Craig Pirrong-The Streetwise Professor

Professor of Finance, University of Houston. Member of the CFTC Energy and Environmental Markets Advisory Committee. Researches commodity pricing, market manipulation, the economics of clearing, and financial market regulation. Blogs at www.streetwiseprofessor.com

[cpirrong]

Begging the Question on VIX Manipulation

Stung by yet another allegation of manipulation of the VIX, Cboe Chairman and CEO Ed Tilly and President and COO Chris Concannon fired off an open letter defending the exchange and VIX.  To say it begs the key questions is an understatement. 

Here’s their explanation of the April 18 event:

During the opening auction on April 18th, a single market participant submitted orders to buy approximately 212,000 SPX options across a wide range of strike prices. Five additional market participants submitted buy orders totaling 20,000 options. The size and structure of these buy orders appeared consistent with the weights prescribed by the VIX Index formula. Offsetting this buy interest were sell orders submitted by nine participants for a total of 118,000 contracts. This left a buy order imbalance of 114,000 SPX options. This buy order imbalance contributed to the opening prices of the option series that were used to calculate the final VIX settlement value. Based on the orders that were submitted, we believe the auction process functioned as intended, notwithstanding that the final settlement value was higher than what market participants may have otherwise expected.

Although oddly disconnected from the discussion of the 18 April spike in the VIX, this statement ostensibly directed at the Griffen and Shams paper claiming to find frequent manipulations of the VIX strongly suggests that they are denying there was a manipulation on 18 April as well:

Finally, we would like to again address the claims of possible manipulation of the settlement process. We reiterate that we believe these claims are without merit, and that the academic paper’s analysis and conclusions are based upon a fundamental misunderstanding about how VIX derivatives are traded and settled. The trading behavior the author considered suspicious is consistent with normal and legitimate trading behavior.

The explanation of what happened a couple of weeks ago begs the question because in no way does it disprove that a manipulation took place.  Indeed, what they describe is exactly how a large trader could and would “bang the auction” to influence the settlement price of VIX derivatives, in order to profit on positions in those derivatives.  What Tilly and Concannon describe involves a single large trader submitting a huge order on one side of a market with liquidity constraints.  That is almost certain to affect the auction price. That’s how that kind of manipulation works.

Note that the order--again, entered by a single participant--represented about 90 percent of the buy side interest, and more than 80 percent of the order imbalance.  Further, Tilly and Concannon’s touting of the Cboe’s efforts to improve liquidity at the auctions (perhaps inadvertently) concedes that the liquidity at the auctions is presently inadequate, which would mean that a huge order imbalance would almost certainly move prices--as occurred on the 18th--and be anticipated to move prices.  “There’s no problem (’the auction process functioned as intended’), but we’re fixing it!” hardly inspires confidence.

Any participant with the heft to enter such a large order would surely be sophisticated enough to know that it would be highly likely to move prices.  Note that non-manipulative traders would typically want to mitigate price impact, not trade in a way that exacerbates it.  So why do this?

Thus, there is evidence to support all of the elements of a manipulation case, but one.  There is evidence for artificial price, causation, and ability to cause.  The missing element is intent.  I’d be open to suggestions as to why this one market participant would enter such a large order but for an intent to distort prices.  Any such explanation would have to show how this was the most economical way of achieving some non-manipulative objective, such as hedging. 

Addressing the issue of intent would require knowledge of the large trader’s positions in VIX-related instruments.  Tilly and Concannon are silent on that issue, which makes their confident disavowal of manipulation incomplete and hence unpersuasive.  Discussing the auction alone, disconnected from the VIX derivatives markets tied to the auction, is inadequate to dispel suspicions of manipulation. 

Perhaps the exchange execs are right, and this “whale” (as the FT referred to the trader) was not manipulating.  But the information in the public record, including the information in their letter, is not sufficient to demonstrate this claim. The question-begging defense will therefore likely feed suspicions about VIX, rather than lay them to rest, as the letter’s authors intended. 

[cpirrong]

Rusal: Premature Celebration

Rusal shares rose sharply and aluminum prices fell sharply on the news that the US Treasury had eased sanctions on the company.  The concrete change was an extension in the time granted for those dealing with Deripaska-linked entities to wind down those dealings.  But the market was more encouraged by the Treasury’s statement that the extension was being granted in order to permit it to evaluate Rusal’s petition to be removed from the SDN list.  It is inclusion on that list that sent the company into a downward spiral.

Methinks that the celebration is premature.  Treasury made clear that a stay of execution for Rusal was contingent upon it cutting ties with Deripaska.  Well, just how is that supposed to happen? This is especially the case if any transaction that removes Deripaska from the company not benefit him financially.  Well, then why would he sell?  He would have no incentive to make certain something--the total loss of his investment in Rusal--that is only a possibility now.  

Of course, Putin has ways of making this happen, the most pleasant of which would be nationalization without compensation to Deripaska, perhaps followed by a sale to . . . somebody (more on this below). (Less pleasant ways would involve, say, Chita, or a fall from a great height.)

But if the US were to say that this was sufficient to bring Rusal in from the cold, the entire sanctions regime would be exposed as an incoherent farce.  For the ultimate target of the sanctions is not Deripaska per se, but the government of Russia, for an explicit foreign policy purpose--a “response to the actions and polices of the Government of the Russian Federation, including the purported annexation of the Crimea region of Ukraine.”  

Deripaska didn’t personally annex Crimea or support insurrection in the Donbas.  The Russian government did.  The idea behind sanctions was to put pressure on those the Russian government (allegedly) cares about in order to change Putin’s policies.  They are an indirect assault on Putin/the Russian government, but an assault on them nonetheless.

So removing Rusal from the SDN list because it had been seized by the Russian government would make no sense based on the purported purpose of the sanctions.  Indeed, under the logic of the sanctions, the current discomfiture of the Russian government, facing as it does the potential unemployment of tens of thousands of workers, should be a feature not a bug. The sanctions were levied under an act whose title refers to “America’s adversaries,” which would be the Russian state, and were intended to punish said adversaries.  

Mission accomplished!  Which is precisely why the Russian government is completely rational to view the Treasury announcement “cautiously,” and to view the US signals as “contradictory.”  The Russians would be fools to believe that nationalization and kicking Deripaska to the curb would free Rusal from the mortal threat that sanctions pose.

Perhaps Treasury has viewed the market carnage, and is trying to find a face-saving way out.  But it cannot do so without losing all credibility, and appearing rash, and quite frankly stupid, for failing to understand the ramifications of imposing SDN on Deripaska.  Also, doing so would feed the political fire that Trump is soft on Russia.

Further, who would be willing to take the risk buying Rusal from Deripaska either directly, or indirectly after nationalization?  They would only do so if they had iron clad guarantees from the US government that no further sanctions would be forthcoming.  But the US government is unlikely to give such guarantees, and I doubt that they would be all that reliable in any event.  Analogous to sovereign debt, just what could anyone do if the US were to say: “Sorry.  We changed our mind.”? 

Indeed, the Treasury’s signaling of a change of heart indicates just how capricious it can be.  Any potential buyer would only buy at a substantial discount, given this massive uncertainty.  A discount so big that Deripaska or the Russian government would be unlikely to accept.

And who would the buyers be anyways?  Glencore already has a stake in Rusal, and a long history of dealings.  But it is probably particularly reluctant to get crosswise with the US, especially given its vulnerabilities arising from, say, its various African dealings. 

The Chinese?  Well, since China is already on the verge of a trade war in the US, and a trade war involving aluminum in particular, they would have to be especially chary about buying out Deripaska.  Such a deal would present the US with a twofer--an ability to shaft both Russia and China.  And perhaps a three-fer: providing support to the US aluminum industry in the bargain (although of course harming aluminum consuming industries, but that hasn’t deterred Trump so far.)

So short of the US going full Emily Litella (and thus demolishing its credibility), it’s hard to see a viable path to freeing Rusal from SDN sanctions.  Meaning: Put away the party hats.  The celebration is premature. 

[cpirrong]

Where’s Hercules When You Need Him? McCabe’s “Defender” Unwittingly Reveals How DC Puts the Augean Stables in the Shade

Writing on the relentlessly anti-Trump, pro-swamp Lawfare site, Steptoe & Johnson attorney (and made swamp thang) Stewart Baker attempts to explain and rationalize Andrew McCabe and the “lack of candor” (swamp-speak for “lying”) that resulted in his termination.  What he really accomplishes, however, is to demonstrate just how depraved DC is. 

Baker’s essay is a target-rich environment, but I will focus on just a couple of things.  

There’s this gem: 

But the Trump administration’s ferocious response to leaks, including FBI leaks, led to an internal investigation. 

That is, Andy would have gotten away with leaking if it hadn’t been for that blasted Trump! It’s Trump’s fault! He doesn’t understand the rules! 

Apparently, leaking is droite du bureaucrate, and the upstart Trump was violating privileges and immunities of longstanding by attacking this conduct. 

But the best (or worst, depending on how you look at it) is this:

So, what should we think of Andrew McCabe? He’s certainly no hero. But he’s no sacrificial goat, either. Assuming he did what the IG says he did, the recommendation that he be fired is completely understandable. Still, the things McCabe did are not uncommon in government, even—perhaps especially—among talented and effective officials. His bad luck, and his failing, is that the issue kept coming back month after month, and his efforts to give misleading but not quite false answers grew ever more strained. It’s hard not to feel some sympathy. If the times had been different, he might have ended his service as a respected bureaucrat like many others—with a reputation for being talented and a bit slippery.

“Everybody does it!” is the best that Baker can muster in McCabe’s defense.  It is probably true that everybody does it.  But what the DC denizen cannot see is that is precisely the problem.  It may indeed be the case that McCabe is something of a Sad Sack who behaved completely in accordance with the rules of the DC game, but fell afoul of developments that he could never have imagined.  Karma! 

But the fact that McCabe’s behavior was “normal” is (a) exactly why US politics--and the administrative state--is a sewer, and (b) why Trump was elected in a fit of Jacksonian revulsion at corruption.  

Baker is right: if Andy McCabe is fired, everyone in DC deserves to be fired. 

If we could only be so lucky.

Baker’s piece also lays out the chronology and background of McCabe’s agonies, which further demonstrates how perverse the Potomac Swamp is.  

Baker relates that McCabe was leaking as part of a bureaucratic war against Sally Yates at DOJ, and one of McCabe’s lackeys (the now notorious Lisa Page) exulted at throwing one of Yates’ lackeys under the bus.  Now remember that Yates has rushed to McCabe’s defense.  Further, McCabe leaks undercut Comey, and he lied to Comey’s face.  Yet Comey has also leapt to McCabe’s defense and savaged Trump’s firing of him.  Another defender of both Comey and McCabe is the execrable (there has to be a better epithet--execrable seems so tame!) John Brennan.  Yet if Lee Smith’s reporting is to be credited, Brennan basically strong-armed Comey into launching the counterintelligence operation against Trump. 

In other words, when in power, and behind the scenes, these paragons of public virtue waged vicious bureaucratic battles against one another.  But they deliver slobbering encomiums to one another and their virtue when it advances their war against a common enemy: Trump. 

So thank you, Stewart Baker, for inadvertently laying bare precisely why DC makes the Augean Stables pale in comparison, and why it needs to be cleansed, post haste.  Unfortunately, Trump is probably not quite the Hercules we need.  And alas, DC is so overflowing in filth that even Hercules hisself would be hard pressed to perform that labor. 

[cpirrong]

Mars(?) Attacks

I have taken refuge here on Tumblr because Streetwise Professor is under relentless attack.  It is like a DDOS attack, but worse.  Someone apparently inserted malicious code that has registered 70,000 pages that are getting pinged from numerous sites.

Perhaps it is coincidence . . . but perhaps not: the US and UK have warned of a substantial increase in Russian hacking activity.  

What I do know is that this is the third major attack I have suffered since January.  And as Ian Fleming said, once is happenstance; twice is coincidence; three times is enemy action.  Who the enemy might be? Well, the first choice is obvious, but there’s not just one choice.  As I said on Twitter, it’s validation, in a way.  Which is why I will be back, more pugnacious than ever. 

Keep a weather eye here for updates.  I hope to post again soon, travel schedule permitting.  

[cpirrong]

The Joint Report on the Treasury Spike: Unanswered Questions, and You Can’t Stand in the Same River Twice

The Treasury, Fed (Board of Governors and NYFed), SEC, and CFTC released a joint report on the short-lived spike in Treasury prices on 15 October, 2014. The report does a credible job laying out what happened, based on a deep dive into the high frequency data. But it does not answer the most interesting questions.

One thing of note, which shouldn’t really need mentioning, but does, is the report’s documentation of the diversity of algorithmic/high frequency trading carried out by what the report refers to as PTFs, or proprietary trading firms. This diversity is illustrated by the fact that these firms were both the largest passive suppliers of liquidity and the largest aggressive takers of liquidity during the October “event.” Indeed, the report documents the diversity within individual PTFs: there was considerable “self-trading,” whereby a particular PTF was on both sides of a trade. Meaning presumably that these PTFs had both aggressive and passive algos working simultaneously. So talking about “HFT” as some single, homogeneous thing is radically oversimplistic and misleading.

But let’s cut to the chase: Whodunnit? The report’s answer?: It’s complicated. The report says there was no single cause (e.g., a fat finger problem or whale trader).

This should not be surprising. In emergent orders, which financial markets are, large changes can occur in response to small (and indeed, very small) shocks: these systems can go non-linear. Complex feedbacks make attribution of cause impossible.  Although there is much chin-pulling (both in the report, and more generally) about the impact of technology and changes in market structure, the fundamental sources of feedback, and the types of participants in the ecosystem, are largely independent of technology.

Insofar as the events of 15 October are concerned, the report documents a substantial decline in market depth on both the futures market, and the main cash Treasury platforms (BrokerTec and eSpeed) in the hour following the release of the retail sales report. The decline in depth was due to PTFs reducing the size (but not the price) of their limit orders, and banks/dealers widening their quotes. Then, starting about 0930, there was a substantial order imbalance to the buy side on the futures: this initial order imbalance was driven primarily by banks/dealers. About 3 minutes later, aggressive PTFs kicked in on the buy side on both futures and the cash platforms.  Buying pressure peaked around 0939, and then both aggressive PTFs and the banks/dealers switched to the sell side. Prices rose when aggressors bought, and fell when they sold.

None of this is particularly surprising, but the report begs the most important questions. In particular, what caused the acute decline in depth in the hour leading up to the big price movement, and what triggered the surge in buy orders?

The first conjecture that comes to mind is related to informed trading and adverse selection. For some reason, PTFs (or more accurately, their algos) in particular apparently detected an increase in the toxicity of order flow, or observed some other information that implied that adverse selection risk was increasing, and they reduced their quote sizes to reduce the risk of being picked off.

Did order flow become more toxic in the roughly hour-long period following the release of the retail number? The report does not investigate that issue, which is unfortunate. Since liquidity declines were also marked in the minutes before the Flash Crash, it is imperative to have a better understanding of what drives these declines. There are metrics of toxicity (i.e., order flow informativeness). Liquidity suppliers (including HFT) monitor it in real time.  Understanding these events requires an analysis of whether variations in toxicity drive variations in liquidity, and in particular marked declines in depth.

Private information could also explain a surge in order imbalances. Those with private information would be the aggressors on the side of the net imbalance. In this case, the first indication of an imbalance is in the futures, and comes from the banks and asset managers. PTF net buying kicks in a few minutes later, suggesting they were extracting information from the banks’ and asset managers’ trading.

This raises the question: what was the private information, and what was the source of that information?

One problem with the asymmetric information story is the rapid reversal of the price movement. Informed trades have persistent effects. I’ve even seen in the data from some episodes that arguably manipulative (and hence uninformed) trades that could not be identified as such had persistent price impacts. So did new information arrive that led the buyers to start selling?

A potentially more problematic explanation of events (and I am just throwing out a hypothesis here) is that increased order flow toxicity due to informed trading eroded liquidity, and this created the conditions in which pernicious algorithms could thrive. For instance, momentum triggering (and momentum following) algorithms could have a bigger impact when the market lacks depth, as then smallish imbalances can move prices substantially, which then triggers trend following. When prices get sufficiently out of line, these algos might turn off or switch directions, or other contrarian algorithms might kick in.

These questions cannot be answered without knowing the algorithms, on both the passive and aggressive sides. What information did they have, and how did they react to it? Right now, we are just seeing their shadows. To understand the full chronology here–the decline in depth/liquidity, the surge in order imbalances from banks/dealers around 0930, the following surge in aggressive PTF buying, and the reversal in signed net order flow–it is necessary to understand in detail the entire algo ecosystem. We obviously don’t understand it, and likely never will.

Even if it was possible to go back and get a granular understanding of the algorithms and their interactions, this would be of limited utility going forward because the emergent ecosystem evolves continuously and rapidly. Indeed, no doubt the PTFs and banks carried out their own forensic analyses of the events of 15 October, and changed their algorithms accordingly. This means that even if we knew the  causal connections and feedbacks that produced the abrupt movement and reversal in Treasury prices, that knowledge will not really permit anticipation of future episodes, as the event itself will have changed the system, its connections, and its feedbacks. Further, independent of the effect of 15 October, the system will have evolved in the past 9 months. Given the dependence of the behavior of such systems on their very fine details, the system will behave differently today than it did then.

In sum, the joint report provides some useful information on what happened on 15 October, 2014, but it leaves the most important questions unanswered. What’s more, the answers regarding this one event would likely be only modestly informative going forward because that very event likely caused the system to change. Pace Heraclitus, when it comes to financial markets, “You cannot step twice into the same river; for other waters are continually flowing in.”

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Hey, Elon-Put *OUR* Money Where Your Big, Fat Mouth Is

In one of my periodic Quixotic moments, I tilted at the Cult of Elon Musk. First, I argued that he or someone manipulated the prices of Tesla and Solar City stocks: I stand by that analysis. Second, I argued that the supposed visionary's true genius was for feeding lustily at the taxpayer teat.

It is a testament to my great influence that the Cult of Musk has grown only larger in the two years since I made a run at him. But maybe the spell is breaking. For the LA Times just ran a long article detailing just how much his fortune was picked from our pockets. According to the LAT, Musk companies have raked in $4.9 billion in various subsidies and tax breaks, give or take.

That's 10 figures, people.

That's bad enough. What's worse is Musk's "defense." It is a farrago of intellectual dishonesty, logical fallacies, condescension, and arrogance.

Musk only replied to the LAT after repeated inquiries, but it is good that the paper persisted. Musk's rationalizations have to be seen to be believed.

For one thing, he says he doesn't really need the subsidies:

"If I cared about subsidies, I would have entered the oil and gas industry," said Musk.

. . . .

"Tesla could be profitable right now if we went into low-growth mode and we just served premium buyers," he said. "The reason we are not profitable is because we are making massive investments to create an affordable long-range electric car."

We are making massive investments? What do you mean by "we", paleface?

So fine. You don't care about subsidies. You don't need them.

Then put your money-excuse me, our money-where your big fat mouth is and don't cash the checks.

The rest of Musk's defense consists of various incarnations of N wrongs make a right (or, put differently, other people suck at the government teat, why shouldn't I?):

Musk said the subsidies for Tesla and SolarCity are "a pittance" compared with government support of the oil and gas industry.

"What is remarkable about my companies is that they have been successful despite having such a tiny incentive from the government relative to our competitors," Musk told The Times.

. . . .

Tesla, Musk said, competes with a mature auto industry that has seen massive federal bailouts for General Motors and Chrysler.

"Tesla and Ford are the only American auto companies not to have gone bankrupt," Musk said.

SolarCity, he said, is in a nascent industry that must fight entrenched oil and gas interests that have myriad subsidies.

Throwing good money after bad is not good public policy.

Musk cites numerous junk studies to support his case. Some of these are studies of the alleged economic benefits arising from investments in his battery plants, etc. I guarantee, all such studies are garbage based on mythical multipliers and crypto-Keynesian mumbo jumbo. Others are studies of the alleged subsidies of other industries, notably the energy industry. Even taking the numbers at face value, the subsidies of fossil fuels are a pittance on a per BTU or megawatt basis compared to those for renewables. Further, fossil fuels are also heavily taxed directly and indirectly, including by substantial geopolitical and expropriation risks. The study that cites the environmental costs of fossil fuels is particularly susceptible to abuse. And to quote Sonicharm, of the blog Rhymes With Cars and Girls-also not a Musk fan!-all large calculations are wrong.

Elon Musk is a rent seeker masquerading as a visionary. If he is one-tenth the innovator and genius his fawning fans believe him to be he wouldn't need any subsidies. We should give him the chance to prove it.

[cpirrong]

I Think I Read These Predictions About the Impending Revolution in LNG Trading Somewhere Before

The FT, Goldman, Jonathan Stern at the Oxford Institute of Energy Research, Vitol, and others are now predicting that the emergence of the US as an LNG exporter, and the looming surplus driven by that plus supplies from Australia, PNG, and elsewhere, are inexorably pushing this commodity away from traditional oil-based long term contracts towards spot trading.

Huh. I remember reading something along those lines last September. Oh, yeah. Here it is. (Also available in Spanish!) I guess it’s more accurate to say I remember writing something exactly along those lines in September.

The opening of the Cheniere* and later the Freeport and Cameron LNG trains in the Gulf will be particularly important. The US is likely to be at the margin in Asia, Latin America and perhaps Europe. Prices are set at the margin, meaning that the LNG pricing mechanism can be integrated into the already robust US/Henry Hub pricing mechanism. Giving the tipping effects discussed in my paper, the transition in the pricing mechanism and the development of a robust spot market is likely to take place relatively rapidly.

I know there is skepticism in the industry about this, but I am pretty confident in my prediction. Experiences in other markets, notably iron ore and to some degree coal, indicate how rapid these transitions can be.

Funny story (to me anyways). I gave the keynote speech at LNG World Asia in Singapore in September, and I laid out my views on this subject. I gave the talk in front of the giant shark tank at the Singapore Aquarium, and I could help but think of Team America, Kim Jung Il, and Hans Blix. I’m sure there were a few people in the audience who would have liked to feed me to the sharks for calling oil-linked pricing “a barbarous relic” and encouraging them to embrace the brave new world of LNG trading.

But whether they like it or not, it’s coming. The inflection point is nigh.

*Full disclosure. Number One Daughter works for Cheniere.

[cpirrong]

Gazprom Agonistes

It has been a hellish few months for Gazprom. It’s profits were down 86 percent on lower prices and volumes and the weak ruble. Although the ruble has rebounded, the bad price news will persist for several months at least, given the lagged relationship between the price oil and the price of gas in the company’s oil-linked contracts. The company has been a die-hard defender of the link: another example of be careful what you ask for.

Moreover, the EU finally moved against the firm, filing antitrust charges. Although many of the European Commission’s antitrust actions, especially against US tech firms, are a travesty, the Gazprom brief is actually well-grounded. At the core of the case is Gazprom’s pervasive price discrimination, which is made possible by its vertical integration into transportation and contractual terms preventing resale of gas. Absent these measures, a buyer in a low-price country could resell to a higher price country, thereby undercutting Gazprom’s price discrimination strategy.

It is interesting to note that the main rationale for Gazprom’s vertical integration is one which was identified long ago, based on basic price theory, rather than more elaborate transactions cost economics or property rights economics theories of integration. Back in the 1930s  economists identified price discrimination as a rationale for Alcoa’s vertical integration. There was some formal work on this in the 70s.

Gazprom is attempting to argue that as an arm of the Russian state, it is not subject to European competition rules. Good luck with that. There is therefore a decent chance that by negotiation or adverse decision that Gazprom will essentially become a common carrier/have to unbundle gas sales and transportation, and forego destination clauses that limit resale. This will reduce its ability to engage in price discrimination, either for economic or political reasons.

The company is also having problems closer to home, where it is engaged in a battle with an old enemy (Sechin/Rosneft) and some new ones (Timchenko/Novatek), and it is not faring well.

Gazprom and Putin have always held out China as the answer to all its problems. There were new gas “deals” between Russia and China signed during Xi’s visit to the 70th Victory Day celebration. (Somehow I missed the role China, let alone the Chinese Communists, played in defeating the Nazis.) But the word “deal” always has to be in quotes, because they never seem to be finalized. Remember the “deal” closed with such fanfare last May? I expressed skepticism about its firmness, with good reason. There is a dispute over the interest rate on the $25 billion loan that was part of the plan. Minor detail, surely.

Further, Gazprom doesn’t like the eastern route agreed to last year. It involves massive new greenfield investments in gas fields as well as transportation. It has therefore been pushing for a western route (the Altai route) that would take gas from where Gazprom already has it (in western Siberia) to where China doesn’t want it (its western provinces, rather than the more vibrant and populous east). The “deal” agreed to in Moscow relates to this western route, but as is almost always the case, price is still to be determined.

If you don’t have a price, you don’t have a deal. And the Chinese realize they have the whip hand. Further, they are less than enamored with Russia as a negotiating partner. Who could have ever predicted this? I’m shocked! Shocked!:

Chinese and Russian executives and advisers said that in addition to the challenge of negotiating prices acceptable to both sides, energy deals between the countries have also been hampered by mutual distrust and Chinese concerns about antagonising the US.

“The Russians are unreliable. They are always flipping things around for their own interest,” said one Chinese oil executive.

Who knew?

Putin is evidently losing patience with the company, and its boss Alexei Miller, is far less powerful than Sechin and Timchenko. When it was a strategic asset in Europe, and offered real possibilities in Asia, it could defend itself. Now that leverage is diminishing, its future is much cloudier.

The impending new supplies of LNG coming online in the US and Australia dim its future prospects further.

In sum, Gazprom is beset by many agonies. Couldn’t happen to a better company.

[cpirrong]

A Matter of Magnitudes: Making Matterhorn Out of a Molehill in the Sarao Prosecution

The CFTC released its civil complaint in the Sarao case yesterday, along with the affidavit of Cal-Berkeley's Terrence Hendershott. Hendershott's report makes for startling reading. Rather than supporting the lurid claims that Sarao's actions had a large impact on E Mini prices, and indeed contributed to the Flash Crash, the very small price impacts that Hendershott quantifies undermine these claims.

In one analysis, Hendershott calculates the average return in a five second interval following the observation of an order book imbalance. (I have problems with this analysis because it aggregates all orders up to 10 price levels on each side of the book, rather than focusing on away-from-the market orders, but leave that aside for a moment.) For the biggest order imbalances-over 3000 contracts on the sell side, over 5000 on the buy side-the return impact is on the order of .06 basis points. Point zero six basis points. A basis point is one-one-hundredth of a percent, so we are talking about 6 ten-thousandths of one percent. On the day of the Flash Crash, the E Mini was trading around 1165. A .06 basis point return impact therefore translates into a price impact of .007, which is one-thirty-fifth of a tick. And that's the biggest impact, mind you.

To put the comparison another way, during the Flash Crash, prices plunged about 9 percent, that is, 900 basis points. Hendershott's biggest measured impact is therefore 4 orders of magnitude smaller than the size of the Crash.

This analysis does not take into account the overall cumulative impact of the entry of an away-from-the market order, nor does it account for the fact that orders can affect prices, prices can affect orders, and orders can affect orders. To address these issues, Hendershott carried out a vector autoregression (VAR) analysis. He estimates the cumulative impact of an order at levels 4-7 of the book, accounting for direct and indirect impacts, through an examination of the impulse response function (IRF) generated by the estimated VAR.* He estimates that the entry of a limit order to sell 1000 contracts at levels 4-7 "has a price impact of roughly .3 basis points."

Point 3 basis points. Three one-thousandths of one percent. Given a price of 1165, this is a price impact of .035, or about one-seventh of a tick.

Note further that the DOJ, the CFTC, and Hendershott all state that Sarao see-sawed back and forth, turning the algorithm on and off, and that turning off the algorithm caused prices to rebound by approximately the same amount as turning it on caused prices to fall. So, as I conjectured originally, his activity-even based on the government's theory and evidence-did not bias prices upwards or downwards systematically.

This is directly contrary to the consistent insinuation throughout the criminal and civil complaints that Sarao was driving down prices. For example, the criminal complaint states that during the period of time that Sarao was using the algorithm "the E-Mini price fell by 361 [price] basis points" (which corresponds to a negative return of about 31 basis points). This is two orders of magnitude bigger than the impact calculated based on Hendershott's .3 return basis point estimate even assuming that the algorithm was working only one way during this interval.

Further, Sarao was buying and selling in about equal quantities. So based on the theory and evidence advanced by the government, Sarao was causing oscillations in the price of a magnitude of a fraction of a tick, even though the complaints repeatedly suggest his algorithm depressed prices. To the extent he made money, he was making it by trading large volumes and earning a small profit on each trade that he might have enhanced slightly by layering, not by having a big unidirectional impact on prices as the government alleges.

The small magnitudes are a big deal, given the way the complaints are written, in particular the insinuations that Sarao helped cause the Flash Crash. The magnitudes of market price movements dwarf the impacts that the CFTC's own outside expert calculates. And the small magnitudes raise serious questions about the propriety of bringing such serious charges.

Hendershott repeatedly says his results are "statistically significant." Maybe he should read Deirdre McCloskey's evisceration of the Cult of Statistical Significance. It's economic significance that matters, and his results are economically miniscule, compared to the impact alleged. Hendershott has a huge sample size, which can make even trivial economic impacts statistically significant. But it is the economic significance that is relevant. On this, Hendershott is completely silent.

The CFTC complaint has a section labeled "Example of the Layering Algorithm Causing an Artificial Price." I read with interest, looking for, you know, actual evidence and stuff. There was none. Zero. Zip. There is no analysis of the market price at all. None! This is a piece of the other assertions of price artificiality, including most notably the effect of the activity on the Flash Crash: a series of conclusory statements either backed by no evidence, or evidence (in the form of the Hendershott affidavit) that demonstrates how laughable the assertions are.

CFTC enforcement routinely whines at the burdens it faces proving artificiality, causation and intent in a manipulation case. Here they have taken on a huge burden and are running a serious risk of getting hammered in court. I've already addressed the artificiality issue, so consider causation for a moment. If CFTC dares to try to prove that Sarao caused-or even contributed to-the Crash, it will face huge obstacles. Yes, as Chris Clearfield and James Weatherall rightly point out, financial markets are emergent, highly interconnected and tightly coupled. This creates non-linearities: small changes in initial conditions can lead to huge changes in the state of the system. A butterfly flapping its wings in the Amazon can cause a hurricane in the Gulf of Mexico: but tell me, exactly, which of the billions of butterflies in the Amazon caused a particular storm? And note, that it is the nature of these systems that changing the butterfly's position slightly (or changing the position of other butterflies) can result in a completely different outcome (because such systems are highly sensitive to initial conditions). There were many actors in the markets on 6 May, 2010. Attributing the huge change in the system to the behavior of any one individual is clearly impossible. As a matter of theory, yes, it is possible that given the state of the system on 6 May that activity that Sarao undertook with no adverse consequences on myriad other days caused the market to crash on that particular day when it didn't on other days: it is metaphysically impossible to prove it. The very nature of emergent orders makes it impossible to reverse engineer the cause out of the effect.

A few additional points.

I continue to be deeply disturbed by the "sample days" concept employed in the complaints and in Hendershott's analysis. This smacks of cherry picking.

Further, Hendershott (in paragraph 22 of his affidavit) asserts that there was a statistically significant price decline after Sarao turned on the algorithm, and a statistically significant price increase when he turned it off. But he presents no numbers, whereas he does report impacts of non-Sarao-specific activity elsewhere in the affidavit. This is highly suspicious. Is he too embarrassed to report the magnitude?

Moreover, Hendershott's concluding paragraph (paragraph 23) is incredibly weak, and smacks of post hoc, ergo propter hoc reasoning. He insinuates that Sarao contributed to the Crash, but oddly distances himself from responsibility for the claim, throwing it on regulators instead: "The layering algorithm contributed to the overall Order Book imbalances and market conditions that the regulators say led to the liquidity deterioration prior to the Flash Crash." Uhm, Terrence, you are the expert here: it is incumbent on you to demonstrate that connection, using rigorous empirical methods.

In sum, the criminal and civil complaints make a Matterhorn out of a molehill, and a small molehill at that. And don't take my word for it: take the "[declaration] under penalty of perjury" of the CFTC's expert. This is a matter of magnitudes, and magnitudes matter. The CFTC's own expert estimates very small impacts, and impacts that oscillate up and down with the activation and de-activation of the algorithm.

Yes, Sarao's conduct was dodgy, clearly, and there is a colorable case that he did engage in spoofing and layering. But the disparity between the impact of his conduct as estimated by the government's own expert and the legal consequences that could arise from his prosecution is so huge as to be outrageous.

Particularly so since over the years CFTC has responded to acts that have caused huge price distortions, and inflicted losses in nine and ten figures, with all of the situational awareness of Helen Keller. It is as if the enforcers see the world through a fun house mirror that grotesquely magnifies some things, and microscopically shrinks others.

In proceeding as they have, DOJ and the CFTC have set off a feeding frenzy that could have huge regulatory and political impacts that affect the exchanges, the markets, and all market participants. CFTC's new anti-manipulation authority permits it to sanction reckless conduct. If it was held to that standard, the Sarao prosecution would earn it a long stretch of hard time.

*Hendershott's affidavit says that Exhibit 4 reports the IRF analysis, but it does not.

[cpirrong]

Did Spoofing Cause the Flash Crash? Not So Fast!

The United States has filed criminal charges against on Navinder Sarao, of London, for manipulation via "spoofing" (in the form of "layering") and "flashing." The most attention-grabbing aspect of the complaint is that Sarao engaged in this activity on 6 May, 2010-the day of the Flash Crash. Journalists have run wild with this allegation, concluding that he caused the Crash.

Sarao's layering strategy involved placement of sell orders at various levels more than two ticks away from the best offer. At his request, "Trading Software Company #1" (I am dying to know who that would be) created an algorithm implemented in a spreadsheet that would cancel these orders if the inside market got close to these resting offers, and replace them with new orders multiple levels away from the new inside market. The algorithm would also cancel orders if the depth in the book at better prices fell below a certain level. Similarly, if the market moved away from his resting orders, those orders would be cancelled and reenetered at the designated distances from the new inside market level.

The complaint is mystifying on the issue of how Sarao made money (allegedly $40 million dollars between 2010 and 2014). To make money, you need to buy low, sell high (you read it here first!), which requires actual transactions. And although the complaint details how many contracts Sarao traded and how many trades (e.g., 10682 buys totaling 74380 lots and 8959 sells totaling 74380 lots on 5 May, 2010-big numbers), it doesn't say how the trades were executed and what Sarao's execution strategy was.

The complaint goes into great detail regarding the allegedly fraudulent orders that were never executed, it is maddeningly vague on the trades that were. It says only:

[W]hile the dynamic layering technique exerted downward pressure on the market SARAO typically executed a series of trades to exploit his own manipulative activity by repeatedly selling futures  only to buy them back at a slightly lower price. Conversely, when the market mved back upward as a result of SARAO's ceasing the dynamic layering technique, SARAO typically did the opposite, that is he repeatedly bought contracts only to sell them at a slightly higher price.

But how were these buys and sells executed? Market orders? Limit orders? Since crossing the spread is expensive, I seriously doubt he used market orders: even if the strategy drove down both bids and offers, using aggressive orders would have forced Sarao to pay the spread, making it impossible to profit. What was the sequence? The complaint suggests that he sold (bought) after driving the price down (up). This seems weird: it would make more sense to do the reverse.

In previous cases, Moncada and Coscia (well-summarized here), the scheme allegedly worked by placing limit orders on both sides of the market in unbalanced quantities, and see-sawing back and forth. For instance, the schemers would allegedly place a small buy order at the prevailing bid, and then put big away from the market orders on the offer side. Once the schemer's bid was hit, the contra side orders would be cancelled, and he would then switch sides: entering a sell order at the inside market and large away-from-market buys. This strategy is best seen as a way of earning the spread. Presumably its intent is to increase the likelihood of execution of the at-the-market order by using the big contra orders to induce others with orders at the inside market to cancel or reprice. This allowed the alleged manipulators to earn the spread more often than they would have without using this "artifice."

But we don't have that detail in Sarao. The complaint does describe the "flashing" strategy in similar terms as in Moncada and Coscia, (i.e., entering limit orders on both sides of the market) but it does not describe the execution strategy in the layering scheme, which the complaint calls "the most prominent manipulative technique he used."

If, as I conjecture, he was using something like Moncada and Coscia were alleged to have employed, it is difficult to see how his activities would have caused prices to move systematically one direction or the other as the government alleges. Aggressive orders tend to move the market, and if my conjecture is correct, Sarao was using passive orders. Further, he was buying and selling in almost (and sometimes exactly) equal quantities. Trading involving lots of cancellations plus trades in equal quantities at the bid and offer shares similarities with classic market making strategies. This should not move price systematically one way or the other.

But both with regards to the Flash Crash, and 4 May, 2010, the complaint insinuates that Sarao moved the price down:

As the graph displays, SARAO successfully modified nearly all of his orders to stay between levels 4 and 7 of the sell side of the order book. What is more, Exhibit A shows the overall decline in the market price of the E-Minis during this period.

But on 4 May, Sarao bought and sold the exact same number of contracts (65,015). How did that cause price to decline?

Attributing the Flash Crash to his activity is also highly problematic. It smacks of post hoc, ergo propter hoc reasoning. Or look at it this way. The complaint alleges that Sarao employed the layering strategy about 250 days, meaning that he caused 250 out of the last one flash crashes. I can see the defense strategy. When the government expert is on the stand, the defense will go through every day. "You claim Sarao used layering on this day, correct?" "Yes." "There was no Flash Crash on that day, was there?" "No." Repeating this 250 times will make the causal connection between his trading and Flash Clash seem very problematic, at best. Yes, perhaps the market was unduly vulnerable to dislocation in response to layering on 6 May, 2010, and hence his strategy might have been the straw that broke the camels back, but that is a very, very, very hard case to make given the very complex conditions on that day.

There is also the issue of who this conduct harmed. Presumably HFTs were the target. But how did it harm them? If my conjecture about the strategy is correct, it increased the odds that Sarao earned the spread, and reduced the odds that HFTs earned the spread. Alternatively, it might have induced some people (HFTs, or others) to submit market orders that they wouldn't have submitted otherwise. Further, HFT strategies are dynamic, and HFTs learn. One puzzle is why away from the market orders would be considered informative, particularly if they are used frequently in a fraudulent way (i.e., they do not communicate any information). HFTs mine huge amounts of data to detect patterns. The complaint alleges Sarao engaged in a pronounced pattern of trading that certainly HFTs would have picked up, especially since allegations of layering have been around ever since the markets went electronic. This makes it likely that there was a natural self-correcting mechanism that would tend to undermine the profitability of any manipulative strategy.

There are also some interesting legal issues. The government charges Sarao under the pre-Dodd-Frank Section 7 (anti-manipulation) of the Commodity Exchange Act. Proving this manipulation claim requires proof of price artificiality, causation, and intent. The customized software might make the intent easy to prove in this case. But price artificiality and causation will be real challenges, particularly if Sarao's strategy was similar to Moncada's and Coscia's. Proving causation in the Flash Crash will be particularly challenging, given the complex circumstances of that day, and the fact that the government has already laid the blame elsewhere, namely on the Wardell-Reed trades. Causation and artificiality arguments will also be difficult to make given that the government is charging him only for a handful of days that he used the strategy. One suspects some cherry-picking. Then, of course, there is the issue of whether the statute is Constitutionally vague. Coscia recently lost on that issue, but Radley won on it in Houston. It's an open question.

I am less familiar with Section 18 fraud claims, or the burden of proof regarding them. Even under my conjecture, it is plausible that HFTs were defrauded from earning the spread, or that some traders paid the spread on trades they wouldn't have made. But if causation is an element here, there will be challenges. It will require showing how HFTs (or other limit order traders) responded to the spoofing. That won't be easy, especially since HFTs are unlikely to want to reveal their algorithms.

The spoofing charge is based on the post-Frankendodd CEA, with its lower burden of proof (recklessness not intent, and no necessity of proving an artificial price). That will be easier for the government to make stick. That gives the government considerable leverage. But it is largely unexplored territory: this is almost a case of first impression, or at least it is proceeding in parallel with other cases based on this claim, and so there are no precedents.

There are other issues here, including most notably the role of CME and the CFTC. I will cover those in a future post. Suffice it to say that this will be a complex and challenging case going forward, and the government is going to have to do a lot more explaining before it is possible to understand exactly what Sarao did and the impact he had.

[cpirrong]

Cargill: Still Private After All These Years to Solve Agency Problems, or Because of Them?

The commodity trading sector is remarkable for the prevalence of private ownership, even among the largest firms. My recent white paper discusses this issue in some detail. In a nutshell, publicly-held equity is a risk sharing mechanism. The ability of commodity traders to share some of their largest risks-notably, commodity flat price risks-through the derivatives markets reduces the need to rely on public equity. Moreover, private ownership can mitigate agency problems between equity owners and managers: the equity owners are often the managers. As a consequence, private ownership is more viable in the commodity trading sector.

The biggest cost of this ownership structure is that it constrains the ability to fund large investments in fixed assets. Thus, private ownership can impede a firm’s ability to pursue asset heavy strategies. As I note in this white paper, and my earlier one, commodity firms have used various means to loosen this constraint, including perpetual debt, and spinoffs of equity from asset-heavy subsidiaries.

Another cost is that owners tend to be poorly diversified. But to the extent that the benefits of high powered incentives exceed this cost, private ownership remains viable.

Cargill is the oldest, and one of the largest, of the major privately held commodity traders. (Whether it is biggest depends on whether you want to consider Koch a commodity trader.) It is now commemorating its 150th anniversary: its history began as the American Civil War ended. Greg Meyer and Neil Hume have a nice piece in the FT that discusses some of Cargill’s challenges. Foremost among these is funding its ambitious plans in Indonesia and Brazil.

The article also details the tensions between Cargill management, and the members of the Cargill and McMillan families who still own 90 percent of the firm.

The last family member to serve as chief executive retired in 1995, and now only one family member works full time there. This raises questions about how long the company will remain private, despite management’s stated determination to keep it that way. The families are already chafing due to their inability to diversify. Further, at Cargill private ownership no longer serves to align the incentives of owners and managers, in contrast to firms like Trafigura, Vitol, and Gunvor: even though Cargill is private, the owners aren’t the managers. Thus, the negatives of private ownership are becoming more prominent, and the benefits are diminishing. There is separation of ownership and control, with its associated incentive problems, but there is no compensating benefit of diversification.

Indeed, it is arguable that the company remains private because of agency problems. Current management, which does not own a large fraction of the firm, is not incentivized to de-privatize: there would be no big payday for them from going public, because they own little equity. Moreover, as long as the families can be kept happy, management doesn’t have to worry about capital market discipline or nosy analysts. Thus, management may be well entrenched in the current private structure, and the number of family owners (about 100) could make it difficult to form a coalition that would force the company to go public, or to craft a package that would make it worth management’s while to pursue that option.

In sum, Cargill is a marvelous company, and has been amazingly successful over the years. Its longevity as a private company is remarkable. But there are grounds to wonder whether that structure is still efficient, or whether it persists because it benefits management.

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[cpirrong]

Not So Krafty?

The CFTC has filed a complaint against Kraft and Mondelez Global, accusing the companies of manipulating the December, 2011 CBT Wheat Futures Contract. A few comments, based on what is laid out in the complaint (and therefore not on a full evaluation of all relevant facts and data):

A trader executes a market power manipulation (i.e., a corner or a squeeze) by taking excessive, and uneconomic, deliveries on a futures contract. This causes the calendar spread to increase, and the basis at locations where delivery does not (or cannot) occur to fall. The complaint alleges that Kraft took large deliveries. The relevant calendar spread (December-March) rose sharply, and according to Kraft emails cited in the complaint, the basis at Toledo declined.  Thus, the facts in the CFTC complaint support a plausible allegation that Kraft and Mondelez executed a market power manipulation/corner/squeeze.

A cornerer takes uneconomic deliveries. That is, the deliveries taken are not the cheapest source of the physical commodity for the cornerer. The complaint does not provide sufficient detail to determine with precision whether this was the case here (but discovery will!), but it does include circumstantial evidence. Specifically, Kraft took delivery on the Mississippi, whereas it needed physical wheat at its mill in Toledo. Further, Kraft did not use most of the wheat it bought via delivery. Instead, it sold it, which is consistent with “burying the corpse.” In addition, given cash bids in Toledo and the futures price at which the defendants took delivery, it is highly likely that it was cheaper for Kraft to buy wheat delivered to its mill in Toledo than it was to take delivery (at an opportunity cost equal to the futures price) and pay load out and freight costs to move the wheat from the Mississippi to Toledo. Again, though, the complaint doesn’t provide direct evidence of this.

A cornerer liquidates a large fraction of its futures position: whereas it loses money on the deliveries it takes, it makes money by liquidating futures at a super competitive price. Kraft liquidated more than half its futures position. This provides further evidence that it did not establish its futures position as a means of securing the cheapest source of cash wheat, and is consistent with the execution of a corner/squeeze.

A processor hedging anticipated cash purchases doesn’t buy calendar spreads. The complaint quotes an email stating that Kraft did.

One clunker in the complaint is the allegation that Kraft’s actions “proximately caused cash wheat prices in Toledo to decline.” Market power manipulation when Toledo is not the cheapest to deliver location (as was evidently the case here, as deliveries did not occur in Toledo) would be expected to reduce the Toledo basis (i.e., the difference between the Toledo cash price and the December futures price), and there is some evidence in the complaint that this occurred. But this is different from causing the flat price of wheat to decline, which is what the CFTC alleges. Any coherent theory of market power manipulation implies that a corner or squeeze would increase, or at least not reduce, the cash price at locations where delivery does not occur, but that the rise in the cash price at these locations is smaller than the rise in the futures price (and in the cash price at the delivery location). This results in a compression of the basis, but a rise (or non-decline) in flat prices.

In sum, the complaint presents a plausible case that Kraft-Mondelez executed a market power manipulation.

But the CFTC doesn’t come out and allege a corner, squeeze, or market power manipulation: these words are totally absent. Instead, the agency relies on its shiny new anti-manipulation authority conferred by Frankendodd under section 6(c)(1) of the Commodity Exchange Act, and CFTC Rule 180.1 that it adopted to implement this authority. This is essentially a Xerox of the SEC’s Rule 10b-5, and proscribes the employment of any “deceptive or manipulative device.” That is, this is basically an anti-fraud rule that has nothing to do with market power and therefore it is ill-adapted to reaching the exercise of market power.

The CFTC no doubt is doing this because under 6(c)(1) and Rule 180.1 the CFTC has a lower burden of proof than under its pre-Frankendodd anti-manipulation authority. Specifically, it does not have to show that Kraft-Mondelez had specific intent to manipulate the market, as was the case prior to Dodd-Frank. Instead, “recklessness” suffices. Further, it does not have to demonstrate that the price of wheat was artificial. In my view, the straightforward application of economics permits determination of both specific intent and price artificiality, but earlier decisions like Indiana Farm and in re Cox make it difficult to for the CFTC to do so. Or at least that’s what CFTC believes.

Although I understand the CFTC’s choice, it has jumped from the frying pan into the fire. Why? Well, to mix metaphors, there is a square peg-round hole problem. As I’ve been shouting about for years, fraud-based manipulations and market power manipulations are very different, and using a statute that targets fraudulent (“deceptive”) actions to prosecute a market power manipulation is likely to end in tears because the legal concept does not fit the allegedly manipulative conduct. The DOJ learned this to its dismay in the Radley case (which grew out of the BP propane corner in 2004). Even though BP executed a garden variety corner, the DOJ alleged that the company engaged in a massive fraud. Judge Miller found this entirely unpersuasive, and shot down the DOJ in flames. The CFTC risks the exact same outcome. Tellingly, it asserts in a conclusory fashion that Kraft-Mondelez employed a “deceptive or manipulative contrivance” but doesn’t say: (a) what that device was, (b) how Kraft’s taking of a large number of deliveries deceived anyone, (c) who was deceived, and (d) how the deception affected prices.

It will be interesting to see what happens going forward. The CFTC is obviously using this as a test case of its new authority. Perhaps it thinks it is being crafty (or would that be Krafty?) but I fear that by using a law and rule targeted against fraudulent conduct to prosecute a market power manipulation, the agency will just be finding a new way to screw up manipulation law, thereby undermining, rather than strengthening, deterrence of market power manipulation.

[cpirrong]

The Biggest Loser, Iran Deal Edition: That Would Be Russia

I am following around Iranian negotiator Javad Zarif, arriving this morning in Geneva, and then going to Brussels next week. Don’t worry, I won’t go biking. Certainly not in the absurd getup that Zarif’s interlocutor-or should I say Sancho Panza-John Kerry did here on the shores of Lac Leman. The man is obviously immune to mockery.

I am resigned that Sancho-I mean John-and Javad (remember, they are on a first name basis!) will reach some sort of deal that will clear Iran’s path to becoming a nuclear power in the near-to-medium term, with all of the malign consequences that entails. Which leads me to contemplate some of those consequences.

One of which relates to the price of oil (and natural gas), the malignity of which depends on whether you are long or short oil (and gas). Of course, one of the countries that is very long oil (and gas) is Russia, and from its perspective the consequences of a deal will be very malign. Which makes one wonder if Putin (or whoever is really in charge these days!) will attempt to do something to derail it. (Or are they too distracted by the folly in Ukraine? Or by dog fights under the carpet?)

The crucial issue is how rapidly, and by how much, Iranian output will ramp up if a deal is reached. There is both a political dimension to this, and an operational one.

The political issue is how rapidly a deal will result in the dismantling of the myriad sanctions that impede Iran’s ability to sell oil:

“Don’t expect to open the tap on oil,” one Gulf-based Western diplomat told Reuters. It is much easier to lift financial sanctions because so many components of Iran’s oil trade have been targeted, the diplomat said. . . . . But for Iran to sell significantly more crude and repatriate hard currency earnings, many U.S. and European restrictions on its shipping, insurance, ports, banking, and oil trade would have to be lifted or waived.

Yet because they represent the bulk of world powers’ leverage over Iran, initial relief would probably be modest, said Zachary Goldman, a former policy advisor at the U.S. Treasury Department’s Office of Terrorism and Financial Intelligence, where he helped develop Iransanctions policy.

Goldman predicted the first step would be to allow Tehran to use more of its foreign currency reserves abroad, now limited to specific bilateral trade.

“It’s discrete, and it doesn’t involve dismantling the architecture of sanctions that has been built up painstakingly over the last five years,” said Goldman, who now heads the Center on Law and Security at New York University.

Even with a nuclear deal, oil sanctions would probably effectively stay in place until early 2016, said Bob McNally, a former White House adviser under George W. Bush and now president of the Rapidan Group energy consultancy.

The operational issue is how rapidly Iran can reactivate its idled fields, and how much damage they have suffered while they have been off-line. The Iranians claim that 1mm barrels per day can come online within months. The IEA concurs:

Turning lots of production back on suddenly can be complicated—and time consuming—even if wells and reservoirs are maintained studiously. It could be even harder in complex Iranian fields that have been pumping for decades.

Still, some analysts have concluded that a good deal of that lost output could return more quickly than often anticipated. The International Energy Agency, for example, has said that it expects a relatively rapid burst of exports if sanctions are lifted.

“They’ve deployed considerable ingenuity in getting around sanctions and keeping fields in tiptop shape. We think Iran could pretty much come back to the market on a dime,” Antoine Halff, head of the IEA’s oil industry and markets division, recently told an audience at the Center for Strategic Studies in Washington.

Perhaps up to 2mm bpd of additional output could come back later. Then there is the issue of how a relaxation or elimination of sanctions would affect output in the long run as (a) western investment flows into the Iranian oil sector, and (b) other producers, and notably OPEC, respond to Iran’s return to the market.

In the short run, the 1mm bpd number  (corresponding to about 1.1 percent of world output) looks reasonable, and given a demand elasticity of approximately 10, that would result in a 10 percent decline in oil prices. Additional flows in the medium term would produce additional declines.

Even if Iran’s return to the market is expected to take some time, due to the aforementioned complications of undoing sanctions, much of the price effect would be immediate. The mechanism is that an anticipated rise in future output reduces the demand to store oil today: the anticipated increase in future output reduces future scarcity relative to current scarcity, reducing the benefit of carrying inventories. There will be de-stocking, which will put downward pressure on spot prices. Moreover, since an increase in expected future output reduces future scarcity relative to current scarcity, future prices will fall more than the spot price, meaning that contango will decline.

Some of the price decline effect may have already occurred due to anticipation of the clinching of a deal: the May Brent price has declined about $10/bbl in the last month. However, the movement in the May-December spread is not consistent with the recent price decline being driven by the market’s estimation that the odds  that Iranian output will increase in the future have risen. The May-December spread has fallen from -$4.47 (contango) to -$6.36. This is consistent with a near-term supply-demand imbalance rather than an anticipated change in the future balance in favor of greater supply. So too is the increase in inventories seen in recent weeks.

Predicting the magnitude of the price response to the announcement of a deal-or the breakdown of negotiations-is difficult because that requires knowing how much has already been priced in. My lack of a yacht that would make a Russian oligarch jealous indicates quite clearly that I lack such penetrating insight. However, the directional effect is pretty clear-down (for a deal, up for a breakdown).

Which is very bad news for the Russian government and economy, which are groaning under the effects of the oil price decline that has already occurred. Indeed, Iran’s return to the market would weigh on prices for years, reducing the odds that Russia could count on a 2009-like rebound to retrieve its fortunes.

Add to this the fact that a lifting of sanctions would open Iran’s vast gas reserves (second only to Russia’s) to be supplied to Europe and Asia, dramatically reducing the profitability of Russian gas sales in the future, and Iran’s return to the energy markets is a near term and long term threat to Russia.

Which makes Putin’s apparent indifference to a deal passing strange. The Russians freak out over developments (e.g., the prospect for an antitrust investigation of Gazprom, or pipsqueak pipeline projects like Nabucco) that pose a much smaller threat than the reemergence of Iran as a major energy producer. But they have not done anything overt to scupper a deal, nor have they unleashed their usual screeching rhetoric.

What gives? Acceptance of the inevitable? A belief that in the long run the deal will actually increase the likelihood of chaos in the Middle East that will redound to Russia’s benefit? Strategic myopia (i.e., an obsession with reassembling Sovokistan, starting with Donbas) that makes the leadership blind to broader strategic considerations? Distraction by internal disputes? Or does Putin (or whoever is calling the shots!) have something up his (their) sleeve(s)?

My aforementioned pining for a super yacht that would make Abramovich turn green again betrays my inability to penetrate such mysteries. But it is quite a puzzle, for at least insofar as the immediate economic consequences are concerned, Russia would be the Biggest Loser from a deal that clears Iran’s return to the oil market.

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[cpirrong]

The Clayton Rule on Speed: Is HFT Manipulative?

I have written often of the Clayton Rule of Manipulation, named after a cotton broker who, in testimony before Congress, uttered these wise words:

“The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

High Frequency Trading has created the possibility of the promiscuous application of the Clayton Rule, because there is a lot of things about HFT that do not suit a lot of gentlemen at this moment, and a lot of ladies for that matter. The CFTC’s Frankendodd-based Disruptive Practices Rule, plus the fraud based manipulation Rule 180.1 (also a product of Dodd-Frank) provide the agency’s enforcement staff with the tools to pursue a pretty much anything that does not suit them at any particular moment.

At present, the thing that least suits government enforcers-including not just CFTC but the Department of Justice as well-is spoofing. As I discussed late last year, the DOJ has filed criminal charges in a spoofing case.

Here’s my description of spoofing:

What is spoofing? It’s the futures market equivalent of Lucy and the football. A trader submits buy (sell) orders above (below) the inside market in the hope that this convinces other market participants that there is strong demand (supply) for (of) the futures contract. If others are so fooled, they will raise their bids (lower their offers). Right before they do this, the spoofer pulls his orders just like Lucy pulls the football away from Charlie Brown, and then hits (lifts) the higher (lower) bids (offers). If the pre-spoof prices are “right”, the post-spoof bids (offers) are too high (too low), which means the spoofer sells high and buys low.

Order cancellation is a crucial component of the spoofing strategy, and this has created widespread suspicion about the legitimacy of order cancellation generally. Whatever you think about spoofing, if such futures market rule enforcers (exchanges, the CFTC, or the dreaded DOJ) begin to believe that traders who cancel orders at a high rate are doing something nefarious, and begin applying the Clayton Rule to such traders, the potential for mischief-and far worse-is great.

Many legitimate strategies involve high rates of order cancellation. In particular, market making strategies, including market making strategies pursued by HFT firms, typically involve high cancellation rates, especially in markets with small ticks, narrow spreads, and high volatility. Market makers can quote tighter spreads if they can adjust their quotes rapidly in response to new information. High volatility essentially means a high rate of information flow, and a need to adjust quotes frequently. Moreover, HFT traders can condition their quotes in a given market based on information (e.g., trades or quote changes) in other markets. Thus, to be able to quote tight markets in these conditions, market makers need to be able to adjust quotes frequently, and this in turn requires frequent order cancellations.

Order cancellation is also a means of protecting market making HFTs from being picked off by traders with better information. HFTs attempt to identify when order flow becomes “toxic” (i.e., is characterized by a large proportion of better-informed traders) and rationally cancel orders when this occurs. This reduces the cost of making markets.

This creates a considerable tension if order cancellation rates are used as a metric to detect potential manipulative conduct. Tweaking strategies to reduce cancellation rates to reduce the probability of getting caught in an enforcement dragnet increases the frequency that a trader is picked off and thereby raises trading costs: the rational response is to quote less aggressively, which reduces market liquidity. But not doing so raises the risk of a torturous investigation, or worse.

What’s more, the complexity of HFT strategies will make ex post forensic analyses of traders’ activities fraught with potential error. There is likely to be a high rate of false positives-the identification of legitimate strategies as manipulative. This is particularly true for firms that trade intensively in multiple markets. With some frequency, such firms will quote one side of the market, cancel, and then take liquidity from the other side of the market (the pattern that is symptomatic of spoofing). They will do that because that can be the rational response to some patterns of information arrival. But try explaining that to a suspicious regulator.

The problem here inheres in large part in the inductive nature of legal reasoning, which generalizes from specific cases and relies heavily on analogy. With such reasoning there is always a danger that a necessary condition (“all spoofing strategies involve high rates of order cancellation”) morphs into a sufficient condition (“high rates of order cancellation indicate manipulation”). This danger is particularly acute in complex environments in which subtle differences in strategies that are difficult for laymen to grasp (and may even be difficult for the strategist or experts to explain) can lead to very different conclusions about their legitimacy.

The potential for a regulatory dragnet directed against spoofing catching legitimate strategies by mistake is probably the greatest near-term concern that traders should have, because such a dragnet is underway. But the widespread misunderstanding and suspicion of HFT more generally means that over the medium to long term, the scope of the Clayton Rule may expand dramatically.

This is particularly worrisome given that suspected offenders are at risk to criminal charges. This dramatic escalation in the stakes raises compliance costs because every inquiry, even from an exchange, demands a fully-lawyered response. Moreover, it will make firms avoid some perfectly rational strategies that reduce the costs of making markets, thereby reducing liquidity and inflating trading costs for everyone.

The vagueness of the statute and the regulations that derive from it pose a huge risk to HFT firms. The only saving grace is that this vagueness may result in the law being declared unconstitutional and preventing it from being used in criminal prosecutions.

Although he wrote in a non-official capacity, an article by CFTC attorney Gregory Scopino illustrates how expansive regulators may become in their criminalization of HFT strategies. In a Connecticut Law Review article, Scopino questions the legality of “high-speed ‘pinging’ and ‘front running’ in futures markets.” It’s frightening to watch him stretch the concepts of fraud and “deceptive contrivance or device” to cover a variety of defensible practices which he seems not to understand.

In particular, he is very exercised by “pinging”, that is, the submission of small orders in an attempt to detect large orders. As remarkable as it might sound, his understanding of this seems to be even more limited than Michael Lewis’s: see Peter Kovac’s demolition of Lewis in his Not so Fast.

When there is hidden liquidity (due to non-displayed orders or iceberg orders), it makes perfect sense for traders to attempt to learn about market depth. This can be valuable information for liquidity providers, who get to know about competitive conditions in the market and can gauge better the potential profitability of supply ing liquidity. It can also be valuable to informed strategic traders, whose optimal trading strategy depends on market depth (as Pete Kyle showed more than 30 years ago): see a nice paper by Clark-Joseph on such “exploratory trading”, which sadly has been misrepresented by many (including Lewis and Scopino) to mean that HFT firms front run, a conclusion that Clark-Joseph explicitly denies. To call either of these strategies front running, or deem them deceptive or fraudulent is disturbing, to say the least.

Scopino and other critics of HFT also criticize the alleged practice of order anticipation, whereby a trader infers the existence of a large order being executed in pieces as soon as the first pieces trade. I say alleged, because as Kovac points out, the noisiness of order flow sharply limits the ability to detect a large latent order on the basis of a few trades.

What’s more, as I wrote in some posts on HFT just about a year ago, and in a piece in the Journal of Applied Corporate Finance, it’s by no means clear that order anticipation is inefficient, due to the equivocal nature of informed trading. Informed trading reduces liquidity, making it particularly perverse that Scopino wants to treat order anticipation as a form of insider trading (i.e., trading on non-public information). Talk about getting things totally backwards: this would criminalize a type of trading that actually impedes liquidity-reducing informed trading. Maybe there’s a planet on which that makes sense, but its sky ain’t blue.

Fortunately, these are now just gleams in an ambitious attorney’s eye. But from such gleams often come regulatory progeny. Indeed, since there is a strong and vocal constituency to impede HFT, the political economy of regulation tends to favor such an outcome. Regulators gonna regulate, especially when importuned by interested parties. Look no further than the net neutrality debacle.

In sum, the Clayton Rule has been around for the good part of a century, but I fear we ain’t seen nothing yet. HFT doesn’t suit a lot of people, often because of ignorance or self-interest, and as Mr. Clayton observed so long ago, it’s a short step from that to an accusation of manipulation. Regulators armed with broad, vague, and elastic authority (and things don’t get much broader, vaguer, or more elastic than “deceptive contrivance or device”) pose a great danger of running amok and impairing market performance in the name of improving it.

[cpirrong]

As An Oil Market Analyst, Mullet Man Igor Sechin Makes a Better KGB Agent

Igor Sechin, he of the ape drape, has taken to the pages of the Financial Times to diagnose the causes of the recent collapse in oil prices. I am sure you will be  shocked to learn that it is those damned speculators:

In today’s distorted oil markets, prices do not reflect reality. They are driven instead by financial speculation, which outweighs the real-life factors of supply and demand. Financial markets tend to produce economic bubbles, and those bubbles tend to burst. Remember the dotcom bust and the subprime mortgage crisis? Furthermore, they are prone to manipulation. We have not forgotten the rigging of the Libor interest rate benchmark and the gold price.

. . . .

Financial bubbles, market manipulations, excessive regulation, regional disparities — so grotesque are these distortions that you might question whether there is any such thing as an oil “market” at all. There is the semblance of a market: buyers and sellers and prices. But they are performing a charade.

What is to be done? First, financial players should no longer be allowed to have such a big influence on the price of oil. In the US, Senators Carl Levin and John McCain have called for steps to prevent price manipulation, though whether they will be implemented, and when, remains an open question.

In any case, the authorities should go further, ensuring that at least 10 or 15 per cent of oil trades involve actually delivering some physical oil. At present almost all “oil trades” are conducted by financial traders, who exchange nothing but electronic tokens or pieces of paper.

No, condemnations of speculation are not the last refuge of scoundrels attempting to assign blame for sharp movements in commodity prices: they are the first and only refuge. Prices going up? Speculators! Prices going down? Speculators! Poor, poor little companies like doughty Rosneft and even international cartels like OPEC are mere straws at the tossed before the speculative gales.

Sechin's broadside is refreshingly untainted by anything resembling actual evidence. The closest he comes is to invoke long run considerations, relating to the costs of drilling new wells. But supply and demand are both very inelastic in the short run, meaning that even modest demand or supply shocks can have large price impacts that cause prices to deviate substantially from long run equilibrium values driven by long run average costs.

It is also hard to discern a credible mechanism whereby diffuse and numerous financial speculators could cause prices to be artificially low for a considerable period of time. (It is straightforward to construct models of how a local market can be manipulated downwards, but these are implausible for a global market. Moreover as I showed years ago, markets that are vulnerable to upward manipulation by longs are relatively invulnerable to downward manipulation by shorts.)

And the empirical implications of any such artificiality are sharply inconsistent with what we observe now. Artificially low prices would induce excessive consumption, which would in turn result in a drawdown in inventories. This is the exact opposite of what we see now. Inventories are growing rapidly in the US in particular (where we have the best data). There are projections that Cushing storage capacity will be filled by May. Internationally, traders are leasing supertankers to store oil. These are classic effects of demand declines or supply increases or both that are expected to be transient.

Insofar as requiring some percentage of oil contracts (by which I presume he means futures and swaps) be satisfied by delivery, the mere threat of delivery ties futures prices to physical market fundamentals at contract expiration. What's more, the fact that paper traders are largely out of the market when contracts go spot means that they cannot directly affect the supply or demand for the physical commodity.

Sechin's FT piece is based on a presentation he gave at International Petroleum Week. Rosneft thoughtfully, though rather stupidly given the content, posted Sechin's remarks and slides on its website. It makes for some rather amusing reading. Apparently shale oil companies are like dotcoms, and shale oil was a bubble. According to Igor, US shale producers are overvalued. His evidence? A comparison of EOG and Hess to Lukoil. The market cap of the EOG is substantially higher than Lukoils, despite its lower reserves and production, and lack of refining operations. Therefore: Bubble! Overvaluation!

Gee, I wonder if the fact that Lukoil is a Russian company, and that Russian company valuations are substantially below those of international competitors, regardless of the industry, has anything to do with it? In fact, it has everything to do with it. Sechin's comparison of a US company with a Russian one points out vividly the baleful consequences of Russia's lawless business climate. It's not that EOG and other shale producers are bubbles: it's that Lukoil (and other Russian companies) are black holes.  (It was the very fact that Russia's lack of property rights, the rule of law, and other institutional supports of a market economy that got me interested in looking at the country in detail in the first place almost a decade ago.)

I was also amused by Sechin's ringing call for greater transparency in the energy industry. This coming from the CEO of one of the most opaque companies in the most opaque countries in the world.

Reading anything by Sechin purporting to be an objective analysis of markets or market conditions is always good for a chuckle. His FT oped and IPW remarks are no exception. As a market analyst, he makes a better KGB operative. Enjoy!

[cpirrong]

When It Comes to Oil, the "I" in BIS is Superfluous

The Bank for International Settlements  is creating some waves with a teaser about a forthcoming report that claims to show that financialization is largely responsible for the recent fall in oil prices. Even by the standards of argument usually seen criticizing financializaton, this one is particularly lame.

BIS notes that the upstream business is heavily leveraged: "The greater debt burden of the oil sector may have influenced the recent dynamics of the oil market by exposing producers to solvency and liquidity risks." The BIS summarizes the well-known fact that yields on oil company bonds have skyrocketed, and claims that this has contributed to the price decline. But it is plainly obvious that cause and effect overwhelmingly goes the other way: it is the sharp decline in prices that damaged the financial conditions of E&P firms. The closest that BIS can come to showing the direction of causation going from debt to price is this: "Debt service requirements may induce continued physical production of oil to maintain cash flows, delaying the reduction in supply in the market."

At most, this means that future output may be higher in the future than it would have been had these firms been less leveraged, thereby weighing on future prices and through inter temporal linkages (e.g., storage) on current prices. It is difficult indeed to attribute the earlier price declines that caused the financial distress to this effect. Moreover, the BIS suggests that oil output from existing wells can be turned off like a water faucet. Given that the costs of capping a well are not trivial, this is not true: except under rather extreme circumstances, producers will continue to operate wells (which flow at an exogenously determined rate) even when prices fall substantially. Thus, this channel is not a plausible contributor to an appreciable fraction of the 50 percent decline in prices since July.

Then BIS turns its attention to hedging:

Since 2010, oil producers have increasingly relied on swap dealers as counterparties for their hedging transactions. In turn, swap dealers have laid off their exposures on the futures market as suggested by the trend increase in the CFTC short futures positions of swap dealers over the 2009-13 period.

However, at times of heightened volatility and balance sheet strain for leveraged entities, swap dealers may become less willing to sell protection to oil producers. The co-movement in the dealers' positions and bouts of volatility suggests that dealers may have behaved procyclically - cutting back positions whenever financial conditions become more turbulent. In Graph 2, three such episodes can be seen: the onset of the Great Recession in 2008, the euro area crisis combined with the war in Libya in 2011, and the recent price slump. In response to greater reluctance by dealers to take the other side of sales, producers wishing to hedge their falling revenues may have turned to the derivatives markets directly, without going through an intermediary. This shift in the liquidity of hedging markets could have played a role in recent price dynamics.

BIS's conjecture regarding producers hedging directly can be tested directly. The CFTC Commitment of Traders data, which BIS relies on, also includes a "Producers, Merchants, Processors and Users" category. If BIS is correct and producers have gone to the futures market directly rather than hedged through dealers, PMPU short interest should have ticked up. So why they are guessing rather than looking at the data is beyond me.

What's more, using declines in swap dealer futures positions to infer pro-cyclicality seems rather odd. Swap dealer futures hedges of swap positions means that they are not taking on a lot of risk to the balance sheet. That is the risk that is being passed on to the futures market, not the risk that is being kept on the balance sheet.

The decline in swap dealer short futures positions more likely reflects a reduced hedging demand by producers. For instance, at present we are seeing a sharp drop in drilling activity in the US, which means that there is less future production to hedge and hence less hedging activity. The fact that the decline in swap dealer short futures is much more pronounced now than in 2008-2009 is consistent with that, as is the big rise in these positions during the shale boom starting in 2009. This is exactly what you'd expect if hedging demand is driven primarily by E&P companies in the US. Regardless, the BIS release does not disclose any rigorous analysis of what drives swap dealer positions or hedging positions overall, so the "reluctance of dealers" argument is at best an untested hypothesis, and more likely a wild-assed guess. Using drilling activity, or capex, or E&P company borrowing as control variables would help quantify what is really driving hedging activity.

And the conclusion is totally inane: "This [unproven] shift in the liquidity of hedging markets could have played a role in recent price dynamics." Well, maybe. But maybe the fact that the moon will be in the seventh house on Valentine's Day could have played a role too. Seriously: what is the mechanism by which this (unproven) shift in liquidity in hedging markets affected price dynamics?

Further, if E&P company balance sheet woes are making it harder for them to find hedge counterparties, this would impair their ability to fund new drilling, and tend to support prices. This would offset the alleged we've-got-to-keep-pumping-to-pay-the-bills effect.

BIS also offers this pearl of wisdom:

Rather, the steepness of the price decline and very large day-to-day price changes are reminiscent of a financial asset. As with other financial assets, movements in the price of oil are driven by changes in expectations about future market conditions.

What, commodities have not previously been subject to large price moves and high volatility? Who knew? I'll bet if I dug for a while I could find BIS studies casting doubt on the prudence of bank participation commodity markets because the things are so damned volatile. And what accounts for the extremely low volatility in the first half of 2014, something BIS itself documented? Is financialization that fickle?

Moreover, why shouldn't oil prices be driven by changes in expectations about future market conditions? It's a storable commodity (both above and below ground), and storage links the present with the future. Furthermore, investments today affect future production. Current decisions and hence current prices should reflect expected future conditions precisely because of the inter-temporal nature of production and consumption decisions.

In fact, oil is not a financial asset, properly understood. The fact that the oil market goes into backwardation is sufficient to demonstrate that point. But it is hardly a sign of inefficiency, or of a lamentable corruption of the oil markets by the presence of financial players, that expectations of future conditions affect current prices. In fact, it would be inefficient if expectations did not affect current prices.

I understand that what the BIS just put out is only a synopsis of a more complete analysis that will be released next month. Maybe the complete paper will be an improvement on what they've released so far. (It would have to be.) But that just raises another problem.

Research by press release is a lamentable practice, but one that is increasingly common. Release the entire paper along with the synopsis, or just shut up until you do. BIS is getting a big splash with its selective disclosure of its purported results, while making it impossible to evaluate the quality of the research. The impression has been created, and by the time March rolls around and the paper is released it will be much harder to challenge that established impression by pointing out flaws in the analysis: that's much more easily done at the time of the initial announcement when minds are open. This is the wrong way to conduct research, especially on policy-relevant issues.

Update: I had a moment to review the CFTC COT data. It does not support the BIS's claim of a shift from dealer-intermediated hedging to direct hedging. From its peak on 1 July, 2014 to the end of 2014, Open interest in the NYMEX WTI contract fell from 1.78 million contracts to 1.46 million, or 18 percent. PMPU short positions fell from 352K to 270K contracts, or about 24 percent. Swap dealer shorts fell from 502K to 326K, or about 36 percent. Thus, it appears that the fall in short commercial positions were broad-based. Given that PMPU positions include merchants hedging inventories (which have been rising as prices have been falling) not too much can be made of the smaller proportional decline in PMPU positions vs. swap dealer positions. Similarly, dealer shorts include are hedges of swaps done with hedge funds, index funds, and others, and hence are not a clean measure of the amount of hedging done by producers via swaps.

I am also skeptical whether producers who can no longer find a bank to sell them a swap can readily switch to direct hedging. One of the advantages of entering into a swap is that it often has less stringent margining than futures. How can cash-flow stressed producers fund the margins and potential margin calls?

[cpirrong]

Obama Bigfoots Net Neutrality: Wasn't Screwing Up Health Care Enough of a Legacy?

Last week the Chairman of the Federal Communications System announced that the FCC will pursue net neutrality regulation by subjecting the Internet to Title II of the Federal Cable and Telecommunications Act. This will essentially treat the Internet as a utility, rather than as an information service as has been the case since 1996. Like telecoms, Internet Service Providers would effectively become common carriers subject to a panopoly of restrictions on the prices they can charge and their ability to control access to their infrastructures.

The issue is an extremely complex one, and moreover, one that has been subjected to a barrage of simplistic, propagandistic, rhetoric. To cut through the rhetoric to see the economics, I recommend this article by Gary Becker, Dennis Carlton, and Hal Sider.

Becker, Carlton, and Hal characterize the goals of net neutrality as follows:

In the FCC’s view, its proposed net neutrality rules would “prohibit a broadband Internet access provider from discriminating against, or in favor of, any content, application or service.” Broadband access providers would be prohibited from: (1) prioritizing traffic and charging differential prices based on the priority status; (2) imposing congestion-related charges; (3) adopting business models that offer exclusive content or that establish exclu- sive relationships with particular content providers; and (4) charging content providers to access the Internet based on factors other than the bandwidth supplied. [References omitted.]

In a nutshell, NN rules and Title II would limit the pricing policies of ISPs, limit their ability to regulate access to their networks, and limit their ability to vertically integrate upstream or downstream (e.g., by purchasing content providers).

The motivation for all of this is a belief that the broadband industry is not competitive, and that price discrimination, access limitations, and vertical integration are means of exercising market power to the detriment of consumers downstream and suppliers of content upstream.

As Becker et al point out, however, evidence that competition is weak is lacking. Most consumers have choices of broadband providers, and the development of wireless services such as 4G is increasing consumer choice.  (Personally, I would estimate that I have gone from relying 100 percent on wired access to 50 percent wired-50 percent wireless. The focus of Facebook and other social media and content suppliers on mobile indicates how important wireless is becoming.) Moreover, there is considerable switching of suppliers, which is further indication of competition.

Further, as a general matter, price discrimination is often-one might say usually-welfare enhancing when there products are differentiated and the costs of these products differ. Different forms of content utilize different amounts of bandwidth. Services vary in their need for speed (e.g., streaming vs. ordinary web-browsing vs. email). It is more costly to deliver bandwidth-intensive services. Limiting the ability to charge prices that reflect differences in cost and value lead to misallocations in the use of existing bandwidth capacity, and tend to reduce incentives to invest in capacity. Moreover, the "two-sided" nature of the Internet tends to make price discrimination welfare-improving. (This paper by Weismen and Kulick makes the very useful distinction between "differential pricing" and "price discrimination." The former is based on differences in cost, the latter on differences in demand elasticity across customers.) In addition, when there are strong economies of scale, price discrimination (e.g., Ramsey pricing) can be a first-best or second-best way of allowing producers to cover fixed costs.

Put differently, net neutrality/common carrier access treats the internet as a commons which limits the use of prices to allocate scarce resources. Yes there can be cases in which this is beneficial (as in a textbook natural monopoly, but sometimes not even then), but suppressing the price system and price signals is usually a horrible idea. The rebuttable presumption should be that we rely more, not less, on prices to allocate scarce resources and provide incentives to consume, produce, and invest. Net neutrality betrays a strong animus to the price system and the use of prices to allocate resources.

Vertical arrangements are also frequently looked on with deep suspicion. I wrote about this a lot in the context of exchange ownership of clearing some years ago. But usually vertical arrangements, including restrictive contracts and vertical integration, are contractual means to address inefficiencies in price competition. They are typically ways of internalizing externalities or constraining opportunistic behavior. Moreover, they are often particularly important in information-intensive goods, because of the difficulties of enforcing property rights in information and the pervasiveness of free riding on information goods.

Some of the horror stories NN advocates tell involve an ISP denying access to a service or content downstream consumers value high: usually the story involves a small startup proving a bandwidth intensive service that can't afford to pay premium access charges. But in a world where venture capital and other forms of funding is constantly on the lookout for the next big thing, these concerns seem vastly overblown. Moreover, permitting ISPs to own content providers is one way of addressing this issue. The demand for ISP services is derived from the value customers get from the content and services an ISP delivers. It is self-defeating for them to exclude truly valuable content because it reduces demand, and they have incentives to structure pricing and terms of access and vertical arrangements with content providers to maximize value. If there are gains from trade, in a reasonably competitive market there are strong forces pushing entities at all segments of the value chain to reap those gains.

Suppressing price signals and limiting the ability to craft creative arrangements to capture gains from trade are bad ideas, except under exceptional circumstances. So color me deeply skeptical on NN. Other features inherent in intrusive regulatory systems like Title II due to public choice considerations only deepen that skepticism. Such systems are extremely conducive to rent seeking. Though usually sold as ways to enhance competition, in practice they are typically exploited by incumbents to restrict competition. They tend to be strongly biased against innovation-precisely because much innovation of the creative destruction variety is intensely threatening to incumbents who have an advantage in influencing regulators. Classical Peltzman-Becker models of regulation show that regulators have an incentive to suppress cost-justified price differentials in order to redistribute rents, thereby creating distortions.

Other than that, NN and Title II are great.

If the substance isn't bad enough, the process is even worse. FCC Chairman Tom Wheeler was originally leaning towards a less intrusive approach to net neutrality that would avoid dropping the Title II bomb. But Obama orchestrated a campaign behind the scenes to pressure an ostensibly independent agency to go all medieval (or at least all New Deal) on the Internet. Obama added to the backstage pressure with a very public call for intrusive regulation that put Wheeler and the other two Democrats on the Commission in an impossible position. (Another illustration of the consequences of Presidential elections: it's not just the commander that matters, but the anonymous foot soldiers and the camp followers too.)

Yes, part of Obama's insistence reflected his beliefs: after all, he is a big government control freak. And yes, part reflects the fact that some of his biggest supporters and donors are rabid NN supporters-primarily because they will benefit if they don't have to pay the full cost that they impose.

But what convinced Obama to make this a priority was his personal vanity and his determination to engage in political warfare by pursuing initiatives that he can implement unilaterally without Congressional involvement. Read this and weep:

While Obama administration officials were warming to the idea of calling for tougher rules, it took the November elections to sway Mr. Obama into action.

After Republicans gained their Senate majority, Mr. Obama took a number of actions to go around Congress, including a unilateral move to ease immigration rules. Senior aides also began looking for issues that would help define the president’s legacy. Net neutrality seemed like a good fit. Soon, Mr. Zients paid his visit to the FCC to let Mr. Wheeler know the president would make a statement on high-speed Internet regulation. Messrs. Zients and Wheeler didn’t discuss the details, according to Mr. Wheeler. Mr. Obama made them clear in a 1,062-word statement and two-minute video. He told the FCC to regulate mobile and fixed broadband providers more strictly and enact strong rules to prevent those providers from altering download speeds for specific websites or services. In the video, Mr. Obama said his stance was confirmation of a long-standing commitment to net neutrality. The statement boxed in Mr. Wheeler by giving the FCC’s two other Democratic commissioners cover to vote against anything falling short of Mr. Obama’s position. That essentially killed the compromise proposed by Mr. Wheeler, leaving him no choice but to follow the path outlined by the president.

Read this again: "Senior aides also began looking for issues that would help define the president’s legacy. Net neutrality seemed like a good fit." So to achieve a legacy, the Narcissist in Chief decides to interfere with the most successful, innovative industry of the past half-century, and perhaps ever.

What, screwing up the health care industry isn't enough of a legacy?

I guess not. No price is to high to pay to stick it to the evil Republicans. And if you get stuck too, well, omelet, eggs, and all that. You are expendable when there's a legacy at stake.

What comes out of the FCC as a result of Obama's arm-twisting will be a beginning, not an end. It will no doubt set off a flurry of legal challenges.(Among lawyers and lobbyists, as always in such things, there is much rejoicing.)  Congress may get involved, and although Obama can block anything for the next two years, it  may take longer than that to finalize the rules (look at how long it is taking to get a simple-by-comparison position limit rule through the CFTC), and a new president in 2017 might not be so enamored with burnishing Barry's legacy. Well, one can hope, can't one? Looking for silver linings here.

I had thought that old school Progressive and New Deal style regulation had been largely discredited in the 70s and 80s. Indeed, Democrats (including Carter and Ted Kennedy) played vital roles in dismantling regulations in transportation in particular. But Obama is going all back to the future, and attempting to impose a regulatory paradigm that was all the rage when men all wore fedoras to what is arguably the most dynamic and innovative industry ever. Because, legacy.