Sunday, February 15, 2009

Indices Gone Wild

Here is a news story from the Feb 12 Financial Times about the West Texas Intermediate no longer being a reliable measure of oil prices:
The global market’s most important pricing benchmark, the West Texas Intermediate crude contract, was criticised yesterday for “sending mixed and misleading price signals, not only to the market but to economic forecasters, government officials and policymakers”.

The International Energy Agency warned that “deterioration in the fragile WTI pricing mechanism would only serve to reinforce the view that the crude has become an irrevocably broken benchmark”. The damning verdict on the WTI contract, which is traded on the New York Mercantile Exchange, by the energy watchdog of the developed world reflects concern among analysts, traders and investors in commodity indices.

Mike Witter, global head of oil research at Société Générale, said: “Brent is more representative of the global market right now and the disconnect between WTI and Brent is an issue.”
Here is a news story in the same paper from October of last year about Libor not being a reliable measure of interbank lending:
The British Bankers’ Association has opened the door to “evolutionary change” in how it calculates London Interbank Offered Rate – Libor – in response to growing criticism about the accuracy of the global benchmark for borrowing costs …

However, bankers fear the index has become distorted in recent months, particularly in dollar markets, because it is calculated according to the bank’s perceived funding costs rather than actual trades. As a result, some bankers are calling for greater use of indices derived from actual market trades.
You see the similarities, including the wording that puts the blame for misbehaving and misleading the public on the index.

Indices, by definition, reflect the markets; only the markets they are reflecting now are the markets of crisis. One of the characteristics of a speculative capital induced crisis is the destruction of arbitrage relations, so that it is not possible to hedge the positions. That impossibility appears as a “disconnect”, by which traders mean that they could not make risk-free profit from differences that finance theorist had insisted had to be arbitrageable.

In the case of Libor, we saw what the disconnect entailed. Libor stood more than 200 basis points over the Fed Funds for months. In theory, a bank could borrow at the Fed Funds rate of 50 basis points and lend it in the interbank market at 2.50% for an easy profit of 2%. But no bank could do it because: i) their credit lines at the Fed were maxed out and they had no acceptable collateral; ii) whatever sums they could borrow were immediately needed; and iii) they did not trust the counterparty bank to stay solvent.

We shall see in coming weeks what the disconnect in the oil market entails.

All this, too, is a part of the destruction about which I wrote earlier, here and here.