It’s all so confusing. During the last spasm of Congressional criticism of the “financialization” of commodity trading, mainly during the Frankendodd “debates” over position limits, the target of criticism was evil speculators who trade commodities for purely financial reasons, and who have no involvement in the physical markets.
What concerns Brown and Senator Jeff Merkley, Democrat-Oregon, is that banks have numerous physical commodity holdings as well as the means to deliver those commodities, including oil tankers, transmission rights and pipelines, while they at the same time trade on energy prices in futures and swaps markets.
Big banks can buy “vast quantities” of commodities and pipelines, tankers and warehouses, said Merkley. This gives them “a huge amount of market information that’s very advantageous in trading” and gives them a “thumb on the scale in the terms of supply and demand and being able to have some influence over the price,” he said.
“If you’re simultaneously allowed to bet on the price and you’re allowed to have your thumb on the scale in reflecting the price it’s a huge conflict of interest,” he said.
“Financial institutions own fleets of oil tankers and can withhold delivery, while wagering on the price of oil or they can speculate on the price of energy while controlling supply,” Brown said.
This, the senators said, is a clear conflict of interest that is driving up commodity prices.
Make up your minds, people (which generously assumes you have them). Is the combination of physical and financial trading a good thing, or a bad thing?
As someone who has arguably written more about commodity market manipulation than anyone alive, I can say definitively that the most costly manipulative strategies-corners and squeezes-involve trading of “paper” (e.g., futures contracts) and the physical commodity. These strategies involve either taking excessive deliveries, or buying in excessive quantities in the physical market. Engaging in a market power manipulation requires some involvement in the physical market.
Historically, many of the biggest manipulations have been undertaken by hedgers.
And that’s the key point that escapes the Washington hand-wringers. On one of their wringing hands, they lament the involvement of non-hedgers in markets (let’s leave aside how you can have hedgers without speculators to take the other side of trades). On the other, they bemoan the fact that those involved in both the physical and financial commodity markets-who are often hedgers-can sometimes exploit market power to enhance profits. But if you believe that a primary function of commodity derivatives markets is to facilitate risk management by those involved in the producing, marketing, storing, and processing of commodities, you have to permit the physical traders to trade derivatives.
One of the consequences of that is that there will be manipulations by physical players. But severing physical and financial trading in order to prevent manipulation, which is what Brown and Merkley and others are suggesting, is crack-brained. It throws the hedging baby out with the manipulative bath.
And it is particularly crack-brained to focus on just one category of market participants, like banks. The potential for manipulation exists due to frictions in the physical market, and the ability of some market participants to trade both derivatives and the underlying commodities. Someone will step into the banks’ role if they are precluded from the market, and the potential for manipulation will remain. Taken to its logical conclusion, the Brown-Merkley “conflict of interest” standard would preclude any entity-not just banks-from trading both commodity derivatives and the underlying physicals.
So what’s the best way to attack manipulation? Not by destroying the ability of the markets to perform their vital risk transfer function. Instead, as I’ve argued for going on 20 years, the best way is to impose penalties after the fact for manipulative conduct. Thus, at least conceptually, I support FERC and CFTC enforcement efforts. The problem is that practically their efforts are often misdirected and intellectually confused.
Congress should economize on its limited comprehension of these issues by focusing on the key problems, rather than throw around vapid phrases like “conflict of interest” and recommend policies that undermine the ability of financial and physical commodity markets to function effectively. Better anti-manipulation laws predicated on a clear understanding of how manipulation works would be the place to start. And no, this does not involve the Xeroxing of 10(b)(5) of the Securities and Exchange Acts and inserting it into commodity trading laws, which has been Congress’s default response for about a decade. There is a complete mis-match between the fraud-based thrust of 10(b)(5) and the market power problems that sometimes arise in commodity markets. I’ve made recommendations over the years on the right regulatory/legislative approach that would target market power problems more precisely. This approach would permit the markets to exploit the synergies between paper and physical trading while at the same time improving the efficiency of these markets.
But instead, we get Congressional schizophrenia and meat cleaver approaches that would, if taken to their logical conclusion, destroy the markets in order to save them.
A further thought. Those who have the ability to trade the physical, and who have extensive information and developed logistical capabilities are usually the best positioned to break corners, and to mitigate the frictions that make corners possible. They also have the strongest incentive when they have a derivatives position that would be hurt by a manipulation.
I’ll post a link when I have a chance, but P.D. Armor’s breaking of the Leiter wheat corner in 1898 is a great example of this. There are many others.