October 25, 2007
The CFTC is supporting Congressional efforts led by Sen. Levin of MI to pass legislation that would allow it to impose position limits and obtain position information on energy derivatives traded on ICE (and presumably other electronic OTC trading platforms) in order to prevent energy price manipulation:
The CFTC is seeking mandatory daily reporting to the agency of large ICE trades, limits on the number of ICE energy contracts a single trader could control and exchange rules to force a trader to unwind large contract positions.
To recycle a line I’ve used before, they want to reduce manipulation in the worst way–and they’ve found it. Position limits and position reporting are inefficient ways to reduce the frequency of manipulation, as compared to readily available alternatives. There are so many defects in these remedies, it’s hard to know where to begin.
For one thing, position limits must be set based using very crude information about the market conditions that will prevail when the position limits are in effect. Sometimes the limits will be too large to constrain much manipulative behavior. Other times, the limits will be smaller than necessary to combat manipulation, and will be so small that they constrain the legitimate activities of market participants.
This last effect is very important. It is economically efficient for some traders to accumulate large speculative positions. These speculators absorb risk from hedgers. Position limits constrain speculators’ ability to take on risk, meaning that hedgers will find it costlier to transfer risk to speculators. They will hedge less as a result. That’s a real cost.
I have just completed a paper that shows that even if position limits constrain manipulation, they reduce overall welfare because of they interfere with the efficient allocation of risk. In essence, position limits throw out the baby with the bath. Sure, they constrain the rent seeking, manipulative activities of speculators, but they also constrain speculators’ efficiency enhancing risk bearing function too. In the standard mean-variance/Anderson-Danthine hedging/speculation equilibrium model of my paper, the latter effect outweighs the former, and position limits reduce welfare. Thus, even if they are successful in reducing manipulation, that doesn’t mean that they’re good public policy.
This possibility has been totally ignored in the debate, such as it is, over position limits in energy. This reflects a general ignorance of the socially beneficial effects of speculation, and indeed, the hostility to speculation that has dominated the Congressional and regulatory intellect for decades (stretching back into the 19th century.) Risk transfer is a primary function of derivatives markets, and position limits interfere with this primary function. This is a real cost, but one that is too often ignored.
Position reporting wins no prizes for efficiency either. Presumably the theory is that the ability to monitor positions gives regulators the ability to identify incipient manipulations, and intervene before things get out of hand. Now let’s deal with the reality.
The first reality is that how big is big–i.e., how big a position must be before it poses a manipulative threat–depends on variable market conditions, and how the trader acts. Just seeing that somebody holds a big position tells you absolutely bupkus. As a result, regulators will start to scrutinize big positions only when price distortions become manifest in the marketplace. Well, by the time this happens, a lot of the damage is already done. Maybe the regulators can keep things from getting worse, but the idea of preventing manipulation before it affects prices is a pipe dream. Even when armed with position information, regulators only become engaged when price distortions become apparent.
And even when they intervene, there is no guarantee that they will succeed. They can jawbone, but sometimes regulators can be fooled, persuaded–or intimidated–into inaction by manipulators. Think that doesn’t happen? Want to buy a bridge?
Regulators can also be wrong, and it is important to remember that when attempting to intervene during an alleged manipulation regulators necessarily have worse information than is available after things play out. The manipulative “end game” (as I call it in my ’93 JOB piece on manipulation) often provides the most powerful information on whether a manipulation in fact occurred. For one thing, the price movements post-manipulation–the “burying the corpse” effect–often provide the strongest evidence that prices were distorted. (After a corner ends, the manipulated price collapses relative to other prices as the excess deliveries are dumped on the market. These deliveries are the “corpse” of the corner, and disposing of them is referred to in the biz as “burying the corpse.”) (And to reiterate, Bill, I didn’t make up that phrase. P. D. Armour did. Sorry for the inside humor, folks, but I couldn’t resist–although I did restrain myself from making a really cutting remark.) Also, the alleged manipulator’s behavior–whether he takes deliveries at prices that appear uneconomic–provides the strongest evidence on his motives and intent.
Errors are important. Regulators can intervene and force liquidations of large positions when there is really no manipulation, or they can fail to intervene when a manipulation is actually in progress. Both kinds of errors are costly. Given the lack of crucial information before things play out, for a given probability of one type of error, the other type of error is higher when regulators try to intervene before the fact than afterwards. As I’ll discuss momentarily, civil (or even criminal) sanctions imposed after the fact can utilize better information, reduce the frequency of one or both kinds of error, and reduce the frequency and severity more efficiently than early intervention.
Reporting is wasteful for other reasons too. It is costly to collect this information, most of which will never be needed to detect or prevent a manipulation.
Moreover, traders can avoid position limits and reporting by moving their activities into the non-electronic OTC market, using voice brokers or just bilateral deals with other traders. To the extent that it is more efficient to execute transactions electronically on a platform like ICE, this displacement of trading activity is inefficient (though it is a boon to voice brokers.)
So what is better? Dropping the hammer on manipulators after the fact, that’s what. Law and Economics scholars (notably Steve Shavell) have identified conditions under which deterrence through the imposition of sanctions ex post is more efficient than ex ante prevention. Most importantly, deterrence is efficient (relative to prevention) when the offense is detected with high probability, and malfeasors are not judgment proof.
Both conditions characterize manipulation in derivatives markets. As Judge Frank Easterbrook once wrote, an undetected manipulation is an unsuccessful manipulation. A successful manipulation distorts prices–and everybody in the market can observe it. Moreover, most manipulators are well heeled, and can pay legal judgments levied against them.
By waiting to act until after a putative manipulation runs its course, regulatory or judicial authorities–or private plaintiffs harmed by the manipulation–can rely on the best information available on the price impact of the manipulation–including the “burying the corpse” effect–and on the alleged manipulator’s actions. Thus, there should be fewer errors (incorrect convictions, or incorrect acquittals) after the fact than when regulators attempt to intervene during a suspected manipulation.
Litigation is expensive, to be sure. But the expenditures can be targeted, and only incurred when the harm occurs. Position information need only be collected via discovery when the evidence of a manipulation is manifest, and from the likely culprits (who can be identified pretty easily, as there is a lot of information about who is doing what is floating around the markets, and some manipulative behavior is hard to miss, e.g., who ends up owning all the deliverable supply.) This is cheaper than collecting information from everybody (virtually all of whom are completely innocent of anything) all the time (when usually nothing amiss is happening).
So, in a nutshell, deterrence rules, and position limits/reporting are for fools. And guess which way Congress and the CFTC are moving? Draw your own inferences, people; do I have to draw a map?
Ironically, the news about the Levin bill and the CFTC advocacy thereof comes almost simultaneously with the announcement that BP has agreed to pay $300 million(!) (subscription required) to settle civil charges that it manipulated the propane market in 2004, and that four BP traders are facing criminal charges (ditto) arising out of the same incident. I have mixed feelings about the criminal aspect of this case, but the imposition on a hefty fine on BP is the way to go as a way to deter this sort of conduct going forward. Three hundred large large is some major change–especially considering that the alleged (and I guess now admitted) BP corner attempt was apparently unprofitable because the company ended up with a much bigger corpse to bury than it had anticipated. Surely any trader contemplating cornering, squeezing, or hugging a market in the future will think once, twice, and a few more times, before squeezing the next time. It should also be noted that all this activity took place in the OTC market, and that it did not take place on ICE, or to my knowledge, any electronic trading platform. Nonetheless, the manipulation was identified, the culprit fingered, and the hammer brought down. No need for watching everybody all the time, most of said watching effort being completely unnecessary because much of the time manipulation isn’t a serious worry.
For those of you with way too much time on your hands, I have a much expanded analysis of the deterrence vs. prevention debate in my book The Economics, Law, and Public Policy of Market Power Manipulation. (Shameless plug! Now up to #1,302,119 on Amazon! Only 3 copies left! Order soon!) I also presented some rigorous numerical analysis of the power of detection ex post vs. ex ante in the working paper version of what eventually turned into my 2004 ALER article on the Ferruzzi squeeze. I think that version is still posted on my UH web page.
One last comment. I find the obsession with energy market manipulation to be somewhat curious. The US government has manipulation problems much closer to home–the US Treasury securities market. Manipulation problems in this market became so chronic in the early-2000s that two high ranking Treasury officials raised the subject in public speeches, and the FRBNY called bond market heavyweights to a Come-to-Jesus meeting, where the assembled congregation was sternly warned to go away and sin (that is, manipulate) no more. Despite the importance of the Treasury markets, and their size, Congressional interest in this problem seems de minimus as compared to the constant hyperventilating over energy market manipulation. Presumably this has to do with the fact that energy prices affect pretty much everybody, whereas the Treasury markets (especially the repo market) are pretty much inside baseball; Congress has to be seen Doing Something about energy prices even though there is little if any connection between persistently high energy prices and the kinds of manipulation that are allegedly the targets of legislation, and even though (as discussed above) the legislation is an inefficient way to reduce those kinds of manipulation.
I was thinking of inserting an apposite Mark Twain quote here (you probably know the one I’m thinking of), but won’t gild the lily. Like Mom says, if you can’t say anything nice . . . I know I’ve broken that rule a lot already in this post, but I’ll follow it just this once.
Correction. I wrote that to my knowledge, none of BP’s propane transactions were consummated on an electronic system. I took another look at the CFTC’s civil complaint against BP, and noticed that market participants utilized an electronic trading platform called Chalkboard to trade propane. I don’t know the breakdown of volume between voice brokers and Chalkboard.
October 24, 2007
Dunno whether this is all accurate, but it is fascinating. Overall, eXile’s diagnosis is very similar to mine, though he seems to veer off track a bit at the end. I especially liked this paragraph:
Given Russian history, and given the high scary-factor of the two silovik clans, Putin should have every reason to worry about how badly he’s going to sleep once he leaves the Kremlin. If power passed to one or the other clan, then London or Siberia or the untraceable-poison intensive care ward are all serious possibilities.
BTW, I picked this up from Johnson’s Russia List. If you aren’t reading that, you should be.
Robert Amsterdam describes Russia’s divide-and-conquer energy policy “disaggregation.” Disaggregation is also employed domestically. The attacks on civil society, the strangulation of NGOs, the undermining of any potential opposition party, the expanding control over the media, are all designed to atomize Russian society; to prevent the coalescence of any group that could coordinate opposition; thereby to intensify the collective action problems that any opposition must overcome to challenge the incumbent power structures. The emphasis on “vertical” relations–whereby everyone and everything is linked, if at all, only through the intermediation of the central authority–is similarly intended to suppress horizontal coordination among potential sources of opposition.
Such structures are very powerful, but often very brittle. The main threat they face is the spontaneous outbreak of widespread discontent sparked by some issue that affects large numbers of individuals in the same way. If enough people are affected by this issue in the same way, and if it is of sufficient importance to them, it is easier to achieve and sustain spontaneous coordination of the opposition; there is a common issue, a common problem, to rally around. Moreover, the widespread nature of the problem makes it more difficult for the center to stymie the opposition through divide and conquer tactics.
It is far too early to predict that inflation, particularly food price inflation, or the perverse effects of ham-handed attempts to suppress it through price controls, will pose such an existential threat to Putinism. But it is far more dangerous a threat to Putin et al than any political party or movement, individually or collectively. This is especially true given that political maneuvering (firing governors, intimidating reporters, and the like) cannot solve it, and that any economic policy that will mitigate the problem entails other unpalatable costs. These sorts of economic problems are not the kinds of things that Chekists are well-suited to handle, and indeed, many of their instincts are counterproductive.
So, like I say, too early to make dire forecasts . . . but something that bears watching.
The FT reports that Russia is moving towards price controls on food:
Russia is introducing Soviet-style price controls on some basic foods in an effort to prevent spiralling prices from denting the Putin administration’s popularity ahead of parliamentary polls in December.
The country’s biggest food retailers and producers have reached an agreement, expected to be signed with the Russian government on Wednesday, to freeze prices at October 15 levels on selected types of bread, cheese, milk, eggs and vegetable oil until the end of the year.
The consequences of this move are drearily predictable: shortages, empty shelves, lines in stores, black markets in foodstuffs. I expect that these developments will lead, in turn, as day follows night, to publicity/propaganda campaigns against “speculators” and “hoarders,” likely accompanied in today’s increasingly shrill and paranoid political environment by some physical attacks on enterprising black marketeers (most likely ethnic minorities.)
What is to explain this economic stupidity? Is it another manifestation of nostalgia for Soviet days, of a piece with excavations of long-buried statues of Stalin, or Brezhnev chic? Likely not, but it does reflect the economic ignorance that is the legacy of Soviet days, though it should be noted that price controls wreaked havoc in pre-Communist Russia as well. Indeed, Tsarist imposition of price controls on food during WWI was the primary cause of food shortages in St. Petersburg (and other cities) that in turn sparked the civil unrest that culminated in revolution. (See this review of Peter Gatrell’s “Russia’s First World War” for a concise overview of this history.) It also reflects the Russian populace’s longstanding hostility to market mechanisms, a hostility unfortunately reinforced by the experiences of the 1990s.
In this environment, price controls will receive popular support–at least for awhile. And maybe that’s all that Putin and the power structures are looking for–a temporary expedient that will get them past the parliamentary elections in December and March’s presidential “contest.”
But the respite will only be temporary. Price controls do not address the forces driving Russian inflation; the huge demand stimulus resulting from booming energy prices, distributed in part through increasingly generous benefits, and the conscious decision to prevent the ruble from appreciating too much in response to the rise in energy export revenues. The only way to keep the ruble from appreciating is to increase the money supply, thereby feeding inflation. But letting the ruble rise will reduce the competitiveness of domestic Russian industry. So the energy price boom is not all wine and roses for Vlad and Co. It forces adjustments that will discomfit one important political constituency or another. Price controls may kick the political can down the road a ways, but sooner or later a reckoning is inevitable.
And there is one other predictable consequence of price controls that deserves comment: corruption. Underpricing food creates opportunities for the politically powerful, the economically connected, and law enforcement personnel to enrich themselves. Price controls mean that the “official” price of food will be less than the price that consumers are willing to pay. The connected disproportionately will be able to buy at the “official” prices and resell at black market prices, with less risk of prosecution, and profit accordingly. As bad as corruption is in Russia, these controls will only make it that much worse.
I wonder whether the siloviki consider the prospect of increased corruption a bug–or a feature. Indeed, to them it may be a “twofer”; a political palliative that defuses popular discontent for awhile, which at the same time expands their opportunities to line their pockets. Cynical? Yes, indeed. But when dealing with Russia’s current rulers, one must keep in mind Lily Tomlin’s immortal words: “No matter how cynical you become, it’s never enough to keep up.”
October 18, 2007
The following quote (courtesy of Zaxi) leaves me speechless:
“We didn’t really think through the possibility of him staying on in this kind of high-profile position,” a senior US official told The Washington Post a few days after Putin kindly accepted the Kremlin party’s invitation to make himself prime minister next year.
If this is the kind of “thinking” that characterizes the upper levels of the US government, we’d better hope that Bismarck was right when he said “A special Providence protects fools, drunkards, small children and the United States of America.” Even a cursory analysis of Putin’s situation should make it abundantly clear that all considerations compel him to find some way to stay on top. The only question is what tactics he will employ to achieve that objective. The Russian Constitution is no more than a paper obstacle to be circumvented. This should be gobsmackingly obvious to somebody as deaf, dumb, and blind as Helen Keller, but apparently it is lost on some “senior US official[s].” Heaven help us.
Only extreme naivety combined with an overdose of projection could explain such a clueless remark. Hopefully there is some serious wising up going on among those responsible for US Russian policy.
October 14, 2007
This Kommersant article discusses a liquidity crisis in Russia. The Central Bank is releasing state funds through repo market transactions to improve the liquidity of non-state banks. This is a difficult decision, given that inflation has heated up substantially in Russia in recent months; the increase in liquidity will exacerbate the inflation problem. Given the political sensitivity of inflation, the Central Bank’s action can be taken as an indication of how severe the liquidity crisis is–or could become.
This is a serious concern in Russia. A good deal of the growth in Russia’s consumer spending has been driven by consumer debt, and a banking crisis would put put this at risk. During my visit to Russia a couple of years ago, I remarked on the number of banks in Russia–the place seems to be severely “overbanked,” and there is considerable room to doubt the soundness of many of these institutions. Given the opacity of the Russian financial system, and the fact that many Russian borrowers are financial neophytes, a financial crisis is not beyond imagining. The Central Bank seems to be trying to get ahead of this problem, but as events in the UK (specifically, the Northern Rock episode) demonstrate, such acts can actually precipitate problems.
So far, the liquidity issues are mere concerns, and not a crisis. Crisis is not inevitable. And perhaps you should take my musings with a grain of salt, as I have thought for years that a crisis in China’s creaky banking system could occur any day–so much for my record as a prognosticator of such things. But it is something to keep an eye on.
The Nobel Peace Prize is supposed to be about, you know, peace. In awarding this year’s Nobel to Al Gore and the IPCC the prize committee had to pile one mass of tenuous speculations (about how climate change would lead to widespread violence and strife) on top of another (whether climate change will occur and how it will occur) in order to justify its choice. This is a travesty in a world filled with real violence where one needn’t speculate about its proximate causes, and where men and women are risking their lives every day in order to stop this violence or ameliorate its consequences. All Al Gore risks in his jetset Jeremiad is jet lag. And perhaps death by exploding ego.
This paragraph from Peter Baker’s review of Timothy Phillips’s book on the Beslan Massacre caught my eye:
A little more than a week later, Putin announced that because of the Beslan siege, he was eliminating the election of governors in Russia’s 89 regions in favor of Kremlin appointment, a move he had sworn repeatedly never to take, as well as eliminating the election of State Duma members by single-mandate districts in favor of easily controlled party lists. How terrorism in the Caucasus required the elimination of gubernatorial elections in, say, Siberia was never clear. But people close to the Kremlin indicated that Putin had long been planning such a move and simply took advantage of the moment to enact it.
“A move he had sworn repeatedly never to take”–like, remaining for a third term, perhaps? “Putin had long been planning such a move and simply took advantage of the moment”–as I suggested he might do in response to the ongoing “clan war.”
In brief, there is strong precedent for what I suggested in “I’m Still Betting that Putin Will Remain President.” That is, there is precedent for Putin using some pretext to take actions that he had repeatedly stated he would never take in order to increase or cement his power. In other words, Putin’s pronouncements on his intention to step down at the end of his second term are not believable in the least.
October 13, 2007
Crain’s Chicago Business reports that several analysts are touting a potential CME-NYMEX merger. Crain’s cautions that it has no indications that talks are underway, and both exchanges declined comment. Nonetheless, it is clear that the compelling economics of the transaction, which I have been pointing out since early-2006, are becoming widely understood.
Interestingly, NYMEX’s stock price has been relatively flat in recent months, while CME’s has appreciated dramatically to all time highs–up $40/share since early August, and rallying over $80/share since late September after a sell-off earlier in the month. The CME’s warchest is therefore bulging, and CME is more than able to swallow NYMEX. Antitrust considerations would most likely stymie CME’s nemesis in the CBT merger–ICE–in its pursuit of NYMEX. Thus, CME’s most likely competition would be NYSE/Euronext, and Thain is desperate to get into derivatives, but I still give CME the leg up due to the fact that NYMEX contracts already trade on CME’s Globex.
The article also suggests that CME is looking abroad–to exchanges like Brazil’s BM&F. Given CME’s financial heft and management, in my opinion the exchange can do both. So, my guess is that in early ’08 we’ll see CME make a bid for NYMEX, and perhaps BM&F as well. NYMEX is the prize, though, and I expect the CME to focus there first.