I have been a close observer of manipulation since the mid-1980s, when the Japanese were squeezing the 30 year while I was devising interest rate hedging strategies for the clients of the FCM I worked for. Since then, I have examined, intensively and forensically, manipulations in soybeans, Brent, Bunds, Treasuries, canola, copper, aluminum, propane, natural gas, WTI, and other things. I have researched every major manipulation that I could identify, dating back to the 1860s.
I have heard all of the lame alibis, sometimes directly from the manipulators’ mouths, sometimes from the mouths of their mouthpieces. Excuses from the likes of them are to be expected. It is disappointing, however, to see the Financial Times regurgitate their tripe.
Yesterday the FT ran an editorial that recycled many of the tired tales that manipulators tell in defense of Anthony Ward’s actions in the cocoa market. None of it is exculpatory, in the least.
To start with, the FT opines:
Armajaro breached no rules when, in pursuit of its view that cocoa prices would rise after a poor harvest, it snapped up contracts to purchase cocoa beans on the Liffe futures exchange. These gave it the right to take physical delivery of the beans if it chose. What stirred the controversy was that Mr Ward exercised that prerogative over 24,100 contracts. These amounted to about 7 per cent of annual world production.
Yes, the old “I had the contractual right to do what I did” defense. But a market power manipulation involves the opportunistic use of this contractual right to distort prices and the flows of a commodity in commerce. This action degrades the effectiveness of futures contracts as a risk shifting and price discovery mechanism, and leads to wasteful use of the commodity. If “contractual right” trumps everything, then rules against corners are a nullity. If that’s the way the game is played, maybe I should start The Corner Fund and go to town. I’ll hire the FT to flack for me. But I probably won’t even have to hire it: it seems it’s willing to do it for free!
The FT continues with another old standby: the “They had it coming to them for walking in this neighborhood alone dressed in shorts like that” story:
There is no doubt that his decision caused agony for some on the other side of the contracts. A number of cocoa traders use Liffe to hedge against falls in the prices of the stocks they hold. They suffered because they not only hedged their beans – but their holdings of cocoa powder and butter also. These were ineligible for delivery against the contracts, thus forcing the hedgers to settle contracts for cash at penal premiums or to buy sufficient beans to close the trade.
It is hard to see how Mr Ward can be blamed for this. The hedgers did not need to run a mismatch risk. They could have found other ways to insure their exposures – such as entering into a derivative with a bank. That would have been more expensive, but would also have been safer.
But the whole point of centralized markets is to concentrate liquidity, thereby permitting out-of-position hedgers to reduce risk with maximum flexibility while incurring low transactions costs. They willingly trade basis risk for transactions costs. That is no reason to excuse opportunistic actions that exacerbate basis risk. The risks of being cornered induce hedgers to take costly preventative measures, such as investing collecting information about the activities of other traders that is socially wasteful because it is merely intended to reduce the risk of being the source of a wealth transfer, or using markets where transactions costs are higher.
Beating me to the punch, Tullet Prebon’s CEO T.C. Smith skewers the FT’s fatuousness–and hypocrisy:
Many commentators maintain that one lesson of the financial crisis is that all over the counter derivatives should be traded on exchanges.
I wonder how the revelation in your editorial, that the cocoa consumers who attempted to hedge their powder and butter through the imperfect mechanism of the Liffe futures in cocoa beans would have suffered much less if they had taken out OTC contracts with banks which precisely hedged their risk, fits their theory.
They can file your editorial with the reports on the as yet unexplained “Flash Crash” of May 6, in which Apple’s shares traded at one cent per share and $100,000 a share within 20 minutes.
But then, why let the facts get in the way of their theory? It will all be safer and more transparent when everything is on exchange.
Couldn’t have said it better myself.
The FT then plays three card monte and attempts to distract attention from the real issue:
It has been suggested that Mr Ward’s conduct was akin to cornering, and thus led to a disorderly market. But this is a hard case to sustain. Disorderly markets occur when two-way prices cease to be made – thus making cash settlements impossible. But the open interest on the cocoa contract fell in the weeks prior to expiry.
That is, shall we say, an idiosyncratic definition of “disorderly market.” In fact, in many corners trading activity can reach a frenzy. There are two-way prices, but the prices are far above where they would be in a competitive market, and the “cash settlements” are at essentially extortionary prices. Apparently that’s hunky dory with the FT. And even in cornered contracts open interest typically falls. In fact, that’s almost always true. Indeed, it often falls the most when the cornerer makes money by liquidating futures at supercompetitive prices.
The FT then suggests that the quiet word among gentlemen approach is preferable in such matters:
However, squeezes can be managed. Liffe tries to do this by directly stepping in where necessary to guide the activities of traders. This approach, which has been compared to being summoned to the “headmaster’s study for a quiet word”, effectively substitutes for a detailed rule book. The flexibility it provides can be valuable so long as the market is actively policed.
Yeah. That works, except when it doesn’t. And the London markets provide numerous examples of it not working. Remember Sumitomo, and the LME’s rather, shall we say, prone, not to say accommodating, posture in dealing with Hamanaka right to the end? Or all of the Brent shenanigans that occurred over the years?
And in that vein, a shout out to LIFFE, for validating my 1995 JLE article arguing that exchanges were unlikely to act against manipulation. It would be hard to write a letter that does a better job at missing the elephant in the room.
Perhaps due to space limitations, the FT does manage to overlook some of the standard lines from the manipulator’s manual. But a couple of commentors over at SeekingAlpha fill the void.
In this case, it appears that Armajaro already had customers for the cocoa delivered to it. See!, the commentor says, there is real demand, real customers. Well, if you know anything about manipulation, you know that the biggest danger is related to burying the corpse of the manipulation: that is, selling the massive deliveries that you take to squeeze the market. A clever fellow bent on manipulating the market pre-arranges the funeral. If the reports about forward sales of old crop cocoa to processors are correct, that was done in this case. So, rather than being exculpatory, such sales are actually evidence of manipulative intent.
(I’d be interested to know who is making the deliveries. It would be telling if any of the deliveries were made by those who had contracted to buy from Armajaro. It would also be interesting to know more of the details of those contracts, not just the pricing terms but any other features in the contracts relating to use or marketing of the cocoa, and the delivery locations for the contracts.)
The other common excuse, again seen in my SA comments, is that the stuff that is delivered will be consumed. Well, duh. It’s not like the guy is going to eat it all himself, or burn it, or build houses out of cocoa beans. It is going to be consumed. But manipulation distorts consumption pattens–the timing and location of consumption. The stuff is consumed, but in the wrong place at the wrong time, and too much of it is shipped around to the wrong places. The fact that the delivered cocoa will eventually be consumed does not imply that the deliveries are efficient.
All in all, none of the arguments raised in Armajaro’s defense are even remotely exculpatory, and some are actually adverse. A final judgment would require a full forensic and econometric evaluation of prices, pricing relationships, price-quantity relationships, and movements of cocoa. Time permitting I hope to do some of that. But at this juncture, there is sufficient evidence to conclude that there is a colorable case against Armajaro, and that the arguments raised in its defense are risible.
Taking huge deliveries in a large backwardation is consistent with manipulation. This is especially true when one party takes all the deliveries. Delivery economics are pretty straightforward, and if they work for one party they tend to work for several. One firm taking all of the deliveries is suspect.
Moreover, the purported rationale for the trade–an expectation of a small new crop in the autumn–does not explain why the old crop price richened relative to the new crop price. If the real motivation was a view that the market did not appreciate sufficiently the likelihood of a small crop, then the trade should have been to go long the new crop and cash in if and when that view was validated. Taking delivery into a big backwardation, and seeing the backwardation actually increase as result of the deliveries, is not a sensible way to play an anticipated shortage in the new crop. The backwardation across crop years screams: “don’t carry over inventory into the new crop year.” So current inventories do nothing to alleviate future shortages (because the spreads signal that all of the cocoa should be consumed before those shortages arise). (As an example of how the market should work in response to anticipation of a crop shortfall, during the big US drought of 1988, the old crop-new crop spreads for corn and soybeans snapped into a huge carry; indeed, the spreads exceeded full carry charges measured using official storage rates. The warehouses in Chicago were filled to the top with grain and beans. That’s because the market realized that it was desirable to carry over old crop supplies in larger quantities than usual to alleviate the anticipated shortfall in the 1988-1989 crop.) (Ferruzzi told the same lame betting on a new crop shortfall story during its bean manipulation in 1989.)
The rise in the London price relative to the NY price is also what you’d expect to observe in a corner.
I’m not rushing to judgment. But neither should the FT . Its unseemly haste to play Ward’s mouthpiece, its heaving up of tired excuses made for manipulators from time immemorial, and its complete lack of any skepticism, are not befitting a premier financial publication.