Streetwise Professor

While I’m doing the SWP Itoldyasopalooza, three more items.

First, the CFTC has reopened comments on the position limits proposed rule. The CFTC has taken intense incoming fire on the issue of hedge exemptions in particular, and with good reason. There are many problems, but the most egregious is the restriction on “cross hedges” (e.g., using gas futures as a hedge against electricity price risk).

I discussed this issue in my comment letter to the CFTC. Here’s the gist of the problem. The CFTC calculates the hedging effectiveness (measured by the R2 in a regression) of nearby NG futures for spot electricity prices. It finds the effectiveness is low (i.e., the R2 in the relevant regression is small). Looking past the issue of how some risk reduction is better than nothing, this analysis betrays a complete misunderstanding of electricity pricing and how NG futures are used as hedges.

Spot electricity prices are driven by fuel prices, but the main drivers are short term factors such as load shocks (which are driven by weather) and outages. However, these spot-price drivers mean revert rapidly. A weather or outage shock damps out very quickly.

This means that forward power prices are primarily driven by forward fuel prices, because fuel price shocks are persistent while weather and outage shocks are not. So it makes perfect sense to hedge forward power price exposure with gas futures/forwards. The CFTC analysis totally misses the point. Firms don’t use gas forwards/futures to hedge spot power prices. They are using the more liquid gas futures to hedge forward power prices. This is a classic example of hedgers choosing their hedging instrument to balance liquidity and hedging effectiveness. Gas forwards provide a pretty good hedge of power forward prices, and are are more liquid than power forwards. Yes, power forwards may provide a more effective hedge, but that’s little comfort if they turn out to be roach motels that a hedger can check into, but can’t leave if/when it doesn’t need the hedge any more.

The CFTC  ignores liquidity, by the way. How is that possible?

Market participants have strong incentives to make the liquidity-hedging effectiveness trade off efficiently. They do it all the time. Hedgers live with basis risk (e.g., hedging heavy crude with WTI futures) because of the liquidity benefits of more heavily traded contracts. The CFTC position limit rule substitutes the agency’s judgment for that of market participants who actually bear/internalize the costs and benefits of the trade-off. This is a recipe for inefficiency, made all the more severe by the CFTC’s utter failure to understand the economics of the hedge it uses to justify its rule.

As proposed, the rule suggests that the CFTC is so paranoid about market participants using the hedge exemption to circumvent the limit that it has chosen to sharply limit permissible hedges. This is beyond perverse, because it strikes at the most important function of the derivatives markets: risk transfer.

(This issue is discussed in detail in chapter 8 of my 2011 book. I show that the “load delta” for short term power prices is high, but it is low for forward prices. Conversely, the “fuel price delta” is high for power forward prices, precisely because load/weather/outage shocks damp out quickly. The immediate implication of this is that fuel forwards can provide an effective hedge of forward power prices.)

Second, Simon Johnson opines that “Clearing houses could be the next source of chaos.” Who knew? It would have been nice had Simon stepped out on this 5 years ago.

Third, the one arguably beneficial aspect of Frankendodd and Emir-the creation of swaps data repositories-has been totally-and I mean totally-f*cked up in its implementation. Not content with the creation of a single Tower of Babel, American and European regulators have presided over the creation of several! Well played!

Reportedly, less than 30 percent of OTC deals can be matched by the repositories.

This too was predictable-and predicted (modesty prevents me from mentioning by whom). Repositories are natural monopolies and should be set up as utilities. A single repository minimizes fixed costs, and facilitates coordination and the creation of a standard. I went through this in detail in 2003 when I advocated the creation of an Energy Data Hub. But our betters decided to encourage the creation of multiple repositories (suppositories?) with a hodge-podge of reporting obligations and inconsistent reporting formats.

This brings to mind three quotes. One by Ronald Reagan: “‘I’m from the government and here to help you’ are the 8 scariest words in the English language.” The other two by Casey  Stengel. “Can’t anybody play this game?” and “He has third base so screwed up, nobody can play it right.”