Streetwise Professor

Last week I hypothesized that the real reason GM was balking at the Magna deal for Opel was that it wanted nothing to do with Oleg Deripaska and Gaz, widely considered to be the ultimate buyer of the stake originally slated to go to Sberbank.   And right on cue, what should I read in today’s news?:

Russian billionaire Oleg Deripaska’s carmaker GAZ (GAZA.RTS), the Russian industrial partner in a Magna-led bid for Germany’s Opel, is not interested in an equity stake in Opel, Deripaska told Vedomosti newspaper.

As Gomer Pyle would say: Surprise, surprise, surprise.

Seeing, however, that this involves Deripaska and his moving lips, it’s hardly a credible commitment that GM can rely upon.   It is more likely a sweet nothing intended to overcome resistance to the German-sponsored sale to Magna and Sberbank.

I would strongly recommend that even as minority shareholder in any deal that GM (i.e., US taxpayers) signs to sell Opel should give the company a veto over the sale of any large stake.   Otherwise, the likely outcome if the deal goes through, and Sberbank gets a big piece, is for Deripaska to say: “What was I thinking? Of course I want an equity   stake.”   Or: “That was my good twin who said that.   He’s been dealt with.   Of course I want in.”

GM should hang tough and refuse any deal involving Gaz, or other dodgy companies.   It should prevent falling victim to the Lucy-and-the-football scam by insisting that it have veto over any transfer of a material portion of Opel by any of the original equity investors.

It would be interesting indeed to see how German interest, and Sberbank’s, would change in response to GM’s insistence on such a term.   I imagine that the interest of both would cool pretty fast.   But if I were GM, I would put my faith in a veto, and pay no attention to anything Oleg Deripaska says.

CFTC Chairman Gary Gensler and Commissioner Bart Chilton have mooted the idea of replacing the CFTC’s specific intent standard in manipulation cases with the SEC’s weaker recklessness standard:

Gensler asked securities and commodities experts whether it would be appropriate for the CFTC to use the SEC’s less stringent “recklessness” standard for evaluating manipulation cases, rather than the CFTC’s “specific intent” standard. He noted that the CFTC has only once in its 35-year history successfully won a manipulation case in court.

Other CFTC commissioners also are interested in exploring the issue. CFTC Commissioner Bart Chilton said, “I like the SEC’s manipulation standard. For them, it just has to be reckless (to investigate). We have to prove an intent to manipulate.”

The CFTC’s record in manipulation cases is, not to put too fine a point on it, a mess.  To prove manipulation, it is necessary to prove: (a) the existence of an artificial price, (b) the accused had the ability to cause an artificial price, (c) the accused did cause the artificial price, and (d) the accused had the specific intent to cause an artificial price.  The “specific intent” standard means that the artificial price was more than a foreseeable consequence of actions intended to achieve some other objective (e.g., a firm takes delivery pursuant to a marketing program, and as a result of this action the price is distorted).  Instead, under the specific intent standard, the accused must have deliberately intended to create the artificial price and profit therefrom.

As I wrote about 15 years ago in an article in the Washington & Lee Law Review, these criteria for manipulation are in fact sensible.  It’s the Commission’s application and interpretation of these criteria that have been woeful, not to say idiotic.  The silliest Commission decisions were in re Cox & Frey, and especially in re Indiana Farm Bureau.  Both cases are monuments to economic ignorance, for reasons too numerous to detail here.  (The law review article was upwards of 50 single spaced pages.)

Indiana Farm Bureau is the worst offender.  In this case, a split Commission spelled out its interpretation of specific intent, and made a complete hash of it.  Again I’ll spare you the details, but the most important error the Commission made was to make the accused trader’s intent at the time he initiated a position decisive in determining intent.  Unfortunately, in a corner (the most common and important form of manipulation), it is a trader’s actions when he liquidates a position that are crucial.  A cornerer liquidates too few positions and takes too many deliveries; the latter action distorts prices by forcing the market up the supply curve.

So, under IFB, a trader can enter in a position as a hedge or speculation, and then as the contract nears expiration, squeeze the hell out it if the opportunity presents itself, and escape scott-free.

So, it’s not specific intent that is objectionable.  It is the Commission’s boneheaded interpretation of the concept that needs fixing.  The Commission needs to focus on intent at the time the price distortion takes place, not long before.

As currently interpreted, the Commission essentially gives traders a manipulation option.  Enter into a position for any legitimate commercial purpose (e.g., hedging or speculation) and you have the option to squeeze later on.  It’s like saying that murder is OK, as long as you don’t plan it too far in advance, but just take advantage of any opportunity to knock off somebody who bugs you when it comes up.

A recklessness standard is, in my view, too loose, and too subject to abuse by regulators.  A coherent specific intent standard, rather than the current incoherent one, is preferable.

Gensler raised the possibility of going to Congress to get additional authority:

“It may well be that we can do something within our current authority” to boost enforcement against fraud and manipulation, Gensler said. “It may be that we recommend some changes to Congress.”

That would be advisable.  In my 1996 book on manipulation (#2,217,310 on Amazon!  Available in Kindle format!) I laid primary responsibility for the pathetic state of manipulation jurisprudence squarely on Congress’s shoulders for its failure to define manipulation with sufficient clarity, and failing to set out more specific standards/criteria to prove manipulation.  In its desire to create a statute so broad as to encompass every type of manipulation, Congress created one so vague that it was incapable of being used to combat the most serious forms of this conduct, most notably market power manipulations.  (I made a similar suggestion to Sen. Richard Lugar when he was chairman of the Senate Ag Committee in 1996.)

The sad part about all this is that the effects of manipulation are quite distinct, and the kinds of conduct that can cause these effects are very straightforward.  By failing to apply some basic economic reasoning, Congress and the Commission have made things far harder than they need to be.

So, it is indeed about time for the Commission to get serious about addressing its past failures–and getting Congress to address its failings as well.

Gensler and Chilton spoke glowingly of the SEC’s manipulation standards.  I should point out, though, that the SEC has hardly been that successful in prosecuting manipulation, even given its weaker recklessness standard.

And speaking of reckless, one suggestion made at the CFTC-SEC meeting by Columbia Law Professor John Coffee was to make insider trading illegal in commodity futures markets, as it is in securities markets:

Fraud in the derivatives market may be reduced if the CFTC had SEC-like powers to enforce insider-trading and market- manipulation cases, Columbia University securities law professor John Coffee said in prepared remarks to be delivered today.

The CFTC “needs legislation prohibiting insider trading on commodities and transactions within its jurisdiction” and should be able to impose financial penalties in cases of violations. The SEC “is armed with a greater enforcement club” and can impose penalties without going to court, Coffee said.

“The bottom line here is that it would make sense to harmonize these penalty levels so that both agencies had equivalent powers,” he said.

This suggestion, and the reasoning behind it, are inane. There are substantial differences between securities and commodities markets.  Sanford Grossman summarized the key issue in the Journal of Business in 1986:

In securities law, which regulates insider trading, an insider is a corporate employee or some other person with a fiduciary responsibility to the shareholders of the corporation.  The mere possession of valuable private information by a person who owes no fiduciary duty to the shareholders of a company does not make the person an insider under the securities law.

. . . .

It is important to realize that securities law prohibitions against insider trading are not prohibitions against informed trading . . . These laws are designed to prevent corporate officers from violating their fiduciary responsibility to shareholders, for example, by preventing trade by an insider that increases the wealth of the insider at the expense of shareholders.  A futures contract is not a “security” issued by a commercial trader.  The commercial trader is not under any fiduciary obligation. . . . Hence the rationale for regulating insider trading is absent in the case of futures markets.

In the absence of fiduciary duty as the guiding principle behind any regulation of insider trading by a market with no “insiders” as defined in securities markets, it is likely that any inside trading regulation in commodities markets would attempt to restrict some kinds of informed trading.  This would be a disaster.  It would wreak havoc with the price discovery process, deter some market participants from participating, and create a game of regulatory Russian roulette because any attempts to draw lines between “good” informed trading and “bad” informed trading would be inherently arbitrary.

What was Coffee thinking?  I have no idea, but I must say it’s not the first time I have asked myself that question.  It seems that he’s a guy who knows a lot about securities, and virtually nothing about derivatives, but assumes that they are effectively the same even though there are important differences.  A foolish consistency, Mr. Coffee . . . [And no, I’m not talking about Joe Dimaggio.]

Believe it or not, US Army War College historian of Russia Stephen Blank and I are not twins, separated at birth, though you might get that impression reading what we write.  We do, however, share a University of Chicago background, although in different departments a few years apart: maybe it was something in the water.

Latest case in point, Blank’s take on the the controversies over history, and modern Russia’s approach to these controversies, notably those involving the Stalinist period:

While I would not have recommended the OSCE resolution, the issue is not one of equating Nazism with Stalinism. The similarities and the unique aspects of each monstrosity should be studied dispassionately and with true academic rigor.

Nonetheless, Moscow has nobody to blame for this impasse but itself. The Putin regime long ago made a calculated decision to slam the door on a frank study of Soviet history, to glorify Stalin’s wartime and imperial policies, and to draw a veil of silence on the horrors of Stalin not to mention Lenin, no mean mass killer himself.

Admittedly the East European states are using history for nationalist purposes, but the success and utility of such calls were first revealed by Moscow. Indeed, the reason for the ever louder invocation of these cards is Moscow’s stonewalling on the truth.

The continuing glorification of Stalin, e.g., in refurbished metro stations (can anyone imagine the Germans using Hitler quotes in renovated Berlin buildings?) epitomizes the process. As long as Russia refuses to come clean about its past, it will be a morally perverted and politically dangerous society that cannot be trusted.

Russia should learn from Germany’s example (who is Russia’s Willy Brandt?) that genuine contrition and acknowledgment of the truth breeds respect, while Japan is still distrusted because, like Russia, it cannot bring itself to open the debate and tell the truth.

Because Russia will not tell the truth and its leaders still want to reap the benefits of associating themselves with Stalin by putting a positive glow on his actions, they must bear the responsibility for the costs that Russia will continue to incur. Indeed, the Russian Federation, because it will not acknowledge the truth, remains the last and by no means least of Stalin’s posthumous victims.

Russia wants to relive its Glory Days, but in so doing, it scares the bejezus out of its neighbors for whom those days were anything but glorious: Russian “glory” has been their misery.  As Blank notes, Russia truly has a choice to make: acknowledge its past more honestly, and get along better with former Soviet republics and Eastern European nations, or continue the same truculence and feed fear and resistance.  Sadly, given that the current elite believes that its domestic legitimacy rests on maintaining the image of a strong, overawing state, it is almost certain that truculent denial will be the order of the day, today, tomorrow, and for many tomorrows to come.

Blank mentions “respect.”  Typically behind the curve, Newsweek has just figured out that Putin et al are obsessed with respect:

Russia’s apparent recalcitrance isn’t simply a manifestation of evil or pique; it is a reflection of a particular world view. Talk to Russians today from any walk of life about where they see their country’s place in the world and you’ll soon hear them use the word “respect.” Mention history, and you’ll likely hear a lot of blame slung at America for inflicting years of economic hardship and political chaos. No less a figure than the former Soviet leader Mikhail Gorbachev complained recently that “the fall of the Soviet Union made America’s head spin—it was as though Russia was no longer significant, no longer a partner, and worthless to America. Then, when Russia was on its knees, when our economy collapsed, Americans came here and applauded the great job Yeltsin had done. We understood something important then: it suited the West for Russia to be half dead.”

But the important thing to recognize, which Newsweek’s Owen Matthews does not, is the distinction between the kind of respect that Blank is talking about, and the kind of respect that Putin et al (and far too many Russians) want.  Blank means respect that connotes admiration, and a desire to emulate.  The kind of respect Putin, the siloviki, and many Russians seek (nay, demand), however, is at root, a craving to be feared.

It is, as I’ve written in the past, a gangsta’s or mafiosi’s respect.  It is a conception of respect that is rooted in a violent, distrustful, Darwinian, worldview, one that disdains cooperation for mutual gain, and conceives of all human relationships as zero-sum.  It is, alas, in contrast to admiration/emulation-based respect which can support mutually gainful interactions, something that cannot be achieved without somebody else’s abasement.  Since the Russian conception of respect cannot be realized without the subjugation of others, Russia’s continued demands for it are a recipe for chronic conflict.

Given Russia’s existential economic and social problems, this obsession with gangsta respect, and fixation on the past, is more than a little pathetic.  In my mind, it evokes Marlon Brado’s Terry Malloy in On the Waterfront: “I coulda been a contender.”  Living in the past.  Except that even the simpleminded Malloy eventually realized that he had to confront the past and the present honestly.  That is not in prospect anytime soon in Russia.

I haven’t written that much about the Arctic Sea fiasco, because it makes Churchill’s riddle, mystery, enigma characterization of Russia look like the understatement of the millenium.  None of it adds up, least of all the the Russian government’s announcement of the need for a time consuming, thorough search of a small, 4000 ton vessel.

All of the bizarre official statements have done little more than shred further the Russian government’s tattered credibility, and feed conspiracy theories.  One that has gained considerable attention is that the ship wasn’t carrying timber alone, but was also smuggling weapons to a Middle Eastern country.  Some versions of the story claim that the ship was really seized by Israeli commandos, and that Israeli President Peres made a surprise visit to visit Medevev in Sochi in the immediate aftermath of the incident to inform him that Israel had evidence of weapons transfers from Russia to Israel’s enemies (h/t R):

When contacted by TIME, both the Israeli Prime Minister’s office and Mossad, Israel’s secret service, declined to comment.

But in an Aug. 18 statement, the Israeli Foreign Ministry said that Peres had discussed “the sale of Russian weapons and military hardware to countries hostile to Israel” with his Russian counterpart,  Dmitri Medvedev, on that day during four hours of closed-door talks in the Russian city of  Sochi. According to the statement, Peres “stressed that Israel has concrete proof of Russian weapons being transferred to terrorist organizations by Iran and Syria, especially to Hamas and Hizballah.” A spokeswoman for the Israeli President declined to elaborate on any connection with the  Arctic Sea. In a parallel statement, the  Kremlin did not mention weapons sales, saying after the meeting that “we more clearly and precisely understand each other’s positions.”

Well, one Russian who loudly called “bullsh*t” on the official “piracy” story has received a not-so-friendly visit from “some serious guys,” who threatened him with arrest unless he fled the country:

Mikhail Voitenko said he had been told to leave Moscow or face arrest.

The editor of Sovfracht, an online maritime journal, fled on Wednesday, saying he may not be able to return as his life would be in danger.

. . . .

Speaking to the BBC from Turkey, Mr Voitenko said he had received a threatening phone call from “serious people” whom he suggested may have been members of Russia’s intelligence agency, the FSB.

The caller told Mr Voitenko that those involved in the mysterious case of the Arctic Sea were very angry with him because he had spoken publicly, and were planning on taking action against him, he said.

“As long as I am out of Russia I feel safe,” Mr Voitenko told the BBC. “At least they won’t be able to get me back to Russia and convict [me].”

Voitenko was vague about exactly who visited him: go figure!:

“Some serious guys hinted to me yesterday or the day before yesterday,” Voitenko said. “They advised me to return in three or four months.”

Asked who the people were, Voitenko said simply, “Guess.”

Asked if it was because of his role in the Arctic Sea case, Voitenko said, “Yes, it was because of the Arctic Sea.”

Hell, if he did this in the US, instead of visits from mouth breathers, he would be besieged by Hollywood lefties offering a movie deal and asking for help on the screenplay.  But he didn’t do this in the US.  He did it in Russia, and the idea of publicly challenging the government on anything deemed remotely related to national security is a serious health threat.

Voitenko should consider himself very lucky.  Many others who have gained less notoriety than he for their revelations (e.g., numerous journalists or activists reporting on Chechnya, or the military reporter  Ivan Safronov  who blew the whistle on military corruption and problems with the Bulava missile) have wound up very dead.  Indeed, Mr. Voitenko’s very notoriety is probably his saving grace.  Given the international exposure of the Arctic Sea story, and his prominent role in reporting on it from within Russia, even Putin wouldn’t be able to blow off his death.

Maybe Mr. Voitenko was right.  Maybe he was wrong.  If he was wrong, the Russian government’s handling of the matter only bolstered his credibility, and immolated its own.  And his decision to flee the country after a visit from some wiseguys only adds more fuel to the pyre.   It all suggests that Voitenko’s greatest sin was getting too close to the truth, and in Russia that is a very dangerous place to be.

Spiegel has released a long article chronicling the Opel saga.  In brief, the story appears to be that GM originally agreed to the Magna-Sberbank/Avtogaz deal out of desperation, but as its existential crisis eased due to the infusion of massive amounts of US taxpayer support, relief from debts resulting from the lightening bankruptcy, and latterly cash-for-clunkers, GM decided that it wasn’t in any hurry to sell Opel.  And in particular, it wasn’t in any hurry to sell it to Magna-Gaz.

This shouldn’t be a big surprise.  Magna isn’t in great financial shape itself (what autoparts manufacturer is?).  There is also reason to be concerned about IP.  Also, the competing offer from RHJ gives GM a stronger opportunity to buy back Opel.

But I think that the main reason is that GM doesn’t want to be a minority partner in a business with Gaz–and hence with Oleg Deripaska.  Being a minority shareholder in a deal involving a company like Gaz, and a character like Deripaska, is often quite unpleasant.  Deripaska and Gaz are in very bad financial shape, and would have every incentive to try to exploit Opel through myriad means (including transfer pricing and capital expenditures) that would divert funds and resources from Opel into Gaz in order to prop up their tottering operations.  GM would know that the Russian government would throw its weight around in Gaz’s support.  What’s more, with Germany being so subservient to Russia, and providing a good deal of financial support to this deal (but no other), GM (and hence us, fellow American taxpayers) would face the prospect of having the Germans put pressure on GM to favor the Russian partner.  Now Gaz would not have a majority stake, but the Russians are past master at playing divide and conquer, and could exploit and foment divisions between GM and Magna in order to favor Gaz.  With the Russian, and likely German, governments on its side, it could make GM’s life miserable.

GM’s original embrace of the deal is understandable, given its straits at the time it agreed to it.  Similarly, its current reluctance to proceed is understandable, given the unsavory nature of its partner and the passing of its existential crisis.

What is hard to understand is Merkel’s (and Germany’s) intense interest in this deal, as opposed to an alternative like the RHJ offer.  The Magna-Gaz deal and RHJ deal would have about the same impact on jobs in Europe overall (about 10K), but the Magna-Gaz plan would cut fewer jobs in Germany.  (So much for “Europe”–it still usually comes down to national interests.)  But I doubt that the difference of a couple of thousand of German jobs fully explains the German dedication to the Magna-Gaz offer.

Instead, the singleminded way in which Merkel and Steinmeier are pushing for GM to accede to the Russian-Canadian offer seems to be further evidence of their thralldom to Russia, and Russian business interests.  Why Germany should be in thrall to Russia in this rather embarrassingly public way is a puzzle.

Germany has had economic problems, to be sure (who hasn’t?), but its economic fundamentals are far stronger than anything Russia can achieve of ever dreaming.  Why does it seem so intent to tie itself to a shambolic Russian economy, decrepit and corrupt Russian companies, crooked and thuggish Russian oligarchs, and an authoritarian Russian government?  What does it get in return?  Can it really be gas?  If so, does it believe that all this groveling will really make a difference when Putin (or whoever succeeds him) finds it profitable to turn the screws some day hence?

It is really demeaning and unseemly.  Rational calculation seems incapable of explaining this at-the-feet display; some psychological phenomenon seems at work here.  I’m an economist, so I’ll leave the diagnosis to professionals.

In the meantime, I hope GM hangs tough–and leaves Gaz, Deripaska–and Merkel–twisting in the wind.

The joint CFTC-SEC meeting about how the two agencies can play better together has spurred numerous suggestions that the agencies merge, or better yet, that the government create an uber-regulator responsible for all aspects of regulation of financial markets and financial firms.

I’ve written before that this is a very bad idea, and in light of the return of attention to this issue, thought it worthwhile to explain again why I think that’s so.  I’ll also lay out an alternative regulatory scheme that I think makes sense than either the existing system, or the uber-regulator alternative.

The argument against a regulator with myriad responsibilities for myriad firms rests in economic theory, notably agency theory.  Avinash Dixit has laid out the argument in a nice book that is somewhat accessible to a non-professional audience, so I’ll just hit the high points.

The idea here is that a regulator is an agent.  Who is the principal?  Well, Congress is the primary principal.  Thus, fundamental mechanism design issues that arise in the context of agency theory as typically applied to a firm (principal) trying to motivate and control its employees (agents) apply to the Congress-regulator relationship too.

Dixit notes that Congress designs regulators.  Moreover, Congress, both through the statutes it passes establishing and governing the regulators, and through the oversight process, provides regulators with incentives.  In particular, Congress can subject a regulator to very strong, “high powered” incentives, or very weak “low powered” incentives.  Agency theory tells us that the power of the incentives will depend on the nature of the organization/regulator.

Specifically, agency theory implies that low powered incentives are generally desirable when an agent has to perform multiple tasks.  The more tasks, typically, the weaker the incentives.  If you provide really high powered incentives, unless it is possible to measure everything the agent does with high and roughly equal precision, the agent will have an incentive to game the incentive system and do the things that provide very high rewards, and neglect the tasks that don’t.  As an example, let’s say you let cops keep a portion of the stolen goods or drugs that they seize.  You can bet that the cops would spend all their time looking for thieves and drug dealers, and have very little incentive to solve murders or intervene in domestic disputes: where’s the money in that?  Moreover, it’s hard to measure the effort or effectiveness or benefit of murder solving or separating Mr. and Mrs. Smith, so it’s hard to design an incentive to reward what you can’t measure.  So, when that 911 call comes from the Smith residence, don’t expect much of a response: the cops will be out looking for the dealers.

The resulting allocation of effort can be very perverse.  To give an incentive for the agents to do things that are hard to measure, you have to provide low powered incentives.  You can’t reward drug seizures, because that would induce the cops to spend all their time looking for drugs, and little time policing other kinds of (less remunerative to them) crimes.  Thus, low powered incentives are necessary to induce an optimal allocation of effort across tasks.

The more alternative things that the agent can do–the more tasks he performs–the more possibility for gaming high-powered incentive systems, and typically the weaker the incentives have to be.  Therefore, it is typically optimal to subject an agent that is  responsible for many tasks with lower powered incentives.

If the agent has many principals, the problem gets even worse.  Each principal has an incentive to get the agent to do what that principal wants, at the expense of the other principals.  So, it may be optimal to subject an agent working on a single task to weak incentives (fixed salary, no bonus, 9-5 hours) if he works for many principals.

Put these problems together, and you usually have to impose extremely weak incentives in order to reduce opportunistic gaming of the incentive system.  A multi-tasking agent working for many principals should typically be subject to very weak incentives.  And having very weak incentives, he is unlikely to work either hard or smart.  That may seem bad, but it’s less bad than having the agent work hard and smart to game a high-powered incentive system.

This means that a big, uber-regulator responsible for regulating everything in the financial space would be a disaster if Congress subjected it to strong incentives.  The uber-regulator would have many, many tasks to perform: oversight over security issuance, disclosure, bank capital and risk taking, derivatives trading practices, and on and on.  Moreover, it would have many principals.  It might seem there is only one–Congress–but Congress is not a unitary body.  It has numerous committees, many of which would have a piece of the responsibility for overseeing the agency.  Moreover, on a given committee, there are multiple Congressmen, each of whom is responsive to distinct interests unique to his district or state.

So, Congress would likely respond to this by providing the regulator with very weak incentives.

Thus, the alternative outcomes with an uber-regulator: an out of control body gaming high powered incentives, or a slothful, inefficient organization subject to weak incentives.  The likely outcome would be the latter, a living illustration of Eugene McCarthy’s statement that “the only thing that saves us from bureaucracy is its inefficiency.”

So what do I propose instead?  A more functional division of regulatory responsibilities, and one that mitigates the multi-tasking/multi-principal problems.  In a nutshell:

• Split off the primary market, accounting, and disclosure parts of the SEC into a separate organization.  Call it the “Securities Commission” or the “Corporate Financial Information Commission.”  This agency would police fraud in the issuance of securities, and fraudulent disclosures and accounting practices.
• Combine the market operation parts of the SEC and the CFTC into a Trading and Markets Commission.  This body would have responsibility for overseeing the operation of exchange and OTC trading mechanisms.  It would essentially be a “microstructure” regulator responsible for secondary market structure issues in securities and derivatives, manipulation and fraud in securities and derivatives trading, and the policing of agents who execute transactions for principals (e.g., stock brokers).  Under this system, there wouldn’t be the turf battles over the regulation of different kinds of financial products, or attempts to design products in order to have their trading overseen by one regulator or the other.  All trading would be under one regulator.  These trading-related matters are largely distinct from the information/disclosure related issues, and there is no good reason to combine all under one regulator.
• Create a prudential regulator with the responsibility of regulating the risks of financial institutions.  This regulator would cover major financial intermediaries, regardless of corporate form, that potentially pose a systemic risk.  Thus, banks, investment banks, large insurance companies, and other levered institutions whose failure would pose a risk to the financial system would be subject to this prudential regulator

This division of authority along more functional lines would mitigate the multi-tasking and multi-principal problems that an uber-regulator would pose.  Of course, there would still be multiple principal and multiple task problems under this allocation of responsibilities, but the organizations would be more focused, and could be provided with stronger incentives to do their jobs than would be the case under a single, overarching regulator.

Is this likely to happen?  Surely not.  But hopefully people will start to awake to the fact that the seeming elegance and simplicity of one-stop regulatory shopping is actually a recipe for the next crisis.  Think that regulators failed last time?  Just wait until you have only one, and you’ll see a real failure.  Just like businesses are subject to diseconomies of scale and scope, regulators are too.  Sure, securities issuance and securities trading are related.  So are steel manufacture and automobile manufacture.  But it proved very inefficient to combine steel and car production in a single firm, and in my view it is very inefficient to combine all of the many aspects of financial market regulation in a single agency or commission.

Interesting–and flattering–to see the back-and-forth on my Molotov-Ribbentrop anniversary post continue in the comments section.  I haven’t pitched in to much because of other commitments, and because I haven’t read anything that leads me to change my mind (and that includes AK/SO’s long piece on his blog).

I found this post from Paul Goble to be of considerable interest, as it describes an article by a Russian scholar that echoes virtually all of the points I made.  Guess you can’t call somebody named  Leonid Radzikhovsky a Russophobe; no doubt some will label him “traitor” instead.

The article is of interest, and I will post most of it.  [Kindly suggestion to Paul Goble.  Please move to a better blogging platform, and fix the annoying paragraphing.]

Here goes:

Efforts by Prime Minister Vladimir Putin and other Russian officials and commentators to justify the Molotov-Ribbentrop Pact and Stalin’s ill-fated alliance with Hitler because of what British and French leaders had done in Munich highlight a dangerous trend in Russian thinking, according to a Moscow commentator.

Not only was the mendacity of the two actions fundamentally different – the British and French acted shamefully as part of an effort to maintain peace while Stalin acted shamefully to cover his seizure of the territory of neighboring countries, but the lessons the two have learned, Leonid Radzikhovsky says underscore the difference (www.ej.ru/?a=note&id=9405).
In an article in yesterday’s “Yezhednevny zhurnal,” the Moscow commentator says that there is now question that both Western Europe and the Soviet Union “conducted themselves in a mendacious fashion in the 1930s” in their dealings with Hitler. But “there is mendacity and mendacity,” both at the time of action and in the lessons those who engage in it ultimately learn.

It is certainly true, he writes, that “Europe handed over Czechoslovakia to Hitler.” But “European politicians did not conclude secret deals and did not seize pieces of foreign territory.” And however cynical their actions, their goal was “an idiotic hope” of keeping the peace, something those who had experienced the first world war felt was essential.

If the British and French did engage in a shameful action, Radzikhovsky notes, “Europe long ago learned its lesson.” Namely, the continent learned that “a law-based policy is MORE PROFITABLE than one based on force alone –more profitable in a humanitarian, social, economic, and that means in a political sense.”

Indeed, he continues, “politics in contemporary Europe is concentrated humanitarian sociology because the chief priority is not the size of GDP, not the size of production and not the level of consumption but the QUALITY OF LIFE.”

. . . .

But in contrast, “the USSR [at the time of Molotov-Ribbentrop and later] conducted itself much more mendaciously than Europe,” the “Yezhednevny zhurnal” commentator continues, and Russians now are being encouraged by their leaders to behave much more mendaciously than the Europeans are being encouraged by their leaders.

The explanations Russian officials offered and continue to offer about why Stalin reached an agreement with Hitler are “simply a LIE,” Radzikhovsky points out. Russia did not have to reach an agreement with the Nazi leader in order to prevent an alliance between Hitler and the West because the latter, having given guarantees to Poland showed that would not happen.

Thus, if Russians were honest with themselves, they would recognize that the USSR had “ANOTHER way out,” Radzikhovsky continues. It could “simply not have concluded agreements with anyone.” Had Stalin done that, Hitler would have had to reckon with the possibility of a two-front war, something the Nazi leader very much wanted to avoid.

And the fallback argument that Soviet and now Russian officials often employ when they suggest that Molotov-Ribbentrop bought the Soviet Union time does not withstand examination, the Moscow commentator says. Hitler would have moved West and then East at almost exactly the same time had there not been an accord with Stalin.

In any case, Radzikhovsky suggests, “the real motives of the USSR [in concluding the Molotov-Ribbentrop Pact and its secret protocols] were different.” They were “the simple, classical, ‘healthy imperialist’ motives – a secret protocol and the seizure of the territories of others.”
Moscow paid a price for all this, Radzikhovsky argues, first because of the resistance to Soviet occupation of these lands and then because it was precisely from them – the Baltic republics and Western Ukraine that “in 1989-1990 began the collapse of the USSR.” But the real tragedy, he suggests, is elsewhere and continuing.

Encouraged by their leaders, Russians still are unwilling to acknowledge that the Molotov-Ribbentrop Pact opened the way to war and that it was an imperialist act not only by Berlin but by Moscow. And still worse, they have been encouraged by their leaders to view the cynical politics of force that the Europeans have rejected as still the proper order of the day.
Indeed, the Moscow commentator concludes, Russians are being taught exactly the opposite lesson about Molotov-Ribbentrop that Europeans have clearly learned from Munich. As their leaders have insisted, Russians are told to believe that “Comrade Wolf eats everything and listens to no one” and that “such it always was and such it will always be.

Like he said.  Or, like he said like I said.

One thing that I find particularly tiresome in many of the earlier comments, and in some of the commentary I’ve read elsewhere is the pathetic whinging about the alleged imbalance of criticism, with Russia being allegedly being unfairly singled out, and the British and French and Americans escaping blame for appeasement, Munich, isolationism, etc.

What a crock.  Appeasement was the subject of withering criticism at the time, notably by Churchill.  By word and deed, soon after it became clear that appeasement had failed its very architects abandoned it and took a very different policy.  Too little, too late, in the event, but a credible repudiation of the earlier policy.  Moreover, for the last 70 years, the contribution of appeasement to the coming of the war has been almost universally acknowledged, and the subject of withering criticism in Europe and the US.  “Appeasement” and “Munich” have become watchwords for criminal cowardice, and fear of repeating them has arguably contributed to erring in the other direction, e.g., Viet Nam.  If you want an illustration of how quickly this became conventional wisdom on both sides of the Atlantic, just remember that John F. Kennedy wrote “While England Slept” as a Harvard Undergraduate in 1940.  (And, as the man who dramatically increased American involvement in Viet Nam, maybe he learned the lesson too well.)  (Maybe some of those complaining about the alleged lack of criticism of appeasement are just to young to remember that the Western verdict on the subject was made definitively decades ago.  We’ve been there, done that.  I guess you missed it.)

There has never been–and still clearly is not–a willingness among Russian policymakers, or many of its people to make a similar acknowledgement.  Any apparent one-sidedness reflects Russia’s stubborn–and one-sided–refusal to engage in the same self-criticism that has been commonplace in Western Europe and the US since virtually the day that Chamberlain stood on the runway waving that fatal piece of paper.

What’s more, as  Radzikhovsky notes, there was a vast difference between appeasement and Munich, and what Stalin did.  Britain and France acted in the foolish belief that by sacrificing Czechoslovakia and making it clear that they understood the injustices of Versailles, that Hitler would in fact be appeased, and that this would secure the peace.  In contrast, however, Stalin acted not to preserve the peace, but in a way that he knew ensured that a war would break out.  What’s more, as  Radzikhovsky notes, Stalin acted with mercenary imperialistic motives completely lacking in the French and British, and what’s more, acted on those motives.  Furthermore, after Munich France and Britain did not murder, deport, torture, or imprison hundreds of thousands as Stalin’s USSR did.  Nor did, after Munich, Britain and France provide Hitler’s Germany with materiel that was vital to its campaigns in the West, as Stalin’s USSR did.  And Stalin acted after it was abundantly clear that Hitler could not be appeased.

Until those differences are honestly recognized, any more complaints about the supposed unfairness of the focus on the treatment of Molotov-Ribbentrop will appear to be just what they are: pathetic, self-serving, dishonest whines.

And as if to direct a big spotlight on his refusal to deal honestly with the past, Putin felt that he had to go beyond analogizing Molotov-Ribbentrop to Munich in order defend the former: he had to dredge up a non-aggression pact between Poland and Germany.  You know, the one signed in 1934.

Let’s see now.  Just how many material differences is it possible to think up in about two minutes?  Not to be to blunt about it, but the Hitler of 1934 wasn’t the Hitler of 1939.  Or put differently, those dealing with Hitler in 1934–or even 1938–didn’t have quite the same information about Hitler that Stalin did in August, 1939.  1934.  Just to list a few things off the top, that was before:  the remilitarization of the Rhineland, massive German rearmament, Kristallnacht, the Anschluss, the Sudetenland, the final conquest of Czechoslovakia, and numerous other actions that made it abundantly clear that Hitler was a grave menace to peace.  So, to equate an agreement made in 1934 when the gravity of Hitler’s threat was not nearly as blindingly obvious as it was in August 1939, to one made willingly and knowingly while in possession of that information, is about as dishonest as it gets.  But we are talking Putin here.

And perhaps even Putin would stipulate that Poland didn’t use the pact as a license to invade other countries, and to murder, imprison, deport, torture, etc., their citizens.

Not that we should be surprised, but what Putin said is about the most blatant case imaginable of that chronic Russian (and Russophile) ailment of whataboutism.  In an attempt to distract attention from the beam in his eye (and his country’s), he points out the speck in Poland’s.  And he does so even though the two situations have almost nothing in common.  Nobody believes for a moment that the German-Polish pact had the slightest effect on the course of events in subsequent years.  And nobody who looks at the facts squarely in the face believes that the Soviet-Nazi pact was anything but a watershed event.

Put another way.  That Putin feels obliged to dredge up such a non-event, and elevate it to the equivalent of the Hitler-Stalin pact, says everything you need to know about how pathetic his (and Russia’s more broadly) defense of the 1939 agreement is.  And, what is more important, the signals that this defense and the desperation with which it is waged send are exactly why he and Russia are so deeply distrusted in the lands occupied by the USSR then, and in the aftermath of the Second World War.  Eastern Europeans don’t need any acknowledgements from the Western Europeans or the Americans about their actions in the past because (a) they’ve done that repeatedly over the years, and (b) they pose no threat to Eastern Europe today.  In contrast, since Russia hasn’t acknowledged its culpability (except in the most grudging, hedged way), Eastern Europeans are justly fearful of what Russia’s motives are today.  If Russia wants to take a big step towards reducing the distrust with which it is held in the lands to its west, there would be no better way than to stop defending Molotov-Ribbentrop, or playing whataboutit games.  The fact that it seems constitutionally unable to take this step only feeds suspicion.

In other words, just another self-inflicted wound.

Exchange Traded Funds (“ETFs”) are attracting a lot of attention given (a) the CFTC’s clear signaling of its intention to impose limits on these funds, and (b) the reactions of fund issuers to this signal, most notably Deutsche Bank’s announcement that it was closing down some ETFs altogether rather than operate under the anticipated position limit regime.

So what’s the big deal?  As with most discussions of the issues surrounding speculation in commodities, the critics of ETFs are maddeningly vague in their criticisms, and don’t provide any evidence of a demonstrable deleterious effect.  The arguments seem to be that big must be bad.

Case in point.  On CNBC this morning I heard an oil trader say that the UNG fund (which trades natural gas futures) is a problem because it holds 30 percent of the nearby contract; routinely liquidates that position as expiration approaches; and that the liquidation of such a big position must be disruptive.

Call me Alfred E. Newman, but in response, I’m thinking: “What?  Me worry?”  This seems like something that the market is perfectly capable of diagnosing and addressing without any meat cleaver regulatory restrictions.

First, note that the operators of funds have strong incentives to minimize their disruptive effect.  If their liquidations are distorting prices, that is costing the funds money.  They would be moving prices against them–inflating the prices of what they buy and deflating the prices of what they sell.  They have an incentive to trade to minimize that impact.  After all, they have to compete for investor funds, not just with other ETFs, but an immense array of other investment vehicles.  If they become so big, or trade so badly, that their execution costs balloon, their performance relative to that of alternative investments will decline, and they will have trouble attracting investment.  So, they have an incentive to mitigate their price impact.

Second, and relatedly, to the extent that a given fund becomes so big that despite its best efforts its liquidations are messy and its execution costs are high as a result, that will serve as a natural constraint on growth.  Put differently, if these execution cost-related problems create diseconomies of scale, again in a highly competitive investment marketplace, the size of these entities will be limited naturally.  It means they have an efficient scale, and competition will constrain their ability to expand beyond that efficient scale.

All sorts of markets for all sorts of things have natural mechanisms for ensuring that firms operate at efficient scale.  Why should financial markets in general, or ETFs be any different?

Third, the CNBC critic and others who point to the large liquidations of big ETFs fail to recognize that there is a natural set of traders who are ready, willing, and able to buy what the ETFs want to sell when they roll: these are the traders who sold short in the first place in order to allow the ETFs to buy.  They almost certainly don’t want to make delivery, and are looking to liquidate/cover their expiring shorts just as the ETFs are looking to liquidate/cover their expiring longs.  That is, the ETF doesn’t need to find a new set of buyers to take its positions.  There is a natural set of buyers out there; the people who sold to them in the first place.  And wouldcha know it, they just happen to want to buy the exact same amount of stuff that the ETF wants to sell.  A match made in heaven.

The main potential problem is how to coordinate the activities of the ETFs and those they want to sell to at expiration.  If the ETF starts to sell when the natural buyers aren’t around, there can be a temporary price impact as liquidity suppliers must bridge the gap until the natural buyers turn up, and the liquidity suppliers demand compensation for the risks that they bear as a result.

But markets have myriad ways to facilitate this coordination.  Indeed, coordination is what markets are all about.

One way to facilitate coordination would be through block trading facilities.  These have been around in equity markets for a long, long time.  They have started to make inroads into futures markets, but exchange rules and government regulations have been less favorable to block trading in futures than in equity markets.  So, one response would be to put rules and regulations in place that make block trades easier.

Another way is through sunshine trading.  It’s been known for a long time (basically, since the mid-1980s when portfolio insurers used the strategy to reduce their execution costs) that a large, uninformed trader who is buying or selling for liquidity-related reasons, rather than because he has private information, can reduce execution costs by announcing his purchases or sales in advance.  If potential counterparties believe that the trader making the announcement is indeed uninformed, then (a) they will not charge transaction cost (in the form of price impact) to compensate for the possibility of trading with somebody with better information, and (b) they can make sure that they are there to take the other side of the announced trade, thereby ensuring that there’s a lot of liquidity available.

Yet another way is to develop crossing networks that don’t contribute to price discovery, but merely cross offsetting positions at some price taken from an exchange, e.g., the settlement price of NYMEX NG futures. Crossing networks are another way that uninformed traders can credibly signal that they are trading for liquidity reasons, and don’t want to have a price impact.  Stock crossing networks have been around for decades.

An alternative to a crossing network is a call market, which is essentially a one shot auction.  So, for instance, NYMEX could set up a call market in the expiring nat gas or WTI contracts.  The ETFs would submit offers to sell, and knowing that the ETF would be there, its natural counterparties could submit offers to buy.  (Since the ETFs look to roll positions, and hence want to buy the next month when selling the expiring contract, it might be desirable to have a call market in spreads.)

Still another way is to use cash settled contracts.  These contracts use “derivative pricing”–they take the price from another market, such as NYMEX, to determine the final value of the contract.  These contracts are essentially “self liquidating”; they don’t require a trade to close out the position.  The position closes out automatically by reference to another market price.

Indeed, UNG has already moved in this direction, using cash settled nat gas swaps as well as nat gas futures to achieve its exposure to natural gas.

In sum, there are many ways to mitigate price impact even of big funds.  Even if a fund controls 30 percent of the open interest in a contract and wants to liquidate, well, damn close to 100 percent of the opposite side of that open interest wants to liquidate too.  There is an almost perfect double coincidence of wants.  It’s just a matter of coordinating those traders.  There are many market mechanisms to do that, and market participants have the incentive to find the efficient mechanism–or more likely, the efficient combination of mechanisms, including efficiently scaled funds, the use of cash settled contracts, crossing networks/call auctions, block trading and sunshine trading, and stuff I haven’t thought of–to achieve this coordination and mitigate price impact.

The key thing to remember is that somebody internalizes the costs of these alleged liquidation-related disruptions.  As a result, that somebody has the incentive to use mechanisms that minimize that impact, and entrepreneurs have incentives to devise new mechanisms that further reduce the impact–if regulations or legal impediments don’t prevent that from happening.

One last thing.  The market share numbers, e.g., the 30 percent number mentioned by the CNBC talking head, don’t bother me in this context.  A big percentage translates into a big position which could pose a manipulative threat if–IF–the party holding it DOESN’T liquidate enough positions, but demands excessive deliveries.  That is, a big trader that liquidates his entire position–which is a big ETF in a nutshell–does not pose a manipulative threat.

So, let the market develop and employ the mechanisms that facilitate the accumulation and liquidation of large positions that individual investors obviously want to hold.  (Note that they are willing to pay premiums to get into some big ETFs.)  The challenge posed by ETFs is nothing new, and markets have figured out ways to address such challenges efficiently for years.   There’s no real need for the regulators to worry their pretty little heads over this one.

I’m sure that no one would be surprised that CFTC Commissioner Bart Chilton was not pleased by my recent post that lambasted his equation of the activities of ETFs with manipulation.  Well, the sarcasm was arguably overdone (that NEVER happens, I’m sure you’re saying), but I stand foursquare by the substance.

Well, now Commissioner Chilton penned an editorial in the Des Moines Register that lays out his argument for the need to restrict speculation.  It is a very weak argument indeed, and it would be a tragedy if anything like it is the basis for major changes in the regulation of derivatives markets.

He starts with a wild mischaracterization of history:

For a hundred years, farmers in Iowa and around the nation have been able to hedge their business risks in the futures markets. The entire endeavor has worked well for farmers, futures exchanges and our economy. In the last few years, however, things have changed. New “non-traditional” speculators, such as hedge funds, index funds, pension funds and endowments, have all entered the futures markets, bringing with them massive new liquidity but also some very real concerns. Unlike commercial speculators – for example, farmers, processors and refiners who actually do business in the underlying commodity, be it corn or beans, natural gas or crude oil – the new speculators have no such similar interests. The new speculators are only interested in one thing: increasing long-term profits in their investment portfolios. Therefore, their trading strategy differs significantly from the commercial traders who move in and out of the markets on a regular basis, depending upon many market-based factors.

This is to suggest that speculators looking only to make money, without “do[ing] business in the underlying commodity” are a new phenomenon.  I’m sure that readers of the Register in 1909 or 1899 or 1889 would have begged to differ.  Moreover, speculators of whatever age “have moved in and out the markets on a regular basis, depending on many market-based factors.”

This argument seems to make motive the primary criterion for determining whether somebody is eligible to trade a futures market.  This is truly disturbing.  It also suggests that Commissioner Chilton believes that commodities should be fenced off from other financial markets.  This is bad finance, and actually harms market users by interfering with the efficient transfer of risk.

Chilton also says: “The new speculators buy into the markets for years, and stay there.”  And we are to conclude . . . ?  And again, there have been many speculators that have made it their living for long periods.

Additional remark (9/2/2009): I find this criticism of Chilton’s ironic that the classical criticism of speculators is that they are quick buck artists that have no long term stake in any market or company, and hence trade on meaningless short term information.  Now, we have a class of speculators that are not short term, quick-buck traders, but are instead patient investors in the market for a long haul–but that’s bad too.  Damned if you do, damned if you don’t.

As for evidence, Commissioner Chilton relies on one of the least creditable tropes: the “some suggest” argument:

Due to the influence some suggest the new speculators may be having on prices, however, there may be some changes on the horizon for these new players.

I (and others) suggest otherwise.  So where does that leave us?

Then he pulls out the “it’s possible” justification:

Just as the tide raises all boats, it is possible that this massive influx of capital helped to raise commodity prices beyond what the simple forces of supply and demand would dictate. The crude oil “commodity bubble” is a good example. To date this year, crude oil is trading at roughly $70 a barrel. While that is a far cry from the incredible (and some say irrational) high of $147 last summer, the current price is still up over 60 percent from the beginning of this year. Does that make sense?

A lot of things are possible.  Some evidence would be helpful.  The role of evidence is to help sort out what’s probable from what’s possible.  You can’t make policy on the possible, since so much of the possible is contradictory.  X may be possible.  Not X may be possible too.  We’re right where we started.  Reasonable analysis requires effort to determine which of these possible outcomes is more likely, and to estimate the costs of incorrect conclusions.  Identifying the possible is the beginning of an inquiry.  It clearly cannot be the end.

And note the second helping of the “some say” trope: “incredible (and some say irrational) . . .”

In fact, economists have known for a long time that commodities can exhibit substantial variability, and that in particular, in models where only fundamentals drive prices, prices spike and crash with regularity.  That’s exactly what you’d expect in a market for a commodity like oil.  There’s no reason to invoke the “bubble” word to explain big moves in commodity prices.

Indeed, the reason speculators are attracted to commodities is the volatility.  That’s a lot more plausible statement than to say that the speculators cause the volatility.

Now we get to the punchline:

Supply is at a 10-year high and demand is at a 10-year low. You do the math; prices should be lower. And if the cause was uneconomic speculative activity (that is, not caused by the forces of supply and demand), then regulators have a responsibility to act.

There is no doubt that the current commodities market is more puzzling on the surface than what happened in 2008 or early 2009.  But speculation by financial players in the US or the UK is hardly the first thing that bears scrutiny.  Indeed it should be about the last.  In all major commodities, the big buyers have been China, China, and China.  China has engaged in a stimulus that beggars the imagination, and probably in part to reduce its exposure to the dollar, a lot of that money has gone into commodities from aluminum to zinc.  The CFTC–with considerable Congressional cheerleading–is on a snipe hunt, and ignoring major factors in the market.  If Commissioner Chilton is puzzled, he needs to read more.

And note the tricky segue in the argument: “if the cause was uneconomic speculation . . . then regulators have the responsibility to act.”  But the “if” remains just that.  Chilton certainly has not provided a scintilla of evidence to support that contention.  He mentions the CFTC hearings on position limits, which generated zip, zero, nada in terms of anything that would pass the laugh test in terms of evidence.

And Commissioner Chilton then fails to man up and take a stand himself, instead invoking the “some say” argument yet again (for the third time!):  he describes the hearings as a step in a process “to address what many call ‘excessive speculation’ in our futures markets.”  Again.  Many say it ain’t.  “Some say”–even “many say”–is hardly a legitimate basis for any major policy initiative.

Amazingly, Commissioner Chilton repeats the “unintentional manipulation” gaffe:

The clear message is that physical commodities – like those in the agricultural, energy and metals arenas –  are too important to our nation to allow even the possibility of price manipulation, intentional or unintentional.

He will undoubtedly say that he is using the word “manipulation” in some common-sense use of the term to mean the actions of traders that affect prices.

That doesn’t cut it, for at least three reasons.

First.  There is no common-sense use of the term.  That’s been a problem for a long time–and is exactly why I quoted the Texas cotton broker in my original post.  Or to quote my book on manipulation, if Ambrose Bierce was writing the Devil’s Dictionary of Finance, I would define manipulation as anything that causes me to lose money.

Second, this is sort of the immaculate conception theory of prices.  If trading activity doesn’t affect prices, what does?  Surely public information releases (e.g., a crop report) have an effect, but people still interpret those releases differently and trade on their interpretation.  Moreover, some traders have private information, and trading on that information moves prices.  That tends to make prices more informative.  That’s a good thing.  It’s called price discovery.  How can you have price discovery if trades don’t affect prices?  I should also note that hedgers’ trades can affect prices.  Putting on a big hedge may require a move in price to find somebody willing to take the risk.  Here the market is discovering the price of risk, and consenting adults will negotiate a mutually agreeable price.  And such a price will almost certainly be different than if no such trade had taken place. Thus, hedgers can have a price impact.  Are they manipulators too? (And, I might add, hedgers will have a bigger price impact if speculation is constrained.  So, if trades that impact price are manipulative, and hedgers have a bigger price impact when speculation is constrained, wouldn’t that make the party that constrains the speculation an accessory in the manipulation?  That question is only half in jest.)

In other words, defining manipulation to mean any trade that has a price impact is complete non-sense, not common sense.  Such markets exist in textbooks, and nowhere else.

Additional remark (9/2/2009): Price impact may be a necessary condition for concluding that regulatory intervention is needed.  It is definitely not a sufficient condition as Chilton suggests.  A regulatory intervention should require a showing that a certain kind of trading moves prices away from competitive values.  Even if a price impact is demonstrated, it is absolutely wrong to conclude that this is inefficient.

Third, and most importantly, Commissioner Chilton is one of those responsible for enforcing the anti-manipulation laws.  These laws make manipulation a felony.  They also subject manipulators to the prospect of heavy fines, and great reputational damage.  As a result, no CFTC Commissioner should use this term imprecisely, or make statements using words that have legal meaning in such a cavalier way.  In other words,  I don’t believe that someone in the position of enforcing the law has the luxury of making such implicit distinctions on matters of potential legal import.

The term is provocative, and its use suggests that the markets have been manipulated.  People believe that manipulation is wrong, and many know that manipulation is a crime.  This creates a presumption that there is something wrong–manipulated–in the markets that need correction.

I would also suggest that this could lead to serious difficulties for the Commission, and for Commissioner Chilton, if the Commission ever has to rule on a manipulation case.  I can see a defendant appealing an adverse Commission decision on manipulation by saying that one of the Commissioners had written in a way that could suggest ignorance of the law, and/or a prejudicial view of the activities of speculators, and/or is inclined to see a manipulator lurking behind every trade.

It seems to me that Commissioner Chilton is attempting to have it both ways: to insinuate that the markets have been manipulated to persuade people of the need to regulate more aggressively and intrusively, while avoiding having to provide evidence to support his insinuation, escaping instead with evasions about how he’s not using the term in the legal sense, just in some “common sense” way.  But if the activities aren’t illegal, then what is the justification for the regulation?  And if there is a justification other than manipulation as legally defined, why use such an inflammatory term that has a specific legal meaning, rather than explain precisely what that justification is?  Why not set out in plain terms exactly what he thinks is wrong with the activity of speculators, and their effect on prices, and let people analyze that contention without waving the bloody shirt of manipulation to inflame passions?  And maybe, just maybe, provide some reliable evidence in the bargain, rather than relying on the “some say” evasion.

I don’t think that’s too much to ask of those responsible for the regulation of markets with huge sums on the line.  In fact, I think it’s far too little to ask.  But I’ll take it as a start.