Perspective on Risk - July 10, 2022 (Updates)
Updates on: Emerging Markets; LME Nickel; Home Prices; European Gas; Russia/Ukraine War on Insurance; Crypto
This is just a grab-bag of things I’ve seen related to many of the issues discussed in the past Perspectives. No big thoughts this week.
A key theme runs through many of the issues we are seeing: namely that in the short-term, demand elasticities are much more pronounced than supply elasticities.
Reminder: you can still get an iBond yielding 9.62% risk-free through TreasuryDirect. Pure alpha. You’re leaving money on the table if you don’t grab one.
Emerging Markets Update
Charlene Chu, the highly respected China analyst, recently participated in an Apple podcast, China’s Economy: Evergrande a canary in the coal mine?
Chu concluded that “we are entering an era here where we are going to be looking at low-to-mid single-digit growth in China at best.”
Chu saw little probability of an outright financial crisis, in part because Chinese banks are “very quietly in the background working off a lot of this bad debt,” including 3.1 trillion yuan ($462 billion) in writeoffs last year.
We need to keep in mind the declining demographics in China,” she said. “The working-age population, which is really the property-consuming group, peaked in 2015 at 801 million people and is already down 20 million” since then, she said.1
25 years since the East Asian financial crisis: 2 forgotten lessons Kharas, Brookings
The first lesson is that when economies are built on a faulty foundation, growth is not always beneficial.
The second forgotten lesson from the East Asia crisis is that the onset of debt crises has more to do with weak institutions and low resilience than with debt indicators.
LME Nickel Update
Matt Levine, as usual, has a pithy summary2:
If you are big enough, you get to tell the exchange how much money you’re willing to lose, and the exchange and your banks will make sure you don’t lose more than that.
If FIFTY BANKERS ever arrive at your office all at once, (1) you have done something terrible but (2) it is absolutely their problem, not yours.
Here are some of the details:
Tycoon Whose Bet Broke the Nickel Market Walks Away a Billionaire (Bloomberg)
By 2:08 p.m. Shanghai time on March 8, it was clear that Xiang Guangda’s giant bet on a fall in nickel prices was going spectacularly wrong. … Futures had just skyrocketed above $100,000 a ton and his trade was more than $10 billion underwater.
Xiang … has closed out nearly all his short position in nickel, making a loss on the trade of about $1 billion — a manageable sum given the profits being generated elsewhere in his business empire.
Xiang’s position was spread across about 10 banks and brokers
[H]e had executed his nickel trade through a variety of corporate entities – such as the Hong Kong branch of battery unit Ruipu Energy Co. – and it wasn’t clear the banks would even have the right to seize Tsingshan’s most valuable assets.
Xiang told the assembled bankers he had no intention of closing the position anywhere near $50,000.
[H]e wrote a list of the assets he was willing to put up as collateral: a string of ferronickel plants in Indonesia. … Xiang made a further concession that was both valuable and, in Chinese business culture, humbling: a personal guarantee. In exchange, Xiang agreed a series of price levels at which he would reduce his nickel position once prices dropped below about $30,000.
As with other problems, such as Archegoes, one main problem is not having a good estimate of your counterparties similar positions with other firms.
A second critical point is insuring you trade with, or have a guarantee from, the proper entity.
Home Prices Update
Volatility in Home Sales and Prices: Supply or Demand? (Board of Governors)
[H]ousing demand drives short-run fluctuations in home sales and prices, while variation in supply plays only a limited role. … [W]e show that reduction of supply was a minor factor relative to increased demand in the tightening of housing markets during COVID-19. … [W]e estimate that housing demand is very sensitive to changes in mortgage rates, even more so than comparable estimates for home sales.
For longer-run changes in the housing market, supply may play a much larger role. For example, new supply today also increases supply in the future as today’s buyer eventually sells her new home. Our simulations do not account for such a response as we are focused on the short run, but the accumulation of new supply (including new construction) likely explains more of the variation in sales volume over long horizons.
This should probably fit with your priors that in the short-run demand is more elastic than supply. The key here is that this paper focused on the “short-run fluctuations”
European Gas Market Update
Austria Seizes Gas Storage Space Left Empty by Russia’s Gazprom (Bloomberg)
Austria has started clawing back space at one of Europe’s largest gas depots that mainly serves German industrial users after Gazprom PJSC ignored rules requiring minimum storage levels.
The country’s industry regulator, E-control, started the process for assuming control over the underground Haidach site using a law which entered into force this month that allows Austria to seize critical storage spaces if operators fail to fill them to at least 10% of capacity.
Uniper, Germany’s largest gas importer, asks for government bailout. (NY Times)
Uniper, which functions as a kind of middleman between Gazprom and German factories and municipalities, is being forced to make up shortfalls of Russian fuel ordered on long-term contracts by buying more expensive supplies, like liquefied natural gas.
Mr. Maubach has asked the government to compensate Uniper for higher costs, potentially by passing price increases through to customers. … Mr. Maubach also wants the government to beef up the 2 billion-euro credit line it already has from KfW, Germany’s state-owned investment bank. Finally, he is proposing that the government take a substantial equity stake — more than 10 percent — in Uniper, in part to give more assurance to the financial markets and the rating agencies.
Sounds like a standard systemic risk playbook.
Russia/Ukraine and Insurance Update
Russia-Ukraine aviation losses at WTC+ level may impact retro & sidecars (Artemis)
It’s becoming increasingly clear that losses to the aviation class of insurance and reinsurance business caused by the Russia – Ukraine conflict have the potential to impact retrocessional covers and perhaps some third-party capitalised sidecars.
Insurance and reinsurance broker Gallagher provided some insight into just how expensive an issue aviation losses could become, by saying that, “Whilst significant uncertainty exists surrounding the likelihood and size of any loss materializing, put in the context of the World Trade Center attacks (WTC), Russia-Ukraine could be up to 4x the initial WTC reserve, and 7x the final loss amount to the aviation market.”
Lessor SMBC recognises $1.6bn impairment on aircraft stranded in Russia (Reinsurance News)
While the termination of leasing aircraft to Russian airlines has led to a substantial, aggregate one-off impairment, which drove a net loss of $1.1 billion for the firm for FY21, SMBC explains that it has “significant insurance coverage” and expects that “substantial recoveries will be secured.”
Crypto Update
KeyFi Inc. vs Celsius Network Limited (Court Filing)
This is a hoot. Whole filing is worth a read for the financial-porn prurient. Here is a Threadreader rip of the key points for others.3
Prior to Plaintiff coming on board, Defendants had no unified, organized, or overarching investment strategy other than lending out the consumer deposits they received. Instead, they were desperately seeking a potential investment that could earn them more than they owed to their depositors. Otherwise, they would have to use additional deposits to pay the interest owed on prior deposits, a classic “Ponzi scheme.”
Stone discovered that not only did Defendants lack basic security controls to protect the billions of dollars in customers’ funds they held, but that they were actively using customer funds to manipulate crypto-asset markets to their benefit. The most egregious example of this was Plaintiff’s discovery that Celsius used customer bitcoin deposits to inflate its own crypto-asset called the “Celsius token” (“CEL”
Frances Coppula has written an excellent, highly accessible article Why This Crypto Crash Is Different4
The crypto industry’s luxuriant growth since Bitcoin emerged from the ashes of the financial crisis – and particularly since March 2020 – can be directly attributed to the copious monetary fertilizer central banks have been pouring into financial markets.
And as crypto markets have grown, so has the dollar value of the cryptocurrency industry.
But these dollars aren’t real. They exist only in the virtual space. They are not, and never were, guaranteed by the only institution in the world that can create real dollars, namely the Fed. The Fed has no obligation whatsoever to ensure that those who have made life-changing amounts of these “virtual dollars” can actually exchange them for real dollars. So when the crypto bubble bursts, the “virtual dollars” simply disappear. If you can’t exchange your virtual dollars for real dollars, your wealth is an illusion.
The only real dollars in the cryptocurrency industry are those paid by new entrants when they make their first cryptocurrency purchases. The rest of the dollar liquidity on crypto markets is provided by dollar-pegged stablecoins.
There’s now a race on to exchange cryptocurrencies for the few real dollars still available. … When everyone is trying to cash out cryptocurrencies into increasingly scarce dollars, cryptocurrency prices rapidly fall to the level at which there are sufficient dollars in the system for everyone to be able to cash out.
Ed Zitron reviews the Coppola post in When Vibes Aren't Enough. He has a paragraph worthy of Matt Levine:
What may be becoming obvious to some of you is that the crypto industry was built off the back of everybody writing poorly-collateralized and poorly-underwritten loans for incredibly large amounts of money. Based on further analysis, traditional financial institutions weren’t offering this “because the loans were incredibly fucking stupid, and the people loaning the money did not appear to abide by any kind of fiduciary sense.” Crypto lenders have been lending money to other companies so that they can take loans out with other crypto lenders and then use the profits from those loans to invest in more loans with more companies. When these loans fell through, or the time came for further collateral, these companies scrambled to sell off assets like Bitcoin or Ethereum to cover these losses, putting massive sell pressure on the crypto market.
US Bankruptcy Court In Re. VOYAGER DIGITAL HOLDINGS, INC
The filing contains interesting details on the Terra/Luna collapse. It appears that new Luna could not be created (‘burned’) sufficiently quickly to allow the arbitrage mechanism to work.
On May 7, 2022, $2 billion of UST was unstaked and immediately sold. The sale moved UST’s price down to $0.91. UST holders, already sensitive to price movements due to the sell-off in cryptocurrencies generally, saw UST “de-peg” and rushed to unstake and sell their coins. Terra’s arbitrage trade was designed to address this type of situation but was not designed to address a situation of this magnitude. Though traders moved quickly to burn Luna and “arbitrage” the price of UST, traders realized that only $100 million of UST could be burned for Luna each day. Due to high trading volume, $100 million of UST was insufficient to “re-peg” UST to $1.
Peter Thiel-Backed Crypto Lender Vauld Suspends Withdrawals (WSJ)
A cryptocurrency lender backed by Peter Thiel and Coinbase Global Inc suspended withdrawals, trading and deposits on its platform, citing volatile market conditions and financial difficulties facing key business partners.
The platform, Vauld, said Monday that it froze the operations after users pulled almost $200 million over the last three weeks.
As we highlighted in the last few Perspectives, there really isn’t much difference between the exchanges and the lenders; they’re all connected.
Vauld raised $25 million in Series A funding last summer, attracting funds from Valar Ventures, which was founded by Mr. Thiel, as well as Pantera Capital and Coinbase Ventures, a unit of the publicly listed U.S. crypto exchange.
FTX Presses for Crypto Derivatives Approval, Agitating Legacy Exchanges (WSJ)
Traditional exchanges and financial-industry groups say FTX’s proposal might endanger market stability. Their concerns center on a key element of the plan, under which investors could deal directly with FTX instead of going through a broker. This approach represents a change from the way derivatives markets have operated for decades.
To trade bitcoin futures at Coinbase or CME, one must connect to a broker. The broker’s job is to collect the cash collateral that investors post to enter derivatives trades, called margin. If an investor’s bet goes wrong, the broker issues a margin call. The investor typically gets a day to deposit more cash.
We’re going to have a more complete set of customer protections, disclosures and suitability checks in place than currently exists in the futures industry,” Mr. Bankman-Fried said in an interview. “If anything, we’ll be going a little bit overboard on that.”
Based on what we’ve observed in the various court filings, I highly doubt this would be the case.
This is going nowhere.
I don’t put much credence in this yet, but The Tetherer's Dilemma is arguing that the composition of Tether’s ‘commercial paper’ that backs reserves is ‘fake money’ on ‘fake exchanges’ in China.
Sam Bankman-Fried's Alameda Research Owes Bankrupt Voyager $377M (Decrypt)
Alameda Research, the firm founded by crypto billionaire Sam Bankman-Fried that last month extended a $500 million line of credit to crypto broker Voyager Digital, itself owes the company $377 million, according to Voyager’s Chapter 11 bankruptcy filing.
It’s worth pointing out that Sam Bankman-Fried, founder and CEO of cryptocurrency exchange FTX, has a vested interest in seeing Voyager made whole. At one point, Alameda and its venture arm, Alameda Ventures, were the single largest Voyager shareholders with 11.6% of all outstanding shares, according to a June 17 press release. … on June 23, Alameda announced in a press release that it had surrendered, or returned in exchange for no money, 4.5 million of its shares. … Alameda’s share surrender brought its stake in the company to 9.49%—just below the 10% threshold that would have made it an “insider” in the eyes of the U.S. Securities and Exchange Commission.
Shady as f*ck.
Brainard Gives Speech Supporting Crypto Regulation
In Crypto-Assets and Decentralized Finance through a Financial Stability Lens she states:
As we work to future-proof our financial stability agenda, it is important to ensure the regulatory perimeter encompasses crypto finance.
One could alternatively argue that regulators should stay away, and not lend the credibility and barriers-to-entry that comes with regulation to this “asset.” This whole space seems so shady I’d be hesitant to endorse.
Nickel Big Shot Called the Shots Levine, Bloomberg
Why This Crypto Crash Is Different Coppola, Coindesk