eyeballs that also views the agitprop.  And some of the ZH material has made it up the media food chain.

And it is also the RT MO.  RT is well-known for sprinkling its more outlandish “reporting” and commentary in a stream of legitimate news stories told in a relatively straightforward way.

So what is ZH, exactly? Its creator is Daniel Ivandjiiski, a native of Bulgaria.  Daniel has a very dodgy past, including losing a job and his securities license for insider trading.  None of this is hard to find out: it was covered in a New York Magazine piece that ran soon after ZH first gained notoriety.  Mr. Ivandjiiski’s checkered past perhaps explains his clearcut antipathy for Wall Street.   But there may be more to it than that.

In light of my flash analogy of ZH to a  Soviet disinformation operation, what is really interesting is the background of Daniel Ivandjiiski’s father.  Ivandjiiski pere (Kassimir) was a Bulgarian “journalist” and “envoy” during the Cold War.  A member of the Bulgarian Ministry of Foreign Trade, in the COMECON and EU departments.  A journalist.  A “special envoy” (hence presumably with very useful diplomatic cover) in every proxy war in Central Asia and Africa in the 1970s and 1980s.

That is an intel operative’s CV with probability 1.  Probability 1.  Every one of those jobs was a classic cover.  There is no doubt in my mind whatsoever—none—that Mr. Divandjiiski senior was a member of the Bulgarian Committee for State Security (Държавна сигурност or DS for short)—the Bulgarian equivalent of the KGB.  And remember that Bulgarian DS was the USSR KGB’s most reliable allied service during the Cold War.  It carried out wet work in western countries, notably the “umbrella murder” of Georgi Markov in London.  It was linked to the plot to assassinate the Pope; although in the topsy-turvy world of intelligence, it is also alleged that the CIA fabricated the case against the DS.  Regardless of the truth about the links to the attempt on John Paul II, it was a very, very, very nasty operation.  (The African stops in Ivandjiiski’s resume makes it highly likely that his path intersected that of another charmer, Igor Sechin, who was a “translator” in Africa.)

Perhaps it is just coincidence that the son of an obvious Warsaw Pact intelligence service agent with the “journalistic” and “diplomatic” background commonly used in influence and disinformation operations starts a website that employs classic influence and disinformation methods, and spouts an editorial line dripping with vitriol and hostility for American (and Western European) financial institutions and governments: a line that follows that of RT quite closely.  Perhaps.  But if it is, it is a fascinating one, no?  (It amazes me that although Kassimir’s background has been discussed in the context of Zero Hedge, I cannot find anyone in an English language source making the obvious connection with Bulgarian, and hence Soviet, intelligence.  It is as plain as the nose on one’s face.)

So it is clear that there is a strong correlation between OWS, RT, and ZH.  Of course, correlation does not imply causation.  A and B can be correlated not because A causes B, or vice versa, but because a common cause C influences both.  It is evident that this is at work here.  Occupy, RT, and ZH are all strongly committed to the longstanding leftist anti-capitalist critique.  That’s something they clearly have in common.

But a common agenda and a common ideology create the basis for more explicit cooperation and coordination.  With respect to Occupy, there is historical precedent for this.  With respect to ZH, there are even more reasons to wonder.  The employment of classic information operation methods are one.  But the biggest reason is the one degree of separation between the creator of ZH and an obvious Warsaw Pact intelligence operative.  I acknowledge the possibility of coincidence, but that pushes it pretty far.

So if you see a graph from Bloomberg on Italian bond yields or an excerpt from a brokerage report, you can believe it.  Anything else should be treated with extreme caution, and with an understanding of what ZH does, what its methods resemble, and especially its pedigree–literally.

November 7, 2023

The Basis For the Treasury Basis Trade: Leverage Laundering?

Filed under: Clearing,Derivatives,Economics,Regulation — cpirrong @ 3:11 pm

The Treasury basis trade continues to be in the news, with one of the biggest basis traders–Citadel’s Ken Griffin–complaining that the SEC should regulate hedge fund basis trading, but should instead make sure that banks aren’t supplying too much leverage to . . . well, hedge funds mostly. This seems like a raising rival’s costs gambit. No doubt restrictions on leverage would hit Griffin’s competitors harder, whereas SEC regulation might have a more even impact.

Regardless, one question that hasn’t been asked in all the to-ing and fro-ing about Treasury basis trades is why they exist at all, let alone why they get so big. This graph (courtesy of FTAlphaville, based on CFTC data) provides a major clue:

Note the mirror image between leveraged funds (mainly hedged funds) and asset managers (ostensibly non-leveraged funds–the reason for the “ostensibly” will become clear shortly).

To the extent that hedge funds’ short positioning reflects basis trades, the graph suggests the following. Hedge funds take a leveraged market neutral position, buying bonds, funding them via repo, and selling futures. Futures are in zero net supply: the graph shows that the longs on the other side of the hedge funds’ futures short are asset managers.

Most asset managers do not, and in some cases even cannot, take leverage directly. So for example they are constrained in their ability to just buy Treasuries with borrowed money (e.g., via repo). But the basis trade allows them to lever up via futures. So in some sense, the basis trade is just an additional link in a chain of intermediation. Laundering leverage, if you will.

(A more complete picture might add swap dealers to the picture. Some managed money, such as leveraged ETFs, enter into swaps with dealer banks. The dealer banks in turn can hedge by taking offsetting futures positions.)

The hedge funds expect to earn a small margin on the trade–on average, though there is risk. The market is pretty competitive, so to a first approximation that margin (the difference between the actual futures price and the theoretical futures price derived from bond prices, bond vols and correlations, and repo rates) equals hedge funds’ marginal cost of supplying this intermediation. The asset managers on the long side of the futures trade are willing to pay “too high” a futures price (relative to bond prices) because this is a cheaper way of achieving a leverage target than via the available alternatives.

The March 2020 experience shows that the basis trade can be a fragile one that creates some systemic risk: this is why regulators are concerned about basis trades now, to Ken Griffin’s chagrin. Providing this leverage intermediation/laundering creates tail risks for the hedge funds that do so. This raises the question of whether there are regulatory constraints that inefficiently constrain the ability of asset managers to take leverage more directly, rather than via a longer dealer (or money market) to hedge fund to asset manager chain. If so, such constraints could give rise to unnecessary (systemic) risks.

If regulators are concerned about the systemic risks in basis trades, they should take a systemic approach–and understand more fully why basis trades exist in the first place, and why they have periodically become so large. Looking at individual links in the chain (hedge funds, or by Griffin’s lights, banks) can be misleading because it begs the question of why the chain exists in the first place. The link that is driving the process is likely the one that has escaped discussion so far–the asset managers at the end of the chain. Why do they want leverage and why is the basis trade the most cost effective way of supplying a lot of it? Could it be the most cost effective because other, more directly intermediated sources of leverage are unduly expensive because of regulatory or institutional constraints? Definitely worth regulators’ attention.

July 14, 2023

The Hydrogen Economy, or The Hindenberg Economy? Or, Gosplan Goes Gassy

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — cpirrong @ 12:32 pm

The Biden administration, courtesy of the delusionally titled Inflation Reduction Act, has made a huge spending commitment on alternative fuels, and in particular “clean” hydrogen, i.e., hydrogen not produced from fossil fuels (such as methane). Most of the “green” hydrogen stimulus involves supply-side subsidies (especially a $3/kg production tax credit, but also loans to be doled out by the administrative state). The Infrastructure Law sets aside funds for hydrogen electrolysis and hydrogen “hubs” (like that just announced for Germany). The administration is also attempting to make “the economic case for demand-side support,” such power purchase agreements (PPAs), contracts-for-differences (CFDs), advanced market commitments (made by whom?), and prizes (funded by whom?).

It’s hard to know where to begin in criticizing this mess. The biggest problem is that it attempts to address the climate issue (which I will take as a given, focusing on means not ends) by picking technologies. This almost never ends well. First, there is the knowledge problem–bureaucratic governments do not possess the information to make these technology choices. Second, there is the rent seeking/corruption problem–which exacerbates the knowledge problem, as interested parties exploit the ignorance of bureaucrats and funders, and their political connections, to induce investments based not on their economic virtues but instead on political influence.

There are also serious doubts about whether hydrogen qua hydrogen is the right alternative fuel given that it poses numerous problems and costs. The first is that using renewable energy to produce green hydrogen is extremely expensive. The second is that, well, hydrogen is highly explosive: I distinctly remember my 8th grade science teacher, Mr. Fisch, using electrolysis to fill a test tube with hydrogen, putting in a piece of chalk, then lighting a match to set off an explosion that sent the chalk flying across the room. You didn’t have Mr. Fisch as a teacher, but perhaps you’ve heard of the Hindenberg:

Explosiveness creates hazards, of course, and mitigation of them is expensive. Hydrogen is also extremely expensive to transport and store and requires a new and distinct transportation and storage system.

We are talking trillions of dollars to create “the hydrogen economy”–something even its boosters admit. Hell, they brag about it.

Hydrogen “carried” with carbon, in the form of ammonia or methanol, pose fewer problems (although ammonia in particular is nasty stuff). They are also costly, and it is clearly uncertain whether “green” forms of these hydrogen carriers are economical ways to reduce carbon emissions from fuels for transportation and power generation.

But the administration (and Europe too) have gone all in on hydrogen. Why? Maybe because their extreme antipathy towards carbon leads them to disdain fuels with any carbon in them.

Having chosen its technology, for better or more likely worse, now the administration is focused on how to force its adoption. The supply-side incentives are clear enough, so now there is a pivot to the demand-side, as expressed in the appallingly shoddy Council of Economic Advisors document linked above.

According to the CEA–and not just the CEA, as will be seen shortly–the problem is that “[r]eal or perceived risks around clean energy projects can raise the cost of accessing capital,  which could slow the rate at which projects like those in the hydrogen hubs program achieve commercialization..”

Well, I should hope so! That is, I should hope that risks are taken into account when allocating capital!

John Kerry flogged the risk issue on MSNBC (h/t Powerline):

“What’s preventing it is, to some degree, fear, uncertainty about the marketplace. People who manage very significant amounts of money have a fiduciary responsibility, an obligation to the people they manage it for not to lose the money, but to produce returns on that investment. Pension funds, many of them, are very careful about those investments in order to make certain they have the money to pay out to the pensioners who work for that money all their lives. So, there are tricky components of making sure that you have taken the risk away from these investments. And energy, which is what the climate crisis is all about, it’s about energy, it’s about how we fuel our homes, how we heat our homes, how we light our factories, how we drive and go from place to place.”

Damn those money managers for taking into account the risks and rewards of the money their investors entrust to them! Don’t they understand that John Effing Kerry knows what is right for humanity????? After all, he flies around the world in a private jet sharing his wisdom (and then dissembles about it before Congress).

I loved this part: “So, there are tricky components of making sure that you have taken the risk away from these investments.” Does John Kerry have a magic box into which he can make the risks disappear? Do tell!

Of course he doesn’t. What he means, clearly, is that the government must somehow absorb the risks inherent in the technology that they have already decided upon–apparently without analyzing those risks fully or carefully, or wondering whether maybe these damned investors might know something they don’t. (Of course they don’t wonder that! They are all knowing, right?)

At least the CEA attempts to put lipstick on the pig and raise some economic arguments to justify the need for demand-side support. There are market failures! Government never fails, but markets do, right?

In my experience the concept of market failure is most likely to be advanced when the market fails to do what someone thinks should be done, or wants to be done, based on their own vision. That is, when the market disagrees with someone, the market has failed! Especially when that someone is a member of what Thomas Sowell calls “The Anointed.”

The CEA basically cites to some theoretical possibilities. At the core of their argument is that learning by doing, including learning-by-doing that “spills over” among companies, can lead to inefficient investment. The CEA advances a couple of reasons.

One is a contracting failure. LBD–moving down the learning curve–reduces costs, meaning that prices are expected to fall. So, according the CEA, potential buyers are unwilling to enter into long term contracts for fear of agreeing to pay a price that will turn out to be too high: “if rapid declines in technology costs are expected, the willingness of private sector end-users to seek out such contracts with clean energy developers will be limited” (emphasis added). Without such contracts, hydrogen project developers can’t secure financing, so plants won’t get built, no learning takes place, and costs don’t fall. The Curly Equilibrium, in other words:

Really? If costs are expected to fall, market participants can enter contracts with de-escalator clauses, i.e., contractual prices that fall over time. Apparently the CEA only envisions contracts at a fixed price that extends through the life of the contract. But even then, given anticipated cost declines, the developer would be willing to sell at a price below the initial cost, basically, at the average cost expected over the life of the contract.

The CEA mentions the risks of of the magnitude of cost declines, but again, that should be a material consideration in any contracting and investment decision. Is the CEA arguing that the risk compensation demanded by borrowers will be excessive? They don’t say so explicitly, but that’s what you would need to argue that the prices in these contracts would be “too low” and thereby stymie investment.

I’d also note that indexed prices, widely used in a variety of commodity off-take agreements, eliminate the risk to buyers of locking in too high a price. They also address the asymmetric information problem that the CEA frets about. If the developer has better information about the likely trajectory of price declines, then yes, buyers looking at fixed price deals or deals with mechanical (non-market based) price de-escalators face a “winners’ curse” problem: the developer will agree to terms that overestimate his (better) forecast of future prices, and reject deals that underestimate.

I think in fact that the issue is that there is considerable uncertainty among all parties, developers and buyers alike, regarding what the future cost trajectory will look like. That is, there is a real risk here, and that risk should be taken into consideration when deciding whether hydrogen investments make sense. And market participants are far better at assessing the risks, and the pricing of those risks, than the government, which is clearly taking a “Damn the risks, full speed ahead!” Approach.

Sorry, but John Kerry et al don’t inspire confidence like Admiral Farragut at Mobile Bay.

One of the proposals under discussion is Contracts for Differences (“CFDs”) in which the government would (perhaps through a non-profit intermediary) provide a guaranteed revenue stream to a developer and absorb the price risk. To work, CFDs require indexing to some market price–and the market price for H2 hasn’t really been created. Further, they require some mechanism to set the guaranteed price, a non-trivial task given the very information asymmetries that the CEA worries about. The government-appointed third party (or the government for that matter) will certainly be the less informed party in any negotiations with developers, and will almost certainly overpay. (Not that they will mind–not their money!) Meaning that the asymmetric information problem the CEA frets about is present in spades in one of their preferred means of addressing it. Further, CFDs have already presented performance issues, with the sellers (those getting the guaranteed revenue stream) treating these contracts like options rather than forwards, and spurning their CFD commitments when market prices rise above the guaranteed price (as has happened with with generators in the UK when power prices spiked).

The CEA also invokes capital market imperfections also driven by asymmetric information that may impede financing if developers know more about the economics of projects than the financiers. This is a hoary old story that has been used to identify alleged market failures since time immemorial. So long ago, in fact, that when Stigler wrote “Imperfections in the Capital Market” (JPE) 56 years ago, he (in typical Stigler fashion) drolly started thus: “The adult economist, once the subject is called to his attention, will recall the frequency and variety of contexts in which he has encountered ‘imperfections-in-the-capital market.'” That is, “capital market imperfections” were an old joke decades ago.

Here’s another one, George! Based on long experience, George was a skeptic. Based on even longer experience, I am too, in this case in particular.

And let’s look at the empirical record. Learning by doing is a ubiquitous phenomenon. Dynamically declining costs in industries with potential information asymmetries abound. Yet industries have developed and thrived nonetheless.

Some examples.

I recently finished a piece describing extensive learning-by-doing in the shale industry, including evidence of learning spillovers and dynamic cost reductions. Yet, the shale sector has not faced problems getting capital or expanding rapidly. Hell, if anything, a common criticism is that shale drillers have obtained too much capital and drilled too much, not that they are starved for capital and drilled too little.

Does the CEA (or John Kerry!) believe the shale sector in the US is too small?

Insofar as spillovers is concerned, the fact that the costs of firm A decline when firm B produces more output is a necessary, but not a sufficient condition for an externality. One plausible outcome in oil (as identified in a paper on LBD in conventional drilling by Kellogg in the QJE) is that service firms are the ones that do the learning, and capture and internalize it.

LBD is well-documented for computer chips, which have seen relentless cost and price declines over the years. Yet computer chip factories have been built, and companies especially in the US and Asia have attracted the capital necessary to build these very expensive facilities and build new chip lines nonetheless. (In this industry too, there have been chronic complaints about overcapacity, rather than undercapacity. I am not commenting on the validity of those complaints, just noting that their existence contradicts the notion that dynamic scale economies and price declines due to LBD starve an industry of capital.)

The LNG industry has many of the characteristics that the CEA attributes to hydrogen. Yet this industry has expanded apace for well over 50 years now.

I viewed a presentation by DOE people today in which LNG was raised several times, and as an example not to be followed. DOE advisor Leslie Biddle (ex-Goldman) mentioned LNG several times (“I keep going back to the LNG analogy”), and in a negative way. LNG took 30 years to move to a traded market, dontcha know. And we don’t have that time! We need to create such a market in a year! (DOE’s Undersecretary for Infrastructure David Crane was more generous, giving us all of 5 years.) (Crane was also hyping the idea of hydrogen for everything, including home heating–apparently oblivious to the fact that even Net Zero fanatical Britain has just recently determined that H2 is too dangerous to heat homes.)

In the context of the discussion of a grand government plan to transform the energy system, I couldn’t help but think of Gosplan, or Stalin’s race to industrialization (e.g., the Magnitogorsk Steel Factory). We will inevitably–inevitably–meet the “Dizzy With Success” phase in hydrogen, mark my words.

I note that LNG production grew substantially before it became a traded market, which actually undercuts Biddle’s argument. Even though there was not a liquid traded market for LNG in the first decades of its growth and development, long term contracts, usually using crude (no pun intended) indexing features (like tying prices to Brent), contracts were agreed to, financing was obtained on the backs of these contracts, and liquefaction plants were built.

Oil refining faced many of the conditions that worries the CEA about hydrogen. Kerosene was a radical product early on, with a lot of uncertainty about market adoption. But Rockefeller dramatically expanded output and reduced costs: the cost of kerosene by 2/3rds in 10 years (1870-1880), in large part due to extensive learning and research on all aspects of the value chain. Standard Oil’s supposedly predatory acquisitions of were actually ways by which SO’s knowledge could be combined with physical assets to improve their efficiency.

The co-evolution of gasoline refining and the adoption of the automobile represents another example of investment and falling prices in a new market in a capital intensive industry.

I note that the early refining examples occurred when capital markets were far less developed than is currently the case. I further note that large energy firms (IOCs and NOCs like Aramco in particular) can potentially finance hydrogen (and other alternative energy projects) with cash flows generated by their legacy fossil fuel investments: this would largely eliminate any asymmetric information problem between developer and financier (because the developer is the financier) and developer and customer (because the developer could finance without securing a long term price commitment).

Another example. Electricity generation. Beginning with its inception in the early-1880s, electricity generation was highly technologically dynamic, with substantially declining costs. Yet in a few short years most urban areas in the US were electrified, with numerous private companies competing with government utilities. This was another industry in which overbuilding, rather than under-building, was widely discussed. The movement to price regulation occurred well after the industry developed, and was a reaction to intense price competition: regulation effectively cartelized electricity generation.

One more. Aircraft. LBD was first identified in the production of airframes. This phenomenon was first documented by Wright in 1936, and was subsequently observed in myriad other industries (e.g., Liberty Ship construction in WWII). LBD and the associated cost declines have continued in aircraft construction ever since. And aircraft have been built and aircraft manufacturers have been able to attract the capital to design and build new aircraft that benefit from these cost declines.

In the face of all these examples, the CEA and others making these market failure arguments should identify an industry that died aborning due to the alleged chicken-or-egg problem that makes demand side support of hydrogen investment necessary.

The CEA document has echoes of some rather common, but unpersuasive, arguments for government support of industry, such as the infant industry argument and the big push development literature. The latter has been demolished by practical experience: the list of its dismal failures is far too long. There are more than echoes of this discredited approach in the CEA document. It links to a paper that credulously recycles the old, bad, discredited theories.

What is amazing about the infant industry argument is how often it is invoked, and how little empirical evidence supports it. One of the few empirical papers, that of Krueger and Tuncer, rejects the argument in the case of Turkey.

A paper by Juhasz is often touted to support the theory. It shows that after the stimulus of the cotton spinning industry in France due to Napoleon’s Continental system, post-1815 the industry was competitive with the British, indicating that it had moved down the learning curve. Again, at most this identifies a necessary condition for protection–learning–but not a sufficient one. Even if LBD occurs, and even if there are spillovers, the cost of protection may exceed the benefits. A simple story demonstrates this. If the protected industry achieves cost parity with the first-mover (e.g., the UK in cotton), the protected firms merely displace firms in the first-mover country, leaving post-parity total costs unchanged. So in equilibrium, protection is costly but generates no benefits.

All in all, the CEA document reminds me of a rather conventional undergraduate econ paper, repeating textbook wisdom about externalities and market failures. It completely ignores the Coasean insight that market contracting methods are far more sophisticated than those in the textbooks, and that market participants have incentives to find clever ways to contract around what would be market failures if market transactions were limited to the forms considered in textbooks. It also ignores the historical record.

In other words, rather than writing off the difficulties of securing “bankable” contracts to secure funding for H2 developments to “market failures” or the excessive risk aversion of market participants, the government should step back and consider whether this alleged hesitation reflects a more sober and informed evaluation of risks than our betters in DC have undertaken.

I crack myself up sometimes.

In sum, the administration’s entire approach to hydrogen is utterly flawed. It attempts to pick technologies based on a pretense of knowledge it does not possess. It views flashing red lights warning of risks as signals to be suppressed rather than considered when making policy and investment choices. It engages in simplistic analyses of how real markets work, and how they have worked historically, to conclude that market failures requiring government intervention to fix abound in hydrogen.

All of these government failures could be eliminated by cutting the Gordion Knot, pricing carbon, and letting markets and private enterprise develop the technologies, products, contracting practices, and market mechanisms to trade off efficiently the benefits of reducing CO2 emissions. Decentralized mechanisms discover and utilize information, including information about new technologies, far more efficiently than governments. Decentralized mechanisms incentivize learning and innovation–including contracting and organizational innovations that can be instrumental in developing and adopting new technologies, products, and techniques.

In the case of hydrogen, pure or “contaminated” with carbon, priced carbon would address the problems that the CEA frets about, in particular the contracting problem. A carbon price would make it straightforward to index prices in contracts. A formula related to NG prices (because blue hydrogen is likely to drive the price of hydrogen at the margin, and because methane is likely to be the substitute at the margin for H2 in many applications) and the cost of carbon would send the appropriate signals and eliminate the need to fix prices in advance.

What the price of carbon should be and how it should be determined is a whole other question. But it would be far more productive, and not just in regards to hydrogen, to focus on that problem rather than leaving it to the John Kerrys of the world to pick technologies and then devise the coercive mechanisms necessary to force the adoption of those technologies.

Alas, we are on the latter path. And it will not take us to a good place. Probably figuratively, and perhaps literally, to the fate of the Hindenberg.

May 30, 2023

I Sorta Agree With Jerome Powell and Gary Genlser on Something: Sign of the Impending Apocalypse?

Filed under: Clearing,Derivatives,Economics,Exchanges,Regulation — cpirrong @ 1:00 pm

The Fed and the SEC have expressed concerns about Treasury “basis trades” wherein a firm purchases a cash Treasury security funded by repo-ing it out and sells Treasury futures. Their concern is somewhat justified. As mentioned in the linked article, and analyzed in detail in my paper in the Journal of Applied Corporate Finance (“Apocalypse Averted“) the spike in the cash-futures Treasury basis caused by COVID (or more accurately, the policy response to COVID) caused a liquidity crisis. The sharp basis change led to big margin calls (thereby creating a demand for liquidity) and also set off a feedback loop: the unwinding of positions exacerbated the basis shock, and thereby reinforced the liquidity shock.

This is just an example of the inherent systemic risk created by margining, collateralization, and leverage. The issue is not a particular trade per se–it is an inherent feature of a large swathe of trades and instruments. What made the basis trade a big issue in March 2020 was its magnitude. And per the article, it has become big again.

This is not a surprise. Treasuries are a big market, and leveraging a small arb pickup is what hedge funds and other speculators do. It is a picking-up-nickels-in-front-of-a-steamroller kind of trade. It’s usually modestly profitable, but when it goes bad, it goes really bad.

All that said, the article is full of typical harum-scarum. It says the trade is “opaque and risky.” I just discussed the risks, and its not particularly opaque. That is, the “shadowy” of the title is an exaggeration. It has been a well-known part of the Treasury market since Treasury futures were born. Hell, there’s a book about it: first edition in 1989.

Although GiGi is not wrong that basis trades can pose a systemic risk, he too engages in harum-scarum, and flogs his usual nostrums–which ironically could make the situation worse:

“There’s a risk in our capital markets today about the availability of relatively low margin — or even zero margin — funding to large, macro hedge funds,” said Gensler, in response to a Bloomberg News inquiry about the rise of the investing style.

Zero margin? Really? Is there anyone–especially a hedge fund–that can repo Treasuries with zero haircut? (A haircut–borrowing say $99 on $100 in collateral is effectively margin). And how exactly do you trade Treasury futures without a margin?

As for nostrums, “The SEC has been seeking to push more hedge-fund Treasury trades into central clearinghouses.” Er, that would exacerbate the problem, not mitigate it.

Recall that it was the increase in margins and variation margins on Treasury futures, and the increased haircuts on Treasuries, that generated the liquidity shock that the Fed addressed by a massive increase in liquidity supply–the overhang of which lasted beyond the immediate crisis and laid the groundwork for both the inflationary surge and the problems at banks like SVB.

Central clearing of cash Treasuries layers on another potential source of liquidity demand–and liquidity demand shocks. That increases the potential for systemic shocks, rather than reduces it.

In other words, even after all these years, GiGi hasn’t grasped the systemic risks inherent in clearing, and still sees it as a systemic risk panacea.

In other words, even though I agree with Gensler (and the Fed) that basis trades are a source of systemic risk that warrant watching, I disagree enough with GiGi on this issue that the apocalypse that could result from our complete agreement on anything will be averted–without the intervention of the Fed.

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