From The Blind Spot:
A deep dive into Zoltan Pozsar’s Bretton Woods III world view
As an addendum to my original note about Zoltan Pozsar’s Friday note, here are my extended thoughts on his Bretton Woods III magnum opus.
On commodity basis:
Zoltan says:
Furthermore, like there is a “base” interest rate (EFFR and the OIS curve that springs from it) and a basis between that base rate and other interest rates, there are also bases between different sources of similar commodities (WTI, Brent, and Urals), and like harvesting money market bases uses balance sheet capacity, harvesting commodity bases uses “shipping balance sheet capacity” (vessels).
As someone who cut her finance teeth covering the world of commodities I always found it funny that what commodity traders would call “time spreads” or just “arbs” are described as basis trades everywhere else. A lot of the time this linguistic variance is down to how sector-specific heuristics have evolved. So it’s nice to see it acknowledged as a thing.
And yes, all arbs are theoretically profitable to close. But as I mentioned in my piece about how commodity credit markets work they’re expensive to execute in the first place. This is especially the case for time spread trades (such as contango plays) which take up a hell of a lot of balance sheet.
As I also mentioned, sometimes — as with the covered Interest parity breakdown in money markets — there are less visible regulatory constraints that make it impossible to close arbs altogether. In those circumstances rates have to get totally out of whack before it is worthwhile to trade the arb out. And even then, the arb might only open to certain players. That is kind of the situation we are finding ourselves in now.
It could just be that many risk-related regulations brought in under Basel III will have to be unwound to allow for what was previously common trade to be conducted.
On commodity protection:
Zoltan says:
Protection is a conceptual counterpart to par. When you decide to take money out of a sight deposit, you expect the same amount back that you put in (par).
When you sail foreign cargo from port A to port B, you expect to unload the same amount of cargo that you onloaded. Banks can deliver par on deposits most of the time. When not, central banks step in to help. Commodity traders can deliver foreign cargo from port A to port B most of the time, but when not, the state intervenes again: not the monetary arm, but the military arm of the state. What central banks are to the protection of par promises, the military branch is to the protection of shipments: foreign cargo needs to sail on sea routes and through choke points like the Strait of Hormuz, and “par” in this context means being able to sail from here to there freely, safely, and without undue delays…
I’m really glad Zoltan brings this up because it is a much under appreciated point in high finance. No historian or classicist, however, will be surprised by the assertion that trade has to be protected. (Which reminds me, I will have to tell the story one day about how shipping protection and indemnity insurance clubs came about, as it’s a fab story.)
There’s a reason why the British East India Company became indistinguishable to a sovereign military force. Not only did it work on a Royal commission in many areas (sharing proceeds of its activities with the head of state) but developed its own naval force to protect certain trade routes for precisely these reasons. It’s why — by the way — we have British protectorates and so on.....
....MUCH MORE, scary smart (Zoltan too)
Earlier, the naked link: "Credit Suisse' Zoltan Pozsar: "Money, Commodities, and Bretton Woods III"".
