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THE PROBLEM WITH MUSK'S BID FOR TWITTER IS NOT THAT HE'S A BILLIONAIRE

Matt Taibbi, a journalist whose writing I admire, has joined the throng decrying the hypocrisy of pundits who write on the pages of the Washington Post (owned by a billionaire) that if billionaire Elon Musk buys Twitter it will be a threat to democracy. This is too glib. The problem isn’t b...

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I'm Not Hopeful About COP21 in Paris


Monday November 30, 2015

[A version of this appeared Nov. 29 in Yale Climate Connections]

 

 

Starting November 30, some 45,000-plus interested parties converge in Paris to try to influence the final form of what is supposed to be a universal agreement among nations on how to address the unfolding threat of climate change. As the date looms, the prospects are not encouraging.


The first thing to keep in mind is that only the climate gets final-say: the measure that matters most for what comes out of Paris will be the reaction, over time, of the climate itself. Countless unambiguous signals, ranging from disappearing arctic ice to sea level rise, tell us that human-induced changes in climate are already happening. It’s too late to stop global warming; the world’s nations can only try to prevent its worst effects by drastically reducing further emissions of greenhouse gasses. The world may yet do so, but not solely as a result of any agreement that comes out of Paris.

Most of the horse-trading and language that will go into this agreement will be irrelevant to how much carbon dioxide, methane and other greenhouse gasses ultimately rise into the skies. At least that’s the grim conclusion that can be drawn from the history of most U.N. actions devised to address environmental problems, as well as from the signals coming from the ongoing negotiations themselves. Consider the sad history of the Kyoto Protocol, a treaty intended to address the climate threat, with roots extending back to the 1980s. It was finally negotiated in 1997, and went into effect in 2005. Big nations by and large failed to meet the targets, and China, now the world’s largest emitter of greenhouse gasses, was not even bound by its commitments. Moreover, the most successful reductions came not from the treaty, but in the ordinary course of modernizing the outdated and comically inefficient industries of the former communist bloc nations after the collapse of the Soviet Union.

Even as it was being negotiated, few experts believed that Kyoto by itself would forestall global warming. It was pitched to doubters with the argument that once in place, the treaty could be strengthened. It wasn’t. More often, it was either evaded or ignored.


Another troubling sign is the wrangling over money, which conjures up another international environmental effort: The U.N.’s Tropical Forestry Action Plan (TFAP), an effort to slow destruction of the world’s rainforests, was hatched in the 1980s. The program was sold to donors as a way to slow deforestation in these fragile ecosystems, but it was sold to recipients as a way to channel additional money for economic development. The result: in a number of African nations, TFAP actually accelerated logging.

In the case of climate change, one has to wonder how much of the money that is supposed to go from the developed countries to emerging nations will simply be viewed as a new source of development aid (at least those funds that are not simply relabeled existing commitments) that will be channeled into politically favored projects, with little or no impact on emissions.


Shifting the world’s energy sector away from fossil fuels requires investment, and it’s understandable that poorer nations will try to seek funds from richer countries, and that all nations will try to dodge their own responsibilities. That’s what nations have always done. That this wrangling continues even as this supposedly historic meeting convenes, however, bespeaks the lack of urgency that for some surrounds this issue. It’s a depressing indicator of how low climate change ranks on various national agendas that only a tiny number of politicians bother even to pander on the issue.

If Paris were somehow to lead to a robust agreement, how many years will pass before it’s put into place by various countries needing to do so? And then, how many years will it take before its “binding” commitments go into effect? The leisurely timetable and mild demands of the Kyoto Protocol won’t cut it given the pace at which climate is changing.


An aura of unreality surrounds the whole process. Somehow negotiators settled on 2 degrees Centigrade, 3.6 degrees Fahrenheit, as an acceptable amount of warming (by the way, Earth has already warmed by nearly 1.3 degrees F from pre-industrial levels). Despite its nearly iconic status, it’s a target that wrongly presumes that scientists can pin-point how much warming will result from a given amount of GHG emissions, or that economists and social scientists can nail, with precision, the economic and social costs of a given degree of warming. They can’t.

The magical and mystical two degrees number dates back to 1990 for policymakers and was advanced as far back as the 1970s. A lot has changed in climate science in the years since. Until the mid-1990s, for instance, most scientists felt that climate changed in a stately, linear way, over hundreds if not thousands of years. Now, the climate community has come to realize that climate can change quite abruptly, and that climate transitions are characterized by tipping points and non-linear (read unpredictable) responses.

Take, for instance, the question of thawing permafrost. Several times the amount of additional greenhouse gasses humans might “safely” release into the atmosphere remain trapped in permafrost in the northern hemisphere. When the magic two degree number first gelled into consensus, few were considering whether a rise of two degrees might trigger irreversible thawing of that permafrost, leading to runaway warming. Indeed, IPCC estimates of future GHG emissions contain no figure for future permafrost contribution to the carbon budget.

Based on a study of ancient permafrost thawing, Anton Vaks of Oxford University in England estimates that the tipping point might be a rise in global temperatures of 1.5 degrees centigrade. Oops!

More than a decade ago, I helped edit a report on rapid climate change sponsored by an elite group of institutions and a major re-insurer. The idea was to model the implications of rapid climate change for the insurance industry, but what the participants discovered was that the non-linearity that characterizes so much of the climate system made realistic loss estimates impossible. The study reverted to using linear projections – a classic case of looking for the keys under the street lamp because that’s where the light is.

So, the Paris Congress of Parties, COP, now finds itself with participants haggling over an agreement that will take years to come into force, and one that can’t even be called a treaty because that would require ratification by an adamantly opposed Republican majority controlling the U.S. Congress. The agreement will involve unenforceable commitments that few will seriously strive to abide by, and transfers of money that rich nations don’t want to spend. All to avoid a 2 degree rise in global temperatures that few serious observers think will be adequate to prevent a rapidly unfolding climate catastrophe.

Clearly, the world needs a Plan B, and the good news here is that it’s well under way – only it’s not a plan, but rather the actions of millions of consumers, investors, and companies. Alternative energy technologies seem to be going viral as prices fall, and economies are becoming less carbon-intensive, a process driven by simple economics and technological change. It’s heartening too that major investors and finance groups are banding together to help grease the wheels of the transition to a climate-friendly economy.

We can only hope that the jury – which is to say the climate – is still out on whether change will come in time. Ultimately, only the climate will give us the verdict that matters most.

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Short Take

HOW THE OPTIONS TAIL HAS COME TO WAG THE MARKET DOG: A Simple English Language Explanation of How Structural Changes in the Stock Markets Contribute to Whipsaw Movements in Prices.

Lately a string of violent price movements and reversals in the equity markets make it look like the markets are having a nervous breakdown. The last day of trading in April 2022 saw a 939 point drop in the Dow. The day before that, the Dow rose about 625 points, and two days before that it fell over 800 points. The very next week, after two quiet days, the Dow rose over 900 points after the Fed announced its biggest rate hike in 22 years (ordinarily a big negative for the markets), and then, the next day, fell over 1000 points (more on this later).  There have been plenty of headlines – about the Ukraine Invasion, inflation, the threat of a Fed caused recession, supply chain disruptions – to justify increased uncertainty, but the amplitude of the moves (and the sudden reversals) suggest something more may be at work. Here follows an effort to explain in simple language the significant changes in the market that have contributed to this volatility.

 

“This time it’s different” is perhaps the most dangerous phrase in finance as usually it’s uttered by market cheerleaders just before a bubble bursts. That said, markets do change, and those changes have their impacts. One change in the markets has been the shift from intermediaries (such as brokers) to direct electronic trading, a shift that has made the markets somewhat frictionless, and allowed computer driven funds to do high speed trading. This shift began a couple of decades ago. Today’s markets can move faster than a human can react.

 

Another shift has been the degree to which passive investing through index funds and algorithmic trading through various quant funds have come to eclipse retail investing and dominate trading. A consequence of this is that to some degree it has mooted individual stock picking because when investors move in or out of index funds, the managers have to buy or sell the stocks held on a pro rata basis and not on individual merit. This change too has been developing over recent decades.

 

A more recent and consequential shift, however, has been the explosion in the sale of derivatives, particularly options (the right to buy or sell a stock or index at a specified price on or before a specific date). Between 2019 and the end of 2021, the volume of call options (the right to buy a stock at a specified price on or before a particular date) has roughly doubled. During times of volatility, more and more retail and institutional investors now buy calls or puts rather than the stocks. 

 

Today, trading in options has reached a scale that it affects market moves. A critical factor is the role of the dealers who write options and account for a significant percentage of the options issued. Dealers have been happy to accommodate the growth in option trading by selling calls or puts. This however, makes them essentially short what they have just sold. Normally, this doesn't matter as most options expire out of the money and worthless, leaving the happy dealer to book the premium. Being short options, however, does begin to matter more and more as an option both moves closer to being in the money and closer to expiration. 

 

This situation is more likely to occur when markets make large and fast moves, situations such as we have today given the pile of major uncertainties. Such moves force dealers to hedge their exposure. 

 

Here’s how it works. If, for instance, a dealer has sold puts on an index or a stock, as a put comes closer to being in the money (and closer to expiration), the dealer will hedge his short (writing the put) by selling the underlying stock. This has the combined effect of protecting the dealer -- he's hedged his potential losses – while accelerating the downward pressure on the price. In other words, this hedging is pro-cyclical, meaning that the hedging will accelerate a price move in a particular direction.

 

Traders look at crucial second derivatives of stock prices, referred to by the Greek letters delta and gamma to determine exposure to such squeezes. As an option moves closer to in the money it's delta -- it's price movement relative to the price movement of the underlying, and its gamma -- the rate of change of the delta relative to a one point move in the underlying, both rise. The closer to both the strike price and expiration date, the more the dealer is forced to hedge. The result is what’s called a gamma squeeze. Once the overhang of gamma exposure has been cleared, however, the selling or buying pressure abates, and gamma may flip, with new positioning and hedging done in the opposite direction. The result can be a whipsaw in the larger markets. This same phenomenon can happen with indexes and futures.

 

How do we know that the hedging of option positioning are contributing to violent price changes and reversals in the market? While not conclusive, perhaps the strongest evidence is that large lopsided agglomerations of options at or near the money have been coincident with surprising market moves as expiration dates approach. In fact, some market players use this data to reposition investments, in effect shifting investment strategy from individual companies to the technical structure of the markets. This is what Warren Buffett was referring to when, at his recent annual meeting, he decried the explosion of options and other Wall Street fads as reducing companies to “poker chips” in a casino.

 

The week of the May Fed meeting gave us a real-time example of how a market move that looks insane on the surface reflects the underlying positioning in various derivatives. To set the stage: ordinarily, given debt burdens and the threat of recession, the markets would be expected to react badly to a Fed tightening cycle that is accelerated by the biggest rate hike in 22 years. On Wednesday, however, market indices began to soar on Wednesday when Fed Chairman Powell, one half hour after the Fed announced it 50 basis point raise, suggested that the Fed was not considering larger 75 basis point hikes during this tightening cycle. Traders interpreted this as taking the most hawkish scenario off the table. Up to that point, institutions were extremely bearish in their positioning, heavily weighted to puts on indexes and stocks, and also positioned for future rises in volatility in the markets. Right after Powell made his comments, investors started hedging and unwinding this positioning, and all the pro-cyclical elements entailed in this repositioning kicked in. By the end of the day, the technical pressures producing the squeeze had largely abated, setting the stage for a renewed, procyclical push downward the next day, as the negative aspects of the tightening cycle (and other economic headwinds) came to the fore. 

 

What these violent moves in the market are telling us is that while in the broader sense, this time is not different --the overall sine wave of the market is still that bubbles build and burst -- how the present bubble is bursting may be following a different dynamic than previous episodes. The changes since the great financial crisis-- the rise to dominance of passive trading through indexes and algorithmic trading through various quant strategies – reduced the friction in the markets as well as the value of picking individual companies. Now, the more recent explosion of option issuance, further accelerates market moves, and leads to unpredictable reversals that have to do with option positioning rather than fundamentals such as earnings, politics, or the state of the economy. 

 

The tail (the options and other derivatives markets) now wags the dog (the equities markets).

 

 



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