Streetwise Professor

October 28, 2014

Convergence to Agreement With Matt Levine

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 10:10 am

Matt Levine graciously led his daily linkwrap with a response to my post on his copper column:

It’s not that hard to manipulate copper.

Craig Pirrong, who knows a lot more about commodities markets than I do [aw, shucks], objects to my take on copper. My view is sort of efficient-markets-y: If one person buys up all the copper in the LME warehouses and then tries to raise the price, the much much greater supply of copper that’s not in those warehouses will flow into the warehouses and limit his ability to do that. And I still think that’s broadly true, but broadly true may not be the point. Pirrong quite rightly points out that there’s lots of friction along the way, and the frictions may matter more than the limits in actual fact.

. . . .

So there are limits to cornering, but they may not be binding on an actual economic actor: You can’t push prices up very much, or forvery long, but you may be able to push them up high enough and for long enough to make yourself a lot of money.

I agree fully there are limits to cornering. The supply curve isn’t completely inelastic. People can divert supplies (at some cost) into deliverable position. The cornerer presents the shorts with the choice: pay me to get out of your positions, or incur the cost of making delivery. Since those delivery costs are finite, the amount the cornerer can extract is limited too.

I agree as well that corners typically elevate prices temporarily: after all, the manipulator needs to liquidate his positions in order to cash out, and as soon as that happens price relationships snap back. But that temporary period can last for some time. Weeks, sometimes more.

What’s more, when the temporary price distortions happen matters a lot. Some squeezes occur at the very end of a contract. This is what happened in Indiana Farm Bureau in 1973. A more recent example is the expiry of the October, 2008 crude oil contract, in which prices spiked hugely in the last few minutes of trading.

The economic harm of these last minute squeezes isn’t that large. There are few players in the market, most hedgers have rolled or offset, and the time frame of the price distortion is too short to cause inefficient movements of the commodity.

But other corners are more protracted, and occur at precisely the wrong time.

Specifically, some corners start to distort prices well before expiration, and precisely when hedgers are looking to roll or offset. Short, out-of-position hedgers looking to roll or offset try to buy either spreads or outrights. The large long planning to corner the market doesn’t liquidate. So the hedgers bid up the expiring contract. Long still doesn’t budge. So the shorts bid it up some more. Eventually, the large long relents and sells when prices and spreads get substantially out of line, and the hedgers exit their positions but at a painfully artificial price. I have documented price distortions in some episodes of 10 percent or more. That’s a big deal, especially when one considers the very thin margins on which commodity trading is done. Combine that price distortion with the fact that a large number of shorts pay that distorted price to get out of their positions, and the dollar damages can be large. Depending on the size of the contract, and the magnitude of the distortion, nine or ten figures large.  (I analyze the liquidation/roll process theoretically in a paper titled “Squeeze Play” that appeared in the Journal of Alternative Investments a few years ago.)

But this is all paper trading, right, so real reapers of wheat and miners of copper aren’t damaged, right? Well, for the bigger, more protracted squeezes that’s not right.

Most hedgers are “out-of-position” they are using a futures contract to hedge something that isn’t deliverable. For example, shippers of Brazilian beans or holders of soybean inventories in Iowa use CBT soybean futures as a hedge. They are therefore long the basis. Corners distort the basis: the futures price rises to reflect the frictions and bottlenecks and technical features of the delivery mechanism, but the prices of the vastly larger quantities of the physical traded and held elsewhere may rise little, if at all. So the out-of-position hedgers don’t gain on their inventories, but they pay an inflated price to exit their futures.

This is why corners are a bad thing. They undermine  the most vital function of futures markets: hedging/risk transfer. Hedgers pay the biggest price for corners precisely because the delivery market is only a small sliver of the world market for a commodity, and because the network effects of liquidity cause all hedging activity to tip to a single market (with a very few exceptions). Thus, the very inside baseball details of the delivery process in a specific, localized market have global consequences. That’s why temporary and not very big and localized are not much comfort when it comes to the price distortions associated with market power manipulations.


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1 Comment »

  1. SWP- how do you draw the line between an actual corner, and pushing your position into an undersupplied market? IMO it is more of a continuum between taking an honest and speculative view on fundamentals and a nefarious corner. You are correct that the number of possible ways to “create a corner” are too numerous for any person or regulator to contemplate- so why not let the market discipline itself? and learn the best way to transmorgify a futures contract into a hard- deliverable commodity. When Amaranth (Brian Hunter) was in trouble, even Bloomberg knew his position before he could exit the length. Natural gas markets are so deep and liquid it is hard to imagine that Hunter could even contemplate a corner… and yet he was charged with it. There is “smoke” everywhere in commodity markets- if you have the righteous view taken by most regulators that volatility is evil and of nefarious origin.

    Nobody I know wants to own copper right now. Maybe Red Kite is swapping real copper in the ground (assets) for copper in the warehouse? or a million other possibilities. Real life and business is complicated. And derivative trading is infinitely more complicated than a position-length report from CFTC or LME- On top of that, Red Kite is certainly aware of what is easily discoverable information about their position and what is not.

    If there is “smoke” in the copper market, it is more likely in the copper trade-financing deals for chinese companies, and how they account for collateral.

    Comment by scott — November 4, 2014 @ 5:07 am

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