Streetwise Professor

The USDOJ has filed criminal charges against a trader named Michael Coscia for “spoofing” CME and ICE futures markets. Frankendodd made spoofing a crime.

What is spoofing? It’s the futures market equivalent of Lucy and the football. A trader submits buy (sell) orders above (below) the inside market in the hope that this convinces other market participants that there is strong demand (supply) for (of) the futures contract. If others are so fooled, they will raise their bids (lower their offers). Right before they do this, the spoofer pulls his orders just like Lucy pulls the football away from Charlie Brown, and then hits (lifts) the higher (lower) bids (offers). If the pre-spoof prices are “right”, the post-spoof bids (offers) are too high (too low), which means the spoofer sells high and buys low.

Is this inefficient? Yeah, I guess. Is it a big deal? Color me skeptical, especially since the activity is self-correcting. The strategy works if those at the inside market, who these days are likely to be HFT firms, consider the away from the market spoofing orders to be informative. But they aren’t. The HFT firms at the inside market who respond to the spoof will lose money. They will soon figure this out, and won’t respond to the spoofs any more: they will deem away-from-the-market orders as uninformative. Problem solved.

But the CFTC (and now DOJ, apparently) are obsessed with this, and other games for ticks. They pursue these activities with Javert-like mania.

What makes this maddening to me is that while obsessing over ticks gained by spoofs or other HFT strategies, regulators have totally overlooked corners that have distorted prices by many, many ticks.

I know of two market operations in the last ten years plausibly involving major corners that have arguably imposed mid-nine figure losses on futures market participants, and in one of the case, possibly ten-figure losses. Yes, we are talking hundreds of millions and perhaps more than a billion. To put things in context, Coscia is alleged to have made a whopping $1.6 million. That is, two or three orders of magnitude less than the losses involved in these corners.

And what have CFTC and DOJ done in these cases? Exactly bupkus. Zip. Nada. Squat.

Why is that? Part of the explanation is that previous CFTC decisions in the 1980s were economically incoherent, and have posed substantial obstacles to winning a verdict: I wrote about this almost 20 years ago, in a Washington & Lee Law Review article. But I doubt that is the entire story, especially since one of the cases is post-Frankendodd, and hence the one of the legal obstacles that the CFTC complains about (relating to proving intent) has been eliminated.

The other part of the story is too big to jail. Both of the entities involved are very major players in their respective markets. Very major. One has been very much in the news lately.

In other words, the CFTC is likely intimidated by-and arguably captured by-those it is intended to police because they are very major players.

The only recent exception I can think of-and by recent, I mean within the last 10 years-is the DOJ’s prosecution of BP for manipulating the propane market. But BP was already in the DOJ’s sights because of the Texas City explosion. Somebody dropped the dime on BP for propane, and DOJ used that to turn up the heat on BP. BP eventually agreed to a deferred prosecution agreement, in which it paid a $100 million fine to the government, and paid $53 million into a restitution fund to compensate any private litigants.

The Commodity Exchange Act specifically proscribes corners. Corners occur. But the CFTC never goes after corners, even if they cost market participants hundreds of millions of dollars. Probably because corners that cost market participants nine or ten figures can only be carried out by firms that can hire very expensive lawyers and who have multiple congressmen and senators on speed dial.

Instead, the regulators go after much smaller fry so they can crow about how tough they are on wrongdoers. They go after shoplifters, and let axe murderers walk free. Going for the capillaries, ignoring the jugular.

All this said, I am not a fan of criminalizing manipulation. Monetary fines-or damages in private litigation-commensurate to the harm imposed will have the appropriate deterrent effect.

The timidity of regulators in going after manipulators is precisely why a private right of action in manipulation cases is extremely important. (Full disclosure: I have served as an expert in such cases.)

One last comment about criminal charges in manipulation cases. The DOJ prosecuted the individual traders in the propane corner. Judge Miller in the Houston Division of the  Southern District of Texas threw out the cases, on the grounds that the Commodity Exchange Act’s anti-manipulation provisions are unconstitutionally vague. Now this is only a district court decision, and the anti-spoofing case will be brought under new provisions of the CEA adopted as the result of Dodd-Frank. Nonetheless, I think it is highly likely that Coscia will raise the same defense (as well as some others). It will be interesting to see how this plays out.

But regardless of how it plays out, regulators’ obsession with HFT games stands in stark contrast with their conspicuous silence on major corner cases. Given that corners can cause major dislocations in markets, and completely undermine the purposes of futures markets-risk transfer and price discovery-this imbalance speaks very ill of the priorities-and the gumption (I cleaned that up)-of those charged with policing US futures markets.

Silly me, I thought the “gaz” in Gazprom was methane. But reading this article in Platts, I’m thinking it’s nitrous oxide.  I had to read it several times before I could catch a glimpse of what Sergei Komlev, head of Gazprom Export’s contract structuring and price formation department, was getting at. I now see the basic problem is that he thinks the price of gas in Europe is too low. And the culprit? Speculators! Paper traders! “Virtual gas”!

Come on Sergei, you can’t get originality points for that one. Round up the usual suspects and all that.

Anyways, FWIW, here are Sergei’s deep, N20 inspired thoughts on the subject:

“Paradoxically, gas price erosion is taking place at a time when physical supplies are tight,” Komlev said, adding that some European market analysts had acknowledged that hubs were overflowing with largely “paper” gas.

This became possible with the development of the spot gas market as hubs developed a new class of customer such as banks and commodity traders, Komlev said.

But “as no one is in a position to predict the weather, traded volumes of ‘paper’ gas significantly surpassed real world demand for gas because of the abnormally warm winter in 2014,” he said.

This artificial oversupply had put significant pressure on the market, resulting in a collapse in spot prices, he said.

“As a result, our European customers are facing negative margins as they have to supply gas to end-consumers at lower prices than they pay for physical deliveries under long-term contracts,” he said.

“When some time ago our clients sold our contract volumes on a forward curve for many months ahead they targeted this new class of customers first,” he said.

I’m doubled over in convulsions here, and I haven’t even taken a hit. Is there such a thing as second hand N20?

Let me translate what really happened. Speculators went long. Weather was unusually warm. Prices fell, and speculators took a bath. Simple story. As for “tight physical supplies”, later on Sergei lets on that gas demand in Europe fell 20 percent in the 1st half of 2014.

Sorry, but “paper gas” doesn’t heat a single home or turn a single turbine. It doesn’t oversupply. It doesn’t overdemand. It just transfers price risk. As contracts go prompt, the price of paper gas converges to the price of physical gas, which is driven by supply and demand fundamentals-most notably the weather. What frosts (or is it burns?) Sergei is that the price converged to a low price which is out of line with the oil-linked prices in Gazprom contracts. This has imposed pain on Gazprom’s customers, who are clamoring to renegotiate their contracts, which Sergei and Gazprom no likey.

Like the proverbial blind hog and the acorn, Sergei did root up a bit of the truth:

Long-term contracts were shaped at a time when spot gas markets in Europe were not developed, and the gas price — linked to oil prices — “was practically independent of supply/demand dynamics,” Komlev said.

I repeat: The oil linked price was/is “practically independent of supply/demand dynamics.”

Exactly! That’s the problem! That’s why a move to hub-based pricing, where gas prices can reflect gas values, is so necessary: it ensures that contract prices reflect supply/demand dynamics. Prices that don’t reflect values lead to distortions in output and consumption and investment, and to conflicts between buyers and sellers that inflate transactions costs.

Komlev went on to say that since price in the contracts was not flexible, and was out of line with gas values, it was necessary to permit quantity flexibility in Gazprom contracts. If the company is dragged kicking and screaming into the 21st century, and must index its contractual gas prices to-wait for it-gas prices, it will eliminate the quantity optionality.

Throw the customers into that b’rer patch, Sergei. Truth be told, fixed quantity forward supply contracts are quite the thing in the US, and have been since the dysfunctional price controls on gas were discarded in the 1980s. Companies can buy and sell base load volumes using fixed quantity long term contracts (perhaps at indexed prices); respond to near term fundamental conditions with short-term (e.g., month ahead) forward contracts entered into during something analogous to “bid week” and respond to intra-month/daily supply and demand swings with spot transactions. They can also get various customized contracts that are seasonally shaped, or have some optionality that permits efficient responses to supply and demand shocks (though the CFTC’s proposed Seven Prong-Prong, not Pirrong-test for determining whether supply contracts with quantity optionality are swaps subject to Frankendodd could wreak havoc with that).

A liberated gas market offers a variety of contract terms, including contracts that embed various sorts of quantity optionality. But the point is that heterogeneous suppliers and demanders can utilize a variety of contracts tailored to meet their idiosyncratic needs, as opposed to Gazprom contracts, which remind me of nothing so much as an ill-fitting Soviet suit.

I do have to thank Sergei. I haven’t had such a good laugh in a long time, with or without chemical assistance. But I doubt he-and Gazprom-will be laughing for long. The disconnect between oil and gas prices has become too large and too persistent for their beloved oil linkage to survive much longer.

Speaking of oil-linked prices, this is an issue in LNG markets too. I recently authored a white paper on the subject. I’ll provide a link and write a post on that subject in the next few days.

In my earlier posts on the non-war-without-a-name in Iraq and Syria, I said the following:

As I wrote the other day, I do not support a vigorous military operation in Syria. But if we are going to get involved, it must be done the right way, in a militarily sensible way. What Obama is hell-bent on doing is the exact wrong thing. He is repeating the LBJ mistakes, and adding some of his very own making. This is why, even overlooking the meager security stakes and the daunting obstacles involved in Syria and the Middle East generally, I blanch at the idea of a military campaign conducted by Obama, especially when he stubbornly insists on maintaining tight control over it.

And:

But more sober reflection (figuratively and literally!) leads me to conclude that a full-blooded response to ISIS is unwise, especially in Syria. For many reasons, the commitment that would be required to fully extirpate the organization is not worth the cost, and it’s better not to fight at all than to fight a half-assed or quarter-assed battle.

. . . .

I also shudder at the prospect of the Anti-Jackson commander in chief leading a campaign. An extended military action of the type the Pentagon would consider necessary is antithetical to every fiber in his being. It is obvious that he has no appetite for the fight, and has a predilection for limited measures (drone strikes aimed at killing terrorist leaders, the odd special forces raid) that have no strategic purpose or effect. War under such unwilling and uncertain leadership would be a pointless expenditure of American lives and treasure.

These warnings have been borne out fully by the actual execution of the campaign, such as it is.

The utter futility and failure and frankly the immorality of this pitiful effort is epitomized by events in Kobani (or Kobane) a Kurdish town on the Syrian-Turkish border. Lightly armed YPG Kurds have been fighting desperately to hold off an armored attack by ISIS. But they are being overwhelmed, and reports today indicate that at least parts of the town have fallen.

If you look at pictures of the area, you will note that it is perfect for the deployment of US airpower against vehicles and artillery. No cover whatsoever. Wide open desert. PGMs or a few passes by A-10s (which have been deployed to the region) would devastate any ISIS mechanized forces and artillery. But such robust force has not been deployed. ISIS is so confident that they are planting their flags in broad daylight on high points, a la Suribachi. You don’t do that unless you have no fear that death will come from the skies.

The writing was on the wall a few days ago, when Pentagon spokesman Admiral Kirby uttered this:

Kirby said the U.S. operation in Syria targets areas Islamic State can use as a “sanctuary and a safe haven,” compared with strikes in Iraq that are being conducted to back local forces. That doesn’t mean “we are going to turn a blind eye to what’s going on at Kobani or anywhere else,” Kirby said

Er, what is the point of going after “safe havens” and “sanctuaries” if not to prevent them from being used as launching pads for offensive operations? So then why not go after the offensive operations themselves? Aren’t we making Kobane a safe haven? Does this make any sense? Any?

We obviously washed our hands of Kobane and the Kurds last week. And Kirby is right. We haven’t turned a blind eye. We stood by and watched it happen, eyes wide open (and probably beamed back to DC from a Predator via video uplink).

I can usually reverse engineer the military logic behind decisions. Here I am at a total loss. The only think I can think of is that the Turks have waved us off, hating the Kurds as they do. As if we should be deferring to them, for all they’ve done for us in recent years. Or, as @libertylynx suggests, because we didn’t get permission from Assad, and from the Russians and Iranians.

It gets worse, actually. There are now leaks that the US will bomb the environs of Kobane. A day late and a bomb short. Reinforcing failure. Adding insult to injury.

Again: this is Obama’s choice. Remember that he has taken personal control of the selection of bombing targets. I say again: “I blanch at the idea of a military campaign conducted by Obama, especially when he stubbornly insists on maintaining tight control over it. ”

So much for Responsibility to Protect, eh? That’s so like 2011, dude.

We either need to stop bombing, or do it seriously: to paraphrase Napoleon, if you are going to bomb ISIS, bomb ISIS! This half-assed approach is a disaster: it’s more like 10th-assed. It is the worst of all worlds. It has no military effect. This in turn makes ISIS look like they are beating the US which makes them stronger by making them seem to be the “strong horse” that is defying the Crusaders. It also is turning locals against us, in part because of civilian casualties but more because it shows we are not really serious and we are not going after their real enemy.

I doubt Obama could do any worse if he were trying to screw things up. (Don’t go there.)

But never fear! The USG is on the case. The State Department has created a Global Coalition to Counter ISIL (sic) website!

This is clearly an escalation. First hashtags. Now a website. I am sure ISIS is shuddering at the thought of what horrors are to come.

Look at the list of countries:

Albania Arab League Australia Austria Bahrain Belgium Bulgaria Canada Croatia Cyprus Czech Republic Denmark Egypt Estonia European Union

Finland France Georgia Germany Greece Hungary Iraq Ireland Italy Japan Jordan Kosovo Kuwait Latvia

Lebanon Lithuania Luxembourg Macedonia Moldova Montenegro Morocco NATO The Netherlands New Zealand Norway Oman Poland Portugal Qatar

Republic of Korea Romania Saudi Arabia Serbia Slovakia Slovenia Spain Sweden Taiwan Turkey Ukraine United Arab Emirates United Kingdom United States

Every one doing nothing, in equal measure.

I remember that Napoleon once rejoiced when he learned another country had joined a coalition against him. He would have been positively giddy to have been “confronted” by this one.

The US military is allegedly calling this “campaign” Operation Shock and Yawn. It should actually be Operation Avert the Eyes. It is the most incoherent and strategically barren military operation in US history. Please make it stop.

The WSJ recently ran an article describing the ongoing standoff between the EU and the CFTC over swaps clearing. The Europeans have refused to certify any US clearinghouse as being subject to regulations equivalent to those under which European CCPs do. For its part, the CFTC has refused to recognize EU CCPs. The Europeans have pointedly recognized CCPs from a variety of other nations, including Japan, Hong Kong and India: things are so bad between the US and Europe that I wouldn’t be surprised if the Euros certified a North Korean CCP before they did the same for CME or another US CCP.

Failure to certify will mean that it will become prohibitively expensive for US firms to clear swaps in Europe, and vice versa. This will exacerbate the already worrisome fragmentation of swaps markets along jurisdictional lines.

The Euros are furious at the US’s rather imperialistic attitude on derivatives regulation, especially under the Gensler chairmanship of the CFTC. As new commissioner Christopher Giancarlo points out in a scathing speech delivered at the recent FIA meetings in Geneva, this imperialism was not limited to clearing issues alone. It also involved attempts to dictate how trades are executed, that is, the “Worst of Frankendodd” SEF mandate:

Making things worse, the CFTC swaps trading rules contain a host of peculiar limitations based on practices in the US futures markets that have not been adopted in the EU11 or anywhere else. Several of these peculiar CFTC swaps trading rules are contrary to common practice in global markets and are unlikely to be replicated by non-US regulators, including:

• Trading only on order books and request for quote (RFQ) systems to TWO then THREE counterparties;12
• Exchange-certified “made available to trade” determinations;13
• Swap Execution Facility (SEF) position-limit maintenance and enforcement;14
• Limitations on counterparty transparency;15 and
• 10 CFTC Staff Advisory No. 13-69 (Nov. 14, 2013), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/13-69.pdf.

Now I have long been a critic of these rules. And so my criticism is not new and is not directed at the staff of the CFTC who worked hard to adapt existing trading models to meet greatly expedited implementation deadlines.

Here’s the key paragraph:

The avowed purpose of the CFTC’s broad assertion of jurisdiction is to insulate the United States from systemic risk. Yet, on the ostensible grounds of ring-fencing the US economy from harm, the CFTC purports to tell global swaps markets involving US persons to adopt particular CFTC trading mechanics that do almost nothing to reduce counterparty risk. In the words of one former senior CFTC advisor, the Interpretative Guidance “yoked together rules designed to reduce risk with rules designed to promote market transparency. Yet it provided almost no guidance about how to think about the extraterritorial application of market transparency rules independent of risk. As a result, [the CFTC prescribed] how to apply US rules abroad based on considerations that are tangential to the purposes of those rules.”

How do like them apples? (Those who remember the Gensler regime will know what I’m referring to.) As Giancarlo notes, a US obsession with swaps execution, that has nothing to do with reducing systemic risk, is causing jurisdictional fragmentation that likely increases systemic risk. What’s more, I would add that this is nuts even on its own terms. The idea behind SEFs was to increase competition in swaps execution. But fragmenting the market between the US and Europe reduces competition.

Giancarlo also rightly criticizes the fact that the CFTC issued an “Interpretive Guidance” and a “Staff Advisory” rather than a formal rule. In theory firms could disregard this “guidance”, but in practice that would be a very dangerous and risky thing to do. Meaning that the CFTC has effectively imposed an indefensible policy without going through the processes that are intended to mitigate policy mistakes. Unfortunately, a federal judge recently ruled against an industry legal challenge to the CFTC’s imposition of its dictates through such procedural legedermain.

Giancarlo has a concrete proposal to eliminate the impasse:

But we can go further. I intend to do everything I can to encourage the CFTC to replace its cross-border Interpretative Guidance with a formal rulemaking that recognizes outcomes-based substituted compliance for competent non-US regulatory regimes. As part of that effort, I will seek the withdrawal of the CFTC staff’s November 2013 Advisory that fails not only the letter and spirit of the “Path Forward,” but also contradicts the conceptual underpinnings of the CFTC’s Interpretive Guidance.

I hope that happens, but the question is whether it will happen in time. Unless the impasse is resolved soon, the “Balkanization” that Giancarlo laments will only get worse. Once that division becomes established, it will be difficult to reverse later, even if the the US and EU eventually recognize the equivalence of each other’s CCPs.

The good news here is that new Chair Timothy Massad also appears to be substantially less rigid, dictatorial, and imperious than his predecessor Gensler. Perhaps we shall see a more reasonable approach to derivatives regulation, especially on cross-border issues. This will not be sufficient to undo the many defects of Frankendodd, but it may at least mitigate the damage.

A corollary to the old expression “sh*t happens” is “it happens all at once.” That certainly appears to be true in the Age of Obama. The parade of horribles just keeps on getting longer.

Case in point: Ebola. Of course the outbreak in west Africa, unprecedented in both scale, scope, and location (occurring far to the west of most previous episodes) cannot be laid at the doorstep of the White House (guarded as it is by a rather fallen Secret Service!). But the American response to it is very much the administration’s responsibility, and the early indications are: Be afraid. Be very afraid.

The response to the initial case in Dallas, and the very fact that Thomas Duncan made it to Dallas, hardly inspire confidence. Pandemic illnesses have been a threat for a long time. The Ebola threat has been developing for months. There should be, and should have been, off-the-shelf contingency plans well in place to deal with this, and deal quickly and efficiently. Starting with screening procedures regarding whom to let into the country, and with protocols to identify and isolate potential cases. But that didn’t happen in the Duncan case.

So the government has taken a Mulligan, and will nail the next shot, right?

Based on the response of Center for Disease Control and Prevention head Thomas Friedan, the answer is again: Be afraid. Be very afraid. His response is all about defensive spinning and political correctness. He is fighting against measures to restrict travel to the US by those who are at high risk of exposure to Ebola, measures that should have been in place when the crisis began to explode in Sierra Leone, Guinea, and Libera. In his dishonest defense, he has mastered the Obama tropes of straw men, the false choice, and the non sequitur:

Dr. Thomas Frieden, director of the Centers for Disease Control and Prevention, said the federal government is looking at different safety-related suggestions from Capitol Hill and beyond, but he suggested the key is to control the deadly virus where it started overseas, not limiting entry to the United States.

“Though we might wish we can seal ourselves off from the world, there are Americans who have the right of return and many other people that have the right to enter this country,” Frieden said at a press conference Saturday.  “We’re not going to be able to get to zero risk no matter what we do unless we control the outbreak in West Africa.”

Frieden went on to say that limiting entry at the borders could actually put Americans at greater risk.

“In terms of the entry process, we really need to be clear that we don’t inadvertently increase the risk to people in this country by making it harder for us to respond to the needs in those countries, by making it harder to get assistance in and therefore those outbreaks would become worse, go on longer, and paradoxically, something that we did to try and protect ourselves might actually increase our risk,” Frieden said.

Where to begin?

1. Who other than Mr. Straw is wishing, arguing, or advocating that “we seal ourselves off from the world”? A discriminating (yes, discrimination can be a good thing!) approach to admitting people to the US is not “sealing ourselves off from the world.” It is the most basic measure that can be taken to reduce the risk of transmission of the virus to the US.  We’re not talking about pulling up the drawbridge. We’re talking about aggressive screening to identify and isolate high risks, while letting low or zero risk people travel normally.
2. Who is claiming “zero risk” is possible? The issue is reducing the risk in the most efficient and efficacious ways.
3. Since when is the “right to enter the country” unlimited? FFS, several years ago I was hassled at customs/immigration for accidentally bringing a ham sandwich off the plane from Europe, and was subjected to luggage checks the next four times I returned to the country. I apparently got more scrutiny than Mr. Duncan. Friday, while waiting for baggage at Newark, a sniffer dog found a guy who’d brought a banana off the plane. He was given a citation.
4. Since when are fighting against the disease at its origin in west Africa and preventing those from west Africa at high risk to being exposed to the disease from entering the country mutually exclusive alternatives? Can’t we put a “Both” box for Obama to check on the options memo that his staff prepares for him? Does fighting the disease in west Africa compete for resources with screening people entering the US? Hardly.
5. As dysfunctional as west African countries are, we might as well just kill ourselves now if controlling the disease in that region is necessary to prevent an outbreak in the US.
6. Does that last quoted paragraph in the story  make any sense? Any? I’ve read it 10 times and it’s more bizarre and incoherent each time. How does restricting entry of potentially infected individuals to the US impede our efforts in west Africa? That is the non sequitur to beat all non sequiturs.

One struggles to find good reasons for Freiden’s battle (and hence the administration’s battle) to screen entry into the country. The fact that Freiden feels compelled to resort to such dishonest arguments strongly suggests that there is no good reason, but there is likely a political agenda here. I strongly suggest that it is a politically correct agenda as well.

Regardless of the rationale, it is beyond outrageous that a legitimate function of government-public health-is being executed so dishonestly and incompetently. But just throw this on the pile. The VA. IRS. Obamacare website. The Secret Service. The Apostles of Big Government are the best evangelists for libertarianism-hell, anarchocapitalism-one could possibly imagine.