Streetwise Professor

January 13, 2014

Scott Irwin Answers Kocieniewski

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 9:04 pm

Scott Irwin has provided his responses to David Kocieniewski.  Read the whole thing.

It’s My Turn

The responses to the recent NYT article by David Kocieniewksi certainly make interesting reading.   I don’t want to belabor points already made so well by others in response to the numerous problems with the article (especially Craig).  Instead, I want to offer some additional points that I think merit further consideration or elaboration:

  1. To start, it is important to clarify that the heart of the controversy is the trading activities of a new type of participant in commodity futures markets—financial index investors—during the 2007-2008 commodity price spikes.  The concern was that unprecedented buying pressure from index investors created massive bubbles in commodity futures prices, and these bubbles were transmitted to spot prices through arbitrage linkages between futures and spot prices.  The end result was that commodity prices far exceeded fundamental values during the spikes.  Dwight Sanders and I labeled this the “Masters Hypothesis” in honor (dishonor?) of the central role that hedge fund manager Michael W. Masters played in pushing this line of thinking.   It is crucial to understand the key features of the Masters Hypothesis.  First, it implies that index buying in commodity futures markets created massive price bubbles—20, 30, 50% overvaluations (take your pick).  Second, it implies the price bubbles were long-lived, measured in months if not years.  These features have driven the acrimonious debate about “speculation” in commodity markets that first erupted in 2008.  Without the charge of massive and long-lasting bubbles the intense public policy debate about speculation limits would not have taken place.
  2. My position on the validity of the Masters Hypothesis has been consistent from the earliest days of the controversy.   In fact, in an ironic twist, one of my earliest publications on the controversy was an op-ed that Dwight Sanders and I jointly authored—drum roll please—yes, in the NYT in July 2008.   A few quotes:  ”Over all, there is limited evidence that anything other than economic fundamentals is driving the recent run-up in commodity prices…The complex interplay of these factors and how they affect commodity prices is often difficult to grasp immediately, and speculators are a convenient scapegoat for the public’s frustration with rising prices. That’s unfortunate because curbing speculation — and hobbling the ability of businesses that rely on futures markets to reduce their risk — is counterproductive.{
  3. If my work was somehow tainted by associations with “Wall Street,” then why the editorial endorsement by the Paper of Record in 2008?   It also seems convenient that this little fact was omitted in Mr. Kocieniewksi’s recent article.   I made sure he was aware of my previous NYT op-ed article when he interviewed me. I suspect he was already aware of it given his exhaustive background research on the two of us.
  4. The academic research pertaining to the Masters Hypothesis since 2008 has been overwhelmingly negative.  I submit that there is very little credible academic research that is consistent with the basic tenets of the Masters Hypothesis.  That is, index buying is not associated with massive and long-lasting price bubbles in commodity futures markets.  There are no “accidental Hunt Brothers.”   Some unnamed persons (one has the initials GG) like to characterize academic research on the subject as being roughly equally divided between studies that find a positive impact of index positions on prices and studies that fail to find an impact.  This characterization is misleading.  Yes, some studies find evidence of a positive impact but the impacts are invariably small and fleeting or do not line up with the spikes of 2007-2008.  This type of evidence does not support the Masters Hypothesis.  So, when properly interpreted the evidence to date is not divided equally, but instead overwhelmingly rejects the Masters Hypothesis.  And this is what is important from a public policy perspective—small impacts do not provide much justification for costly new regulation of commodity futures markets.
  5. My approach to research on the market impact of index investment has always been to go where the data lead.  My co-authors and I have sliced and diced the available data many different ways and we cannot find a smoking gun (a full list can be found here).  As I like to put it, if the Masters Hypothesis is true then the relationship between index positions and commodity futures prices should literally jump off the page.  It does not.  Importantly, there is also limited evidence of bubbles in commodity futures markets independent of whether or not they are associated with index investment.   My co-authors and I could not find evidence that bubbles have become larger or longer-lasting since index investment came on the scene.  If anything they have become smaller and less frequent.
  6. If my research on speculation is slanted/biased/tainted then it sure has fooled a whole bunch of academics who serve as journal editors and reviewers.  I have published 13 papers since 2009 dealing directly with the speculation controversy in 9 different academic journals.  And several more are currently under review.  Yes, under review.  This means the articles don’t get published unless they first pass muster with reviewers and then a journal editor.  I don’t know exactly how many editors and reviewers I have dealt with on these papers (several were invited submissions but still subject to peer-review), but it is safe to say that it must be at least 20-30 people.  So, we are to believe that my biased research ran this gauntlet of editors and reviewers and the bias managed to go undetected the entire time?  Give me a break.
  7. Just for the record, I want to state in public that I did not even know about the Chicago Mercantile Exchange (CME) donations to the business school here at the University of Illinois when the donations were made.  I only became aware of them in the last year or so through conversations with our development staff.   (OK, I should actually be a little embarrassed by that last statement given my work on commodity futures markets.)   In any event, to draw an inference between the gifts to the business school from the CME and my research really is ridiculous.  I made this clear in my interviews with Mr. Kocieniewksi.
  8. I do have a long working relationship with the CME, and before that, with the Chicago Board of Trade (CBOT).  This after all is my research area.   The CME has not funded any of my research since 2007.  However, I did work on a commissioned white paper for the CME in 2005 when the grain contract convergence problems first erupted.  My co-authors (Phil Garcia and Darrel Good) and I were paid a total of $15,000 for the work, which we split equally.   I did accept a position on a new Agricultural Advisory Council that the CME started in late 2013.  The council will meet three times a year at various locations around the country and serve as a sounding board for various issues that come up with regard to agricultural futures markets.  I will receive the same $10,000 annual stipend for this position as the other members of the council.   That is the sum total of my financial ties to the CME.
  9. I have had numerous interactions with CME staff in recent years on a host of issues related to commodity futures markets, including, of course speculation.  Sometimes I have reached out to them and sometimes they reach out to me.  Most of the time it is the former and involves pretty obscure questions about things like how the grain delivery process works or help in getting some data.  My research would be far less interesting and useful without this help.  I have the utmost respect for the professionalism of the CME staff and I have never been asked for any type of quid pro quo.  Never.  When I have agreed to participate in presentations, write blogs, etc. I have done so because I believed my research and analysis contributed to better understanding of the issues.
  10. My other research on commodity market speculation has been funded from three main sources.  First, the Laurence J. Norton Chair that I hold here at the University of Illinois provides earnings each year that go to support my research program (thank you U of I!).  Second, I have had two grants from the Economic Research Service of the USDA on commodity speculation related topics since 2008.  The first one included work directly on speculation while the second focused on convergence in grain futures contracts. Both have been completed.  Third, Dwight Sanders and I did a commissioned study for the OECD in 2010.  I lost track of the emails with the exact amount we were paid but I know it was only a few thousand dollars.
  11. Yieldcast is a product of T-Storm Weather that I helped develop with a former graduate student, Mike Tannura, and Darrel Good.  Yieldcast provides “real-time” U.S. corn and soybean yield forecasts for subscribers.  My main role is to build the statistical models that form the basis of the forecasts and to prepare the weekly forecasts during the growing season.  As indicated in the NYT article I do not have direct contact with Yieldcast subscribers.  I am fortunate that side of the business is ably handled by Mike Tannura through T-Storm.  It is really laughable to think that I have somehow been rewarded through this channel by Wall Street as a payoff for my speculation research.  I know how hard Mike has worked to build the base of subscribers for this product, and if it only were that easy!  I have never seen one email, one voice mail, or absolutely anything that connects my research on speculation to taking out a subscription for Yieldcast.
  12. As the NYT article indicated, Dwight Sanders and I did conduct a study in 2012 for Gresham Investment LLC on the market impact of index investment.   Given the political sensitivities surrounding the speculation issue, I gave considerable thought as to whether I ought to pursue the consulting project.  I knew some would see taking any funding from a commodity firm as being a conflict of interest.  But, the project provided access to detailed firm level position data that has previously been unavailable to researchers and this made it worthwhile in my mind.  Sure, I didn’t mind getting paid as well.  The NYT article got it wrong when it said I was paid the full $50,000.  Dwight and I split that equally so I was actually only paid $25,000.  We are working on several interesting papers based on this new dataset.
  13. If the charges (really, innuendoes) in the NYT article are baseless, then readers might reasonably ask what does motivate my “defense of Wall Street”?  Good question.   I am indeed a “freshwater” economist that became convinced early in my career that commodity futures markets were an invaluable market institution that improved the discovery of prices and the ability of market participants to shift risks.  While these markets are by no means perfect (as Craig’s work on manipulation highlights), on balance, the good vastly outweighs the bad.  So, when the current speculation controversy erupted in 2008 I was struck by the similarity of the present controversy and those that have buffeted the industry in the past.  Change only the names and dates and not all that much is different.  This has been a reoccurring theme in my own writings since 2008 (including the July 2008 NYT article…could not resist).  And I admit that I made an intentional decision early on to play a more public role in the present controversy.  Three of my professional heroes are Holbrook Working, Tom Hieronymus, and Roger Gray, who spent much of their illustrious academic careers defending futures markets.  All the motivation I needed.

Scott Irwin

University of Illinois

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What is the World Coming To, When SWP Shares Headlines With the Dodd of Frankendodd?

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 7:08 pm

Risk Magazine’s annual review issue includes a set of short contributions on the progress that has been made on the G-20 OTC derivative reforms.  (If you run into paywall problems: there are ways.  There are ways.)  The contribution by yours truly is under the category Academics (plural) even though I am the only academic in the piece.  I guess I count for double, or something.
But that’s not the best part.  The best part is the headline:

Progress and peril: Davie, Dodd, Maijoor, Pirrong and more on the G-20 reforms.

Sharing top billing with Chris Dodd!  What is the world coming to?  I guess it could be better (or worse): it could have been Barney.  Or Gary.  Or Bart.

To spare you having to scroll through all of the contributions by politicians, lawyers and people who actually work in these markets, here’s my two cents:

When the Dodd-Frank Act was passed, I thought the Sef mandate was its worst part. It has nothing to do with the act’s ostensible purpose – reducing systemic risk – and imposes a one-size-fits-all model for trading swaps that will likely decrease the efficiency of the market. The made-available-for-trade provision of the Sef rule merits the title ‘worst of the worst’. This says if a Sef applies to the CFTC to trade a particular type of swap, and it approves the application, all trading of that type of swap must occur on a Sef. This turns the ordinary competitive process on its head. In most markets, a firm introduces new products, and if it is desirable to consumers, it sells. If the product is flawed, it doesn’t. Under this rule, a firm that introduces a flawed execution method imposes this bad choice on all consumers.

The CFTC could prevent such a perverse outcome by not approving an application. However, the agency’s animus to the traditional dealer-centric trading model and its fetish for transparency means the CFTC sets very low standards for approval. It also demonstrates the CFTC’s bizarre interpretation of cost-benefit analysis: it considers only the trivial cost of filing an application, and totally ignores the massive costs that would result if traders are forced to execute in an inefficient way.

Swap market participants and transactions are diverse. There is no execution model to fit all – counterparties themselves are best placed to determine how to execute their trades. Sef mandates already constrain choice, and made-available-for-trade puts the execution decision in the hands of third parties whose interests are not aligned with those actually trading. Given the size of these markets, if the untried Sefs don’t work as hoped – even for a modest subset of traders – the dislocations and inefficiencies will be immense.

The Risk editors chopped my last line, which was: “I fear that the epitaph of the OTC swap market will be: ‘Died of a Theory.’”  (A line lifted from Jefferson Davis’s epitaph on the Confederacy.)  The Theory, of course, is that traditional means of executing OTC derivatives trades are flawed, if not evil, and that Gary Knows Best in imposing a simulacrum of a centralized, order driven market that has worked well for futures on swaps, which are different in many ways.

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January 8, 2014

Thanks, Felix, For Showing What a Total Weasel David Kocieniewski Is

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 8:44 pm

Felix Salmon posed several questions for David Kocieniewski about his scurrilous article about Scott Irwin and me.  And-shockingly!-David Koscieniewski refused to answer a single one.  Not. A. Single. One. So if you don’t win that Pulitzer, Dave (and we know that’s what you want, isn’t it?), there’s always the Royal Order of the Weasel ready to be claimed.  You should be a runaway. Emphasis on the Runaway!

Instead of actually answering direct questions posed to him, our dear David doubled down on insinuation, innuendo, and ad hominem.  That’s our boy: go with what you got, eh?

I will respond more fully later, through multiple channels, but a few comments are in order now.

  1. Kocieniewski insinuates that I have violated the American Economic Association disclosure guidelines.  Fail, Dave. Pure fail.  The AEA guidelines require disclosure of any support (financial, in the form of data, etc.) on submissions to peer reviewed publications.  I have not submitted any work to a peer reviewed publication that has been supported by any party with an interest in the speculation debate.  I told you this during our interview.  So what is it?  Is David ignorant, stupid, or dishonest?  I can’t answer that.  Those are all observationally equivalent.
  2. I responded to all FOIA requests, forwarded to me via the University of Houston’s general counsel’s office, in a timely fashion.  Any suggestion to the contrary is false.
  3. My work for “one of the largest commodity exchanges” had nothing to do with speculation, and occurred after my positions on speculation were public.  Years afterwards.  Years.  As in plural.
  4. My work for “one of the largest commodity trading houses, Trafigura” occurred years after my positions on speculation were public.  Again, years plural.  I had no contractual relationship with Trafigura until September, 2013.  Um, I testified before Congress on speculation-testimony which gives dear David the faints-in July 2008.  You know, five freaking years before. And that’s not even the best part! Trafigura is not a speculator.  It is a hedger.  It routinely sells massive quantities of futures to hedge its massive quantities of oil transactions.  But-correct me if I’m wrong (but I’m not)-Kocieniewski’s article focuses on how speculators drive prices up by buying futures.  Hedgers. Speculators. Buy. Sell.  Up. Down. Whatever, eh? It’s all the same to our Dave. So again: David Kocieniewski: ignoramus, idiot, or liar? I say again: Observationally equivalent.
  5. Kocieniewski explicity refers to  the fact that “this debate [over speculation] began more than five years ago.”  Excuse me, but I wrote my first blog post on this in August, 2006.  I know you are math challenged, David (I read your piece on Goldman’s warehouse operations), but using the fingers on your left and right hands, you should be able to cipher that that works out to about 7 years (and about four months, but hey, let’s round down!).  So I weighed in on this before “the debate began.”  Just call me prescient.  But here’s the point: how did my (non-existent) consulting work on speculation years later affect my opinions?  Do you have issues with the concept that the cause must precede the effect?

More later.  I’m just getting warmed up (spits into palms, old school style).

Thanks again, Felix.  The cat caught the weasel.

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January 5, 2014

Crowdsourcing Opportunity!

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 4:22 pm

David Kocieniewski of the NYT is answering questions this week about his deep thoughts on “issues ranging from the role of Goldman Sachs in the global aluminum market to academics who have reaped financial benefits while defending some of the largest players in the commodities business.”  (Bonus opportunity! Gretchen Morgenson is teaming with DK to answer!)

Have at it, folks. I am sure you have inquiring minds that want to know the answer to some questions about Kocieniewski’s journalism.

Update: Please leave a comment to this post if you ask a question and it is not answered.  Also let me know what your (unanswered) question was.

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December 31, 2013

Let’s Play Connect the Dots! What Did the NYT Conveniently Leave Out of Its Hit Piece?

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 9:26 pm

It’s New Years Eve, and perhaps a little game is in order to get ready for the turn of the calendar in about 3 hours.  Let’s play connect the dots.

  • In July, David Kocieniewski writes a big-totally incoherent, but big-article in the New York Times on the aluminum warehouse controversy involving Goldman Sachs, JP Morgan and others. The article focuses on Goldman’s Metro Warehouse in Detroit.
  • On 1 August, 2013, the law firm Lovell, Stewart, Halebian and Jacobson LLC files suit against Goldman Sachs for violating Sections 1 and 2 of the Sherman Antitrust Act in its operation of the Metro Warehouse in Detroit.
  • The Lovell, Stewart complaint cites the Kocieniewski article.  Numerous news articles state that Lovell, Stewart is the firm that filed the complaint.
  • Lovell, Stewart is one of the leading plaintiffs’ law firms in the country.  It is indisputably the leader in manipulation class action lawsuits filed under the Commodity Exchange Act.  LSHJLLP has been the lead counsel or co-lead counsel in virtually every major manipulation lawsuit in the US, and has won hundreds of millions of dollars in settlements in such cases.  Its web page lists numerous past and current commodity manipulation cases, as well as other cases filed against financial institutions.
  • I have worked as an expert in numerous cases for Lovell, Stewart (and its predecessor law firms) going back to 1994.  Many of these are manipulation cases.
  • David Kocieniewski knew, before writing his hatchet job, that I had worked for Lovell, Stewart.
  • Kocieniewski did not ask me about my work for Lovell, Stewart.  He did ask me about my work for trading firms and banks.  I did mention, on my own initiative, that I had been adverse to such firms in some of my work.
  • Kocieniewski mentioned my work for trading firms and banks, but did not mention my work for Lovell, Stewart.

So there are the dots.  Help me connect them.

Seriously.  I would like you to tell me in the comments what you see when you connect those 8 dots: what inferences do you draw?  I know what I see, but I’d like to crowd-source this.  Maybe you all see something different.  Thanks in advance for your help, and have fun playing!

And to all my readers: have a Happy and Healthy New Year.  Your interest and continued support is what makes this a rewarding endeavor.  Cheers!

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Thank You, Dr. Sowell

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 1:06 pm

I have always admired Thomas Sowell greatly.  I read his Knowledge and Decisions during my first year of graduate school, and it had a profound effect on my thinking and way of looking at the world.  I also read most of his work on discrimination, and found his book on Marxism to be a classic in intellectual history: a truly fair and penetrating appraisal of Marx, and Marxists (the two things aren’t the same, which is one of the points of the book).  Conflict of Visions is a classic: there is no better book for understanding the intellectual roots behind the political divisions in the West.  Yes, Sowell has strong views, but he is like John Stuart Mill in his ability to characterize his opponent’s views fairly and objectively.

Sowell has also been the subject of some the the ugliest personal attacks directed against any scholar over the last 40 years.  For the progressive left, to be black and on the right is to be an anathema who must be destroyed.  Yet he has handled the vicious attacks on him with equanimity and humor, and has never been cowed.

It is therefore beyond humbling to have Dr. Sowell come to my defense, and take on the New York Times “hit piece.”

All I can say is that I am honored beyond words.  Thank you, Dr. Sowell.

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December 30, 2013

Here Comes the Cavalry

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 9:39 pm

The NYT hatchet job has elicited quite a bit of discussion on the web, and on Twitter.  Several major bloggers have saddled up and ridden to the defense of Scott Irwin and I.  Pride of place goes to Felix Salmon, who wrote a long and thoughtful post at Reuters. This is particularly gratifying, because Felix and I have had our differences in the past (e.g., over the empty creditor problem) but I have always found him to be extraordinarily fair and open minded.  Felix wrote his piece before I posted mine, meaning that his was based on publicly available information (including his past interactions with me) which confers a considerable degree of objectivity: most importantly, it shows that information that the NYT ignored or distorted was there in plain sight.  Felix is like a judge entering a summary judgment motion against the NYT, with prejudice, making it unnecessary for the defense even to present its case.  I think it’s correct to say Felix’s verdict is pretty brutal, but eminently fair.

Other members of the cavalry include Jeff Carter’s Points and Figures blog (who was the first to arrive on the scene), Peter Klein at Organizations and Markets, Sonic Charm (or is it Crimsonic?) at Rhymes With Cars and Girls (who always cracks me up, whatever he’s calling himself these days), and John Hinderaker at Powerline. Peter and John point out the double standard under which academics who work with private business are often accused of being corrupt, whereas the motives of those who accept money from the government are almost never questioned.   Peter focuses on the Fed, John on climate research.  The common conclusion of all is that the NYT piece was a deeply biased smear written in bad faith with ulterior motives.  Crimsonic calls for a retraction.  Interesting idea.

Felix’s post and mine also unleashed a torrent of tweets.

Thanks to all.  I’m sure this isn’t over yet.  So keep your horses watered and your powder dry.

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I Have Not Yet Begun to Write: Responding to the New York Times’ Farrago of Dishonesty, Insinuations, and Ad Hominem

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 12:49 pm

The New York Times, in an article written by David Kocieniewski, has singled out me and the University of Illinois’ Scott Irwin for an extended ad hominem treatment alleging that our statements and research on commodity speculation are tainted due to financial connections with “Wall Street.”  As one individual put it to me, the article is “nasty, biased and thinly researched.”   All true (if incomplete-the list of sins is even longer).  But at the risk of providing credence to the incredible, I believe some sort of response is warranted.  So here it goes.

Let me start by saying I have been very fortunate. I have been able to pursue my academic passions, publish papers and books on them, and consult and testify as an expert witness on many matters related to these passions. Through each and all parts of this, I have been true to my Chicago School roots and to what I thought the data and good economics showed.  My opinions on speculation are the product of my training and my research, period.

Moreover, completely contrary to the impression in the NYT piece, the vast bulk of my consulting and testifying work has been adverse to Wall Street and commodity trading firms.  Virtually none of this work relates to the alleged subject of the NYT story: the impact of speculation on commodity prices.  In fact, much of this work relates to market manipulation (which is distinct from speculation) by commodity traders.  I have been, and continue to be, on the side of plaintiffs in attempting to hold traders who abuse markets accountable for their conduct.

The failure of David Kocieniewski to point out this salient fact alone betrays his utter unprofessionalism and bias, and is particularly emblematic of the shockingly shoddy excuse for journalism that his piece represents.

Moreover, none of the research or writing I have done on the speculation issue received financial support from any firm or entity with even a remote stake in this issue.  I started writing about this on my blog in 2006, and have been arguing this issue on my own time with no financial support from anyone.  Unlike, say, Ken Singleton (whom I admire immensely and am not accusing of anything remiss) I have not written any commissioned research on the subject of commodity speculation.  My work that has been done with firms that are connected, in some way, to commodities trading has been on subjects unrelated to financial speculation, and/or with firms that are not financial speculators, and/or took place well after my opinions on the subject were a matter of public record, including in national publications like the Wall Street Journal.  Therefore, to suggest some connection between my paid outside work and my opinions on speculation is misleading, deceptive, and plainly libelous.

True to my Chicago School roots, I believe this is a data issue informed by a strong understanding of the theory and empirics of commodity pricing-a literature to which I have  made many peer reviewed contributions.  And I have been open and remain open to reviewing any data on any market.  I further note that the vast bulk of other research on this subject, undertaken by world-class scholars including James Hamilton and Lutz Killian supports  my conclusions (and those of Scott Irwin).  Ironically, considering the where this piece appears, even Paul Krugman is in agreement.

The simple explanation for my views is that I am avowedly a “super-freshwater economist” by training and conviction.  Because I know that drinking saltwater makes you go crazy. Kidding aside, my work on speculation is a piece with all of my academic work, my background, and my training.  Randall Kroszner, former Fed governor, told me once that I was one of the last true Chicago School economists. That’s a compliment, that’s pretty accurate, and that’s aspirational.  That is a much better predictor of where I come down on any issue than anything else: including money.

What’s more, I do not solicit, have never solicited and would not solicit money for any institution or purpose based upon my views of speculation or the policy issues relating to speculation. Or any other issue.

A couple of other points before getting into specifics.

First, there are no coincidences, comrades. The NY Times has been Tiger Beat effusive in its praise for Gary Gensler of the CFTC.  This piece attacking two of the most prominent academic critics of Gensler’s efforts to impose a speculative position limits rule comes out days after the Commission approved a new version of the rule, and is in the midst of the comment period leading up to the formulation of a final rule.  Gensler fought for this rule for 5 years, and he views it as an important part of his legacy.  That is, there is a clear political agenda at work here: to kneecap those who have the audacity to oppose the regulatory agenda of Gensler and his media acolytes.

Second, this kind of ad hominem attack will have the effect (which is likely intended) of serving as a warning to other academics who cross powerful political interests with their academic research, and who have the temerity to speak out on controversial matters.  How can this be seen as anything other than having a chilling effect on other academic researchers in the the financial and commodity markets?  But maybe that’s exactly the point.

Now some specifics.

  1. There are many egregious distortions in the article, but the most egregious is Kocieniewski’s lying by omission.  Lying. By. Omission. Specifically, he omits the salient fact that the bulk of my consulting engagements (in the form of expert testimony) have been adverse to commodity traders and banks.  I have testified numerous times about manipulations by these types of firms, and have testified against them on other matters unrelated to manipulation.
  2. Let’s examine some of the firms I have been adverse to in my work over the past 20 years, shall we?  Off the top of my head: BP (twice); AEP; Ferruzzi (a commodity trading firm); Duke Energy; Nasdaq market makers; JP Morgan; MetLife; Morgan Stanley; Goldman Sachs; Cargill; Amaranth (a hedge fund that was one of the largest speculative-industry players in the country); Moore Capital (one of the world’s largest hedge funds, and another huge speculative industry player); Optiver (a major trading firm); Pimco (the world’s largest fixed income fund); Merrill Lynch (twice); Sumitomo (major copper trader); Microsoft; Cantor Fitzgerald (twice); and on and on.  A veritable murderers’ row of banksters and traders and energy firms.
  3. I say again: by omitting any mention of this work the Times is lying by omission, and presenting a biased and extremely distorted picture of me and my work.  This biased selectivity makes a joke of the Times’ motto “all the news that is fit to print”.   Leaving out this salient fact makes it plain that Kocieniewski and the Times have an agenda, and no interest in presenting a complete picture of me and my work.  The Times article (inaccurately-see below) lists some of my work on the side of commodity traders and exchanges to create the impression that I am their creature, but leaves out the work in which I have been their fierce antagonist-and in the performance of which I have contributed to their payment of damages running into the many hundreds of millions of dollars.  This failure to mention evidence that contradicts his pre-conceived conclusion is shoddy, dishonest journalism.
  4. Nowhere in the article does the article point out any mistakes or inaccuracies in my research or Scott’s, only making it plain that the problem is that our research does not fit his and the NYT’s preconceived notions about speculators.  I spoke to the reporter for quite a while.  Mostly about the substance of my arguments.  None of that made it into the article, and the reporter wasn’t even able to find another academic to criticize my arguments (or Scott’s): there’s no evidence he even tried, suggesting that the substance was irrelevant to him.  The failure to address the substance of my arguments is very telling.  If I am merely advancing some illegitimate commercial interest, my arguments would be easy to refute, no?  Moreover, Kocieniewski fails to mention my numerous peer-reviewed publications on commodities.  This provides independent validation (though imperfect, because I have serious criticisms of peer review) of my work on the behavior of commodity prices.
  5. There are several factual errors.  Most notably, Kocieniewski claims I wrote a “flurry” of comment letters on speculation/position limits.  I guess in the NYT Thesaurus, “flurry” is a synonym for “one.”   For I wrote a single comment on the issue: as I noted in an earlier post, the comment must have had something of an effect because the CFTC’s new speculative limit proposal eliminates language I had criticized in my letter.  (I also wrote a comment on the CFTC rule proposal relating to clearinghouse governance.  Thus my “flurry” of comments to the CFTC on Frankendodd totals two snowflakes.)  Also, the article ominously suggests that I simultaneously had undisclosed “financial ties” to banks and trading firms when I wrote the study on the systemic risk of commodity trading firms for the Global Financial Markets Association (GFMA).  This is not correct.  I agreed to write a white paper on commodity trading firms for Trafigura more than a year after writing the GFMA report.  Indeed, the GFMA report led to the Trafigura engagement.  Which again indicates that public revelations of my views typically precede any paid retention.
  6. Obviously, the story of the GFMA study, which I have discussed earlier on the blog, demonstrates clearly that my opinions are not for sale, and that I have stood up to and do stand up to “Wall Street.”  I would specifically note that one thing that I adamantly refused to remove from that study, despite the insistence of the attorney for JP Morgan’s commodity trading division, was my statements that commodity trading firms have been known to manipulate markets.
  7. Kocieniewski’s’ claim that I somehow conceal my consulting work by referring to myself “solely as an academic” is refuted by the biography linked to in his story.  That bio includes the following language, which I include in the bio for every speaking engagement I undertake: “Professor Pirrong has consulted widely. His clients have included electric utilities, major commodity processors and consumers, and commodity exchanges around the world.”  Therefore, Kocieniewski’s characterization of how I represent myself is deceptive and fundamentally dishonest.  I gladly reveal that I consult because it suggests I might actually know something about the real world that real people might learn from.
  8. Kocieniewski’s representations about disclosures are invalidated by his dishonest handling of chronology.  He insinuates that I did not disclose my work for the CME or commodity trading firms when I testified before Congress in 2008. But the work for CME Group, GFMA, Trafigura, etc., that Kocieniewski mentions occurred in 2011 and later.  My disclosures in my testimony were accurate at the time I made them.   But I guess I should have invented a time machine, or become Karnac the Magnificent and disclosed things that I would do in the future.
  9. The Times insinuates that my work for CME, Trafigura, TruMarx and others is related to the speculation issue, and hence taints my opinions about this matter.  My work for CME has consisted of evaluating the performance of the WTI contract as a hedging mechanism and an expert witness engagement regarding a patent on electronic trading systems: neither has anything to do with commodity speculation.  Trafigura is a physical commodity trader that uses derivatives almost exclusively to hedge, not speculate.  TruMarx launched a platform to trade physical energy, primarily between end users: again, nothing to do with financial speculation.  These matters and these companies are not related to the financial speculation issue, and Trafigura and TruMarx in particular have no real stake in the speculation debate.  Moreover, my work for them has nothing to do with the speculation issue.  Either Kocieniewski is ignorant of the fact that many commodity traders are not speculators, in which case he is not competent to be writing this story, or he is counting on the inability of his readers to understand the great diversity of firms involved in commodity markets, most notably the fact that many (most?) are not speculators, in which case he is attempting to mislead.  I know where I am laying my bets.
  10. The Times also mis-states facts about Scott Irwin, but that is mainly for Scott to correct.  One particularly egregious thing stands out which I cannot let pass though.  Kocieniewski talks about the $1.5 million that CME Group donated to the University of Illinois.  But not one cent-one cent-of that went to Irwin’s Department of Agricultural and Consumer Economics, let alone to Irwin personally.   To say that Kocieniewski’s connection of the CME’s financial support for the University of Illinois (a $4.4 billion dollar operation) and Scott Irwin is scurrilous is an extreme understatement.

I could go on, and may expand on this in a subsequent post.  But this should suffice to show that the New York Times published a hit piece to achieve a political purpose.  That piece is is a farrago of dishonesty, insinuations, innuendo, and ad hominem.  It is dishonest to its very core because of its egregiously biased omission of some essential material facts and deceptive presentation of others.

And pace John Paul Jones,  I have not yet begun to write-and fight-on policy issues that matter to me.  I will continue to bring my style of economics, data, and facts to issues upon which I can make a constructive contribution. The fact that the New York Times feels compelled to answer with fundamentally dishonest ad hominem means that it knows it cannot win on the substance, and that it views me (and Scott) as a threat to its agenda.  That’s all the encouragement I need to keep it going.

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December 22, 2013

SIPs as Public Goods: Underinvestment in Linkages in Securities Markets

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 7:30 pm

A few days ago the WSJ reported that US securities exchanges are close to upgrading one of the Securities Information Processors, the part of the RegNMS market structure that links the various exchanges.  The SIP consolidates and disseminates quote data from the various exchanges.  It provides the linkages that are necessary for the links-and-information structure created by RegNMS.

The SIPs have been a source of chronic complaints in the industry.  The current fix was compelled by a breakdown in the SIP over the summer that caused a shutdown in trading of some stocks.  But even when the SIPs work, they disseminate information more slowly than the private connections between exchanges and HFT firms.  This gives an advantage to HFT traders.

The WSJ story indicates that the operating system of the SIP is obsolete.

This issue illustrates an inherent problem with a utility-type model in securities markets. I discussed this problem in my research in the late-90s and early-00s, including in a JLEO article that was published in 2002.  That research was focused on a CLOB model, but the same issue is relevant for a the current SLOB (Simulacrum of a Limit Order Book) model. Specifically, a utility CLOB (or SLOB) has strong public good aspects.  All market participants benefit from better technology and improved performance, but would prefer that others pay for it.  Collective action and public goods problems tend to lead to under provision of quality and technological improvement.

SIPs are industry public goods, and face the same problems.  No wonder they are obsolescent.

There are other problems with the linkages approach that undermine incentives to  invest in SIP quality and technology.  The whole idea behind the linkages approach is to facilitate competition between exchanges.  But exchanges have no incentive to facilitate competition between themselves.  Competition is likely to be weaker with a kludgy linkage system, so why should exchanges push to improve it?  Not to mention that some interests, notably HFT, which would face a diminished competitive position with  more advanced SIP, also have an incentive to impede updates.

This is an inherent challenge to the linkages approach.  Its effectiveness depends on, well, the technology that links markets.  But the incentives to invest in those linkages are suboptimal due to the public good problems, exacerbated by the fact that competing exchanges don’t have an incentive to intensify competition between them.

But as I’ve often written, the alternatives have their own problems.  Most notably, if you don’t mandate linkages between markets, order flow network effects tend to cause the dominance of a single exchange.   So you need linkages and socialization of order flow if you want competition, but there will be underinvestment in the linkages.

US securities markets are committed to the linkages approach.  Public goods problems that provide inefficiently weak incentives to invest in the links necessary to make the approach work mean that it will be beset by chronic difficulties.

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November 22, 2013

All Pain, No Gain: The CFTC’s Rule on CCP Qualifying Liquid Resources

Matt Leising had a nice article a few days back about the CFTC’s rule that does not treat US Treasury securities as “qualifying” liquid resources for CCPs.  Instead, under new regulation 33-33 they must obtain “prearranged and highly reliable funding.” Based on Fed rules, this means that a CCP must get  committed line of credit from banks.   This imposes a substantial cost on CCPs, because under new Basel III rules, committed lines impose a large capital charge on the issuing banks.  For purposes of calculating capital, the banks have to assume that the lines are fully drawn.  This capital cost will be passed onto CCPs.

It is ironic that outgoing (resisting the great urge to snark) Chairman Gary Gensler repeatedly argued that one of the main benefits of the Frankendodd clearing mandate is that it would reduce the interconnectedness of the financial markets, especially interconnectedness through derivatives contracts.  Now he has pushed through a regulation that mandates an interconnection among major financial institutions via a derivatives channel: the lines connect derivatives CCPs to major banks.   I have long pointed out that Gensler’s claim that clearing would reduce interconnectedness was grossly exaggerated, and arguably deceptive.  Instead, I pointed out that the mandate would reconfigure-and is reconfiguring-the topology of the network of connections between financial firms.  What the CFTC has done is dictate what that form of interconnection will be.  This particular dictate is extremely problematic.

A CCP needs access to liquidity in the event of a default of a clearing member.  The CCP needs to pay obligations to the winning side of the market, in cash, in a very tight time window.  Failing to make these variation margin payments could impose financial distress on those expecting the cash inflow, and more disturbingly, call into question the solvency of the clearinghouse.  This could spark a run in which parties try to close positions in order to reduce exposure to the CCP.  Given that this is likely to occur in highly unsettled market conditions, such fire sales (and purchases) will inevitably inject substantial additional volatility into price that can exacerbate pressures on the clearing mechanism.

A CCP holding Treasuries posted as IM by the defaulting CM can sell them to raise the cash.  Alternatively, it could repo them out.  During most periods of financial turbulence-and financial crisis-which is likely to be either the cause or effect of the default of one or more large CMs, there is a “flight to quality” and Treasury security prices rise and there is a rush to buy them by investors seeking a safe haven.  Moreover, under such circumstances the Fed will perform its lender of last resort function, and readily accept Treasuries as collateral: even if CCPs could not access the Fed directly*, they could access it indirectly.   Thus, in “normal” crises, Treasuries should be highly liquid, and a ready source of cash that can be used to meet variation margin obligations.

Put differently, from a liquidity perspective, Treasuries are a negative beta asset: they become more liquid when overall market liquidity declines-or verges on collapse.  This is a highly desirable attribute.  Another way to characterize it is that from a liquidity perspective, Treasuries have right way risk.

Bank lines are very different.  Banks become stressed during crisis situations, and face a higher risk of being unable to perform on credit lines under these circumstances.  (Indeed, what if the defaulter is one of the suppliers of a committed line?) Banks fighting for survival but which can perform might try to evade this performance during stressed market conditions, which in a tightly coupled system (and clearing is a source of tight coupling) can be extremely disruptive: a few minutes delay in performing could cause a huge problem.  And if the banks do perform, doing so poses the substantial risk of increasing their risk of financial distress.  That is, committed lines are positive beta from a liquidity perspective: that is, they pose wrong way risks.   If drawn upon, these lines can be an interconnection that is a source of contagion from a derivatives default to systemically important banks, precisely at the time that they are least able to withstand the shock.

In the event, a CCP that does collect Treasuries as IM can likely use these right way assets to raise the cash need to meet its obligations, and can avoid drawing down on its committed line.  But that would mean that the committed line is superfluous, and imposes unnecessary costs on the CCP, and hence on the users of the clearing system.

I also conjecture that having met its liquidity requirements with a committed line, pursuant to the CFTC reg, CCPs would  have a weaker incentive to take Treasuries as collateral, and a stronger incentive to permit the posting of lower quality assets (or incentivizing such posting by reducing haircuts assessed to such collateral) for IM. This would mitigate the cost impact to users that results from the CCP having to secure the committed line, and pay for it (the cost being passed onto the users), thereby reducing the loss of trading/clearing volume and the associated revenues.  This would increase the odds that the line will be drawn on (because the lower quality assets pose a substantial risk of becoming illiquid during a crisis situation-they embed wrong way risk too).  I’ll have to think this through more, because the situation is somewhat complex: it depends on the pricing of the line, which will depend on the likelihood it will be drawn against, and the market conditions at the time it is.  This will depend in part on the quality of collateral that the CCP collects.  I’m not sure of what the equilibrium outcome will be, but I suspect that mandating the obtaining of lines will undermine incentives to demand the posting of high quality collateral.  If it does, this is a bad outcome that increases wrong way and systemic risks.  If it doesn’t, then the cost of the lines is superfluous and a burden on clearing and derivatives trading.

There is one scenario in which Treasuries would not be good collateral: if the financial crisis (and default of a CM or CMs) was the result of a fiscal crisis in the US, or a default (real or technical)  of the kind feared during the last (but the last, most likely) debt ceiling standoff.  But that’s an Armageddon scenario in which banks are likely to be highly stressed and unable to perform, or in which they would incur exceptional and arguably existential costs if they did.  Put differently, there’s likely no good source of liquidity in this scenario, and the CFTC rule will hardly make a difference.

In sum, it is highly unlikely that bank lines are a better source of liquidity, especially under crisis situations, than Treasuries.  Indeed, they are plausibly worse, and actually create an interconnection that can transmit a shock to the derivatives market (and the CCP that clears it) to systemically important banks: this is the exact opposite of what clearing was supposed to achieve. The cost of the lines, which is likely to be substantial, particularly given their necessary size, is a deadweight burden on the markets: all pain, no gain.

Other than that, the rule is great.  And a fitting parting shot from Gensler.

* Frankendodd makes it difficult for US CCPs to obtain Fed liquidity support.  This is a serious mistake that could come back to haunt us in some future crisis.  To work effectively, the LOLR must be able to direct liquidity to where it’s needed,  quickly and efficiently.  CCPs could be a major source of liquidity demand in future crises, which makes isolating them from the Fed highly dangerous, and the invitation to an ad hoc response in some future crisis.

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