Information asymmetry, bad incentives and Taibbi
Izabella Kaminska
Feb 14 10:40
Alert, alert! Matt Taibbi of Vampire Squid fame has discovered contango in a five-page mega opus for Rolling Stone magazine, in which he blames all the usual names for crimes against markets, people and everything good in the world. It’s also a running continuation of his “everything is rigged” theme.
But it’s a terribly nauseating read for anyone following the story since 2008.
First off, Taibbi turns out to be a dependable repackager of other people’s stories. Facts and ideas unearthed by others are borrowed and twisted until they fit his own version of reality (often without citation or attribution). Case in point, the “vampire squid” description is surprisingly similar to popular writer ‘Coin’ Harvey’s 1894 description of the Rothschild bank as a black octopus stretching its tentacles around the world.
True, Taibbi never claimed to have come up with the term himself and perhaps it is just a coincidence, but one can’t deny he’s benefited immensely from borrowing it and applying it to Goldman Sachs.
But let’s move on to the latest opus, in which — amongst other things — Taibbi unearths the sensational news that banks and trading companies respond to contango incentives, own physical assets and use the information derived from these assets for their own financial gain.
Now, we’ve covered the “contango” trade and physical loophole story ad nauseum, and can probably be accused of sensationalism ourselves. But we’d argue there is a difference in our coverage. We have never for one minute suggested that these trades represent illegal activity. Our focus was not to denounce crooks, but rather to inform the market of what goes on. This is to breakdown the information asymmetry which ends up favouring some parties over others, i.e. to figure out their strategies, expose them and allow the market to factor that information in.
The point is to help outsiders learn how the markets operate so that they can make wiser decisions and realise the information disadvantage they’re up against. It’s all a bit like the Krypton Factor, a giant puzzle that needs solving and figuring out in the name of efficient markets. The more pieces of the puzzle you hold, the more likely you are to see the big picture.
It’s entirely farcical to suggest, however, that those who operate in physical markets should either give up all their information to the public voluntarily (as per equity insider trading rules) or construct Chinese walls that separate physical asset management from marketing and hedging. Protecting your economic edge/advantage is capitalism.
Given their fiduciary duties, banks are potentially a different story. And Taibbi’s biggest focus is on the conflict presented by banks that own physical assets. But none of that changes the fact that neither Goldman Sachs or Morgan Stanley broke any rules or laws when they bought up physical assets in the last decade or so.
Yes, regulators are now focusing on potential conflicts and amending legislation accordingly. But that banks exploited a loophole while it existed, is hardly evidence of market abuse. It’s simply a case of some operators being smarter than others, knowing how to gain advantage in a free market where information is king.
As we noted on Thursday, information asymmetry is always to be expected in a free-market. This is because market participants will inevitably use capacity, inventory and privileged information flow to anticipate or influence prices. Setting up barriers to market entry is the natural free-market way of defending one’s market position.
Yet, if you believe in the miraculous self-correcting force of the free market — in which acting according to your own interests results in a cybernetic balance of wonderfulness for everyone — you must acknowledge that preventing these entities from using their own assets for trading advantage constitutes an attempt to rein in that very same force by means of government intervention, rule and/or regulation.
Taibbi’s real beef is with the free market system itself. What’s strange is that he accuses banks of acting anti-capitalistically, when it’s precisely the opposite situation. In his world competition is fine — but only so long as those who turn out to be good at it — either due to superior intelligence, cunning or muscle — don’t end up dominating.
As it happens, we don’t disagree. A civilised society is certainly one that represents and protects everyone, irrespective of their physical or mental faculties — and that means containing overly powerful interests.
But, at the same time, you’re either a free market radical who believes in the self-correcting power of markets and capitalism or you’re not. If you’re not, then you must conversely agree there is room in the market for an even more powerful entity — the government, acting on behalf of the people — which can rein the private powers that get too big, and rig markets in the people’s interests instead.
If that’s the case, you shouldn’t then go around (as Tabbi does) complaining that government initiatives like QE — which at heart are focused on diluting power and market concentration by keeping credit circulating and bank lending going — represent too much government intervention.
The fact that banks don’t want to lend despite the QE subsidy being given to them in the people’s interest, is another matter entirely.
With respect to control and monopolisation Taibbi says:
We disagree. Banks operate according to incentives. Always have done and always will. Currently — due to abundance, technological efficiency, ‘secular stagnation’ et cetera — banks have less of an incentive to lend (and in so doing add to productivity and resources) and more of an interest to facilitate business for those who monopolise resources and restrict production by cornering markets.
That doesn’t mean they’re necessarily doing the cornering or restricting themselves. Taibbi, for example, makes the mistake of taking the New York Times article about Goldman Sachs warehouse queues at face value when it’s been fairly well established that it was never the case that the bank was systematically delaying delivery of metals in order to jack up rents, but rather that the queues resulted from market dynamics, which currently favour the shuffling of inventory in and out of warehouses. GS would gain from warehouse fees either way, but the key motivation for the bank has always been the spread it can earn on the respective deals it facilitates for its clients, not the rents per se.
Traditionally, of course, banks have earned spreads by directing capital to the building of new capital. But now the economic environment is different. It is the economy which provides the incentives to direct capital to deals that encumber, repress or monopolise capital. Banks are just responding accordingly.
This is isn’t because banks are evil per se, but rather that their raison d’etre is challenged by a surplus of capital in the world. A world without returns to capital is a world that doesn’t need conventional banking. By definition, that world turns previously economically stimulating institutions into economic pariahs, ones that need different sources of revenue to survive.
That banks end up providing services to those who corner or suppress abundant capital or resources is hardly surprising, since this creates the illusion of a need for their primary business. The only alternative would be to admit society doesn’t need them anymore and that their model is redundant.
But that would be akin to a world so healthy that doctors are no longer needed — but where doctors realise they instead have an incentive to make people sick on purpose to stay in businesses. Better still if they can suppress the information that society would now be better off without them. No, it’s not ethical. But it is a practice that tallies with free market incentives.
Which, as it happens, is the overall problem with abundance. The only way you can make money in such a world — according to the old rules anyway — is by acting unethically and against social interests. This is because the incentive now is to detract from society, to repress information, to hurt your kin, to make things artificially scarce or once again falsely inefficient.
But what should be understood is that this incentive applies to everyone, not just banks. Even if we stop banks from owning physical commodities, this won’t stop other institutions from responding to the same incentives. Which is why it’s much less of a “Wall Street scam” than Taibbi likes to make it out to be. Small surprise, recent LME rules to force quicker load-out rates have failed to make a difference to premiums. It is only when the dynamics no longer favour the destruction of capital that all these players will forge capital once again.
Meanwhile, because banks act as intermediaries or swap providers to the industry rather than direct players, it isn’t entirely illogical that they be allowed to trade on exchanges despite their warehouse interests. When they trade, they’re acting as swap dealers (and on client behalf), and when they own metal, they own it as custodians.
Taibbi, however, is most offended by JP Morgan’s Blythe Mathers point that owning physical commodity assets allows banks to understand and make better prices. Or as he puts it:
Yes, Matt, banks do “make” prices. That’s the whole point of market-making and intermediation. More specifically, that’s the whole point of banks in commodities. It is the job of banks to offset risk between physical players who need hedges to protect against price declines and market speculators who are prepared to take the opposite view. If they don’t know what the real fundamentals are they can end up taking much more risk than they should, and having to weather the losses themselves.
And given the incentives already outlined above for producers to curb, hoard, monopolise or repress production at the moment, banks have every incentive to encourage inventory to concentrate in zones they can observe and understand, so that they can offer prices that represent the physical reality as opposed to the over-inflated expectations of financial speculators who don’t see what’s going on.
Funnier still, however, is the following comment:
Again, not what happened. As stated already, the delays were not intentional but the product of market-motivated shuffles and economic conditions, while the rebates were motivated by financing deals, i.e. contango trades. That means the metal was being sourced to meet offsetting speculator demand, and funded by those speculators as a result. (It was definitely not anti-capitalistic either.)
As we’ve noted many times before, it is the shape of the curve that plays the key role here. If the curve is in contango it pays producers to produce, irrespective of whether that production is heading towards hoards or industrial consumption.
A producer can always exploit that pricing dynamic by hedging today’s supply forward, and carrying the supply over until the deal settles. The only downside is that the trade takes time to complete, and sits on your balance sheet for the duration of the period. In other words, you’re locked in until the future expires, or until you can liquidate the trade at a profit. What a bank like Goldman Sachs offers is the opportunity to take advantage of the market conditions, but have the trade financed at an effective negative rate.
This frees up a producer’s balance sheet and allows them to consider the inventory as good as sold.
The trade is a no-brainer for the likes of Goldman because of its hedged nature. As long as the cost of Goldman’s financing or storage doesn’t change (unlikely if it owns the warehouse), it knows the spread it has captured can be guaranteed, providing the inventory is held to expiry.
In that sense, warehouse ownership gives the bank a competitive edge on the negative rate it can offer to the producer to attract his business. Business it needs to service the demands of the speculative investor market it also represents, which at the moment — all inventory considered — is overpaying for exposure to metals, and creating the skewed incentives at play.
The fact that the market is providing these incentives is not Goldman’s or the producer’s fault. They’re only responding as per the rules of capitalism. The fault — if any — lies with the economy’s current structure and the zero rate environment which creates the skewed incentives in the first place.
But reading Taibbi you would never know that unfortunately.
But it’s a terribly nauseating read for anyone following the story since 2008.
First off, Taibbi turns out to be a dependable repackager of other people’s stories. Facts and ideas unearthed by others are borrowed and twisted until they fit his own version of reality (often without citation or attribution). Case in point, the “vampire squid” description is surprisingly similar to popular writer ‘Coin’ Harvey’s 1894 description of the Rothschild bank as a black octopus stretching its tentacles around the world.
True, Taibbi never claimed to have come up with the term himself and perhaps it is just a coincidence, but one can’t deny he’s benefited immensely from borrowing it and applying it to Goldman Sachs.
But let’s move on to the latest opus, in which — amongst other things — Taibbi unearths the sensational news that banks and trading companies respond to contango incentives, own physical assets and use the information derived from these assets for their own financial gain.
Now, we’ve covered the “contango” trade and physical loophole story ad nauseum, and can probably be accused of sensationalism ourselves. But we’d argue there is a difference in our coverage. We have never for one minute suggested that these trades represent illegal activity. Our focus was not to denounce crooks, but rather to inform the market of what goes on. This is to breakdown the information asymmetry which ends up favouring some parties over others, i.e. to figure out their strategies, expose them and allow the market to factor that information in.
The point is to help outsiders learn how the markets operate so that they can make wiser decisions and realise the information disadvantage they’re up against. It’s all a bit like the Krypton Factor, a giant puzzle that needs solving and figuring out in the name of efficient markets. The more pieces of the puzzle you hold, the more likely you are to see the big picture.
It’s entirely farcical to suggest, however, that those who operate in physical markets should either give up all their information to the public voluntarily (as per equity insider trading rules) or construct Chinese walls that separate physical asset management from marketing and hedging. Protecting your economic edge/advantage is capitalism.
Given their fiduciary duties, banks are potentially a different story. And Taibbi’s biggest focus is on the conflict presented by banks that own physical assets. But none of that changes the fact that neither Goldman Sachs or Morgan Stanley broke any rules or laws when they bought up physical assets in the last decade or so.
Yes, regulators are now focusing on potential conflicts and amending legislation accordingly. But that banks exploited a loophole while it existed, is hardly evidence of market abuse. It’s simply a case of some operators being smarter than others, knowing how to gain advantage in a free market where information is king.
As we noted on Thursday, information asymmetry is always to be expected in a free-market. This is because market participants will inevitably use capacity, inventory and privileged information flow to anticipate or influence prices. Setting up barriers to market entry is the natural free-market way of defending one’s market position.
Yet, if you believe in the miraculous self-correcting force of the free market — in which acting according to your own interests results in a cybernetic balance of wonderfulness for everyone — you must acknowledge that preventing these entities from using their own assets for trading advantage constitutes an attempt to rein in that very same force by means of government intervention, rule and/or regulation.
Taibbi’s real beef is with the free market system itself. What’s strange is that he accuses banks of acting anti-capitalistically, when it’s precisely the opposite situation. In his world competition is fine — but only so long as those who turn out to be good at it — either due to superior intelligence, cunning or muscle — don’t end up dominating.
As it happens, we don’t disagree. A civilised society is certainly one that represents and protects everyone, irrespective of their physical or mental faculties — and that means containing overly powerful interests.
But, at the same time, you’re either a free market radical who believes in the self-correcting power of markets and capitalism or you’re not. If you’re not, then you must conversely agree there is room in the market for an even more powerful entity — the government, acting on behalf of the people — which can rein the private powers that get too big, and rig markets in the people’s interests instead.
If that’s the case, you shouldn’t then go around (as Tabbi does) complaining that government initiatives like QE — which at heart are focused on diluting power and market concentration by keeping credit circulating and bank lending going — represent too much government intervention.
The fact that banks don’t want to lend despite the QE subsidy being given to them in the people’s interest, is another matter entirely.
With respect to control and monopolisation Taibbi says:
But banks aren’t just buying stuff, they’re buying whole industrial processes. They’re buying oil that’s still in the ground, the tankers that move it across the sea, the refineries that turn it into fuel, and the pipelines that bring it to your home. Then, just for kicks, they’re also betting on the timing and efficiency of these same industrial processes in the financial markets – buying and selling oil stocks on the stock exchange, oil futures on the futures market, swaps on the swaps market, etc. Allowing one company to control the supply of crucial physical commodities, and also trade in the financial products that might be related to those markets, is an open invitation to commit mass manipulation. It’s something akin to letting casino owners who take book on NFL games during the week also coach all the teams on Sundays.
We disagree. Banks operate according to incentives. Always have done and always will. Currently — due to abundance, technological efficiency, ‘secular stagnation’ et cetera — banks have less of an incentive to lend (and in so doing add to productivity and resources) and more of an interest to facilitate business for those who monopolise resources and restrict production by cornering markets.
That doesn’t mean they’re necessarily doing the cornering or restricting themselves. Taibbi, for example, makes the mistake of taking the New York Times article about Goldman Sachs warehouse queues at face value when it’s been fairly well established that it was never the case that the bank was systematically delaying delivery of metals in order to jack up rents, but rather that the queues resulted from market dynamics, which currently favour the shuffling of inventory in and out of warehouses. GS would gain from warehouse fees either way, but the key motivation for the bank has always been the spread it can earn on the respective deals it facilitates for its clients, not the rents per se.
Traditionally, of course, banks have earned spreads by directing capital to the building of new capital. But now the economic environment is different. It is the economy which provides the incentives to direct capital to deals that encumber, repress or monopolise capital. Banks are just responding accordingly.
This is isn’t because banks are evil per se, but rather that their raison d’etre is challenged by a surplus of capital in the world. A world without returns to capital is a world that doesn’t need conventional banking. By definition, that world turns previously economically stimulating institutions into economic pariahs, ones that need different sources of revenue to survive.
That banks end up providing services to those who corner or suppress abundant capital or resources is hardly surprising, since this creates the illusion of a need for their primary business. The only alternative would be to admit society doesn’t need them anymore and that their model is redundant.
But that would be akin to a world so healthy that doctors are no longer needed — but where doctors realise they instead have an incentive to make people sick on purpose to stay in businesses. Better still if they can suppress the information that society would now be better off without them. No, it’s not ethical. But it is a practice that tallies with free market incentives.
Which, as it happens, is the overall problem with abundance. The only way you can make money in such a world — according to the old rules anyway — is by acting unethically and against social interests. This is because the incentive now is to detract from society, to repress information, to hurt your kin, to make things artificially scarce or once again falsely inefficient.
But what should be understood is that this incentive applies to everyone, not just banks. Even if we stop banks from owning physical commodities, this won’t stop other institutions from responding to the same incentives. Which is why it’s much less of a “Wall Street scam” than Taibbi likes to make it out to be. Small surprise, recent LME rules to force quicker load-out rates have failed to make a difference to premiums. It is only when the dynamics no longer favour the destruction of capital that all these players will forge capital once again.
Meanwhile, because banks act as intermediaries or swap providers to the industry rather than direct players, it isn’t entirely illogical that they be allowed to trade on exchanges despite their warehouse interests. When they trade, they’re acting as swap dealers (and on client behalf), and when they own metal, they own it as custodians.
Taibbi, however, is most offended by JP Morgan’s Blythe Mathers point that owning physical commodity assets allows banks to understand and make better prices. Or as he puts it:
We need to make prices. The head of Chase’s commodities division actually said this, out loud, and it speaks to both the general unlikelihood of God’s existence and the consistently low level of competence of America’s regulators...
Yes, Matt, banks do “make” prices. That’s the whole point of market-making and intermediation. More specifically, that’s the whole point of banks in commodities. It is the job of banks to offset risk between physical players who need hedges to protect against price declines and market speculators who are prepared to take the opposite view. If they don’t know what the real fundamentals are they can end up taking much more risk than they should, and having to weather the losses themselves.
And given the incentives already outlined above for producers to curb, hoard, monopolise or repress production at the moment, banks have every incentive to encourage inventory to concentrate in zones they can observe and understand, so that they can offer prices that represent the physical reality as opposed to the over-inflated expectations of financial speculators who don’t see what’s going on.
Funnier still, however, is the following comment:
The intentional warehouse delays were just one part of the anti-capitalist game the banks were playing. As an incentive to get metal under their control, they actually paid the industrial producers of aluminum extra cash to store the metal in their warehouses, fees reportedly as much as $230 a metric ton.
Again, not what happened. As stated already, the delays were not intentional but the product of market-motivated shuffles and economic conditions, while the rebates were motivated by financing deals, i.e. contango trades. That means the metal was being sourced to meet offsetting speculator demand, and funded by those speculators as a result. (It was definitely not anti-capitalistic either.)
As we’ve noted many times before, it is the shape of the curve that plays the key role here. If the curve is in contango it pays producers to produce, irrespective of whether that production is heading towards hoards or industrial consumption.
A producer can always exploit that pricing dynamic by hedging today’s supply forward, and carrying the supply over until the deal settles. The only downside is that the trade takes time to complete, and sits on your balance sheet for the duration of the period. In other words, you’re locked in until the future expires, or until you can liquidate the trade at a profit. What a bank like Goldman Sachs offers is the opportunity to take advantage of the market conditions, but have the trade financed at an effective negative rate.
This frees up a producer’s balance sheet and allows them to consider the inventory as good as sold.
The trade is a no-brainer for the likes of Goldman because of its hedged nature. As long as the cost of Goldman’s financing or storage doesn’t change (unlikely if it owns the warehouse), it knows the spread it has captured can be guaranteed, providing the inventory is held to expiry.
In that sense, warehouse ownership gives the bank a competitive edge on the negative rate it can offer to the producer to attract his business. Business it needs to service the demands of the speculative investor market it also represents, which at the moment — all inventory considered — is overpaying for exposure to metals, and creating the skewed incentives at play.
The fact that the market is providing these incentives is not Goldman’s or the producer’s fault. They’re only responding as per the rules of capitalism. The fault — if any — lies with the economy’s current structure and the zero rate environment which creates the skewed incentives in the first place.
But reading Taibbi you would never know that unfortunately.
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