Streetwise Professor

China is notorious for flouting intellectual property rights. From stolen technology (including notably military gear) to designer knock-offs, China pirates everything and everyone. It is therefore a rather jaw-dropping act of chutzpah for to Chinese Zhengzhou Commodities Exchange to send a nasty cease-and-desist letter to the Singapore subsidiary of ICE demanding that ICE not copy ZCE’s cotton and sugar contracts:

Intercontinental Exchange has been forced to delay the launch of its new Singapore platform after a Chinese exchange threatened legal action to stop the US group launching two commodity futures that are copies of contracts offered in China.

The move by the Zhengzhou Commodity Exchange is likely to send shockwaves through the global futures industry because it signals that China will not tolerate foreign exchanges copying its futures contracts, and comes despite the practice of offering “lookalike” contracts being accepted around the world for years.

The ICE contracts are not copies, exactly. Similar to its “NYMEX lookalike” contracts, which cash settle against the expiring NYMEX future, the ICE Singapore commodity contracts are to be cash settled based on the settlement price of the expiring ZCE future. The ZCE future is delivery-settled. Meaning that the delivery mechanism ensures convergence between physical and futures prices, and the lookalike contract can ensure convergence by cash-settling against the delivery-settled contract.

The issues here are common to all intellectual property controversies. Strong intellectual property rights impede competition. Against that, free riding off the creativity or investment of others can impede innovation.

There isn’t a one-size-fits-all answer to this trade-off. In the case of exchange traded contracts, I tend to lean towards weak intellectual property rights.  The network effects of liquidity tend to weaken competition, and to give incumbents a strong advantage over entrants. There is already a substantial stream of rents to being first that gives strong (and maybe overly-strong) incentives to innovate, making strong intellectual property rights superfluous, and indeed damaging because they place another burden on already weak competition.

The US courts arrived at a similar conclusion, ruling that NYMEX did not have property rights over its settlement prices that it could use to preclude ICE from using them to cash settle its contracts. This is one factor that has encouraged a relatively robust competition in energy derivatives, which is the exception rather than the rule.

In sum, I hope ICE is able to prevail in its battle with ZCE. In part on economic grounds, and in part on the grounds that it burns me to see IP pirates protect their turf by asserting IP, especially over something for which IP is unwarranted.

I have compared Obama to a previous progressive president enamored of executive power and impatient with checks and balances: namely, Woodrow Wilson. Obama is now moving into the League of Nations phase of Wilson’s presidency, intent on ramming through a foreign policy deal in defiance of intense Senate opposition.

Actually, this comparison is unfair. To Wilson. At least he submitted the treaty to the Senate for ratification. It failed because he refused to compromise on Article X. Obama in contrast, refuses to involve Congress in any way, least of all by submitting any agreement for ratification. He scorns the very idea.

Today Obama stooped to a new low. In response to a letter from 47 Republican senators warning him that without ratification, Obama’s deal with the mullahs would not bind a future president or Congress, Obama responded by questioning their loyalty: “It’s somewhat ironic to see some members of Congress wanting to make common cause with the hardliners in Iran.”

Really. The hardliners oppose a deal because it might put a speed bump in the way of their race to develop an atomic weapon and the means to deliver it. The Republicans oppose the deal because they believe that the deal would not go nearly far enough to prevent, or even seriously delay Iran’s building of the bomb.

See the difference? I knew you could. That people with radically opposed objectives both attack a proposed agreement doesn’t mean it is just right. Indeed, the hardliners’ opposition validates the Republicans’ fear that the mullahs are hell-bent on getting the bomb as soon as possible.

Obama would be wise to heed the lesson of Wilson, whose obstinacy and refusal to compromise prevented him from achieving his the legacy-building agreement he craves so intensely. But we know that is not in his nature. It is not in the prog nature.

On the subject of Iran, I’ve been pondering the last couple of days what Putin wants to see here. My sense is that he would actually prefer that Obama fail. Another nuclear power on Russia’s borders cannot be a comforting thought. What’s more, Russia has long harbored imperial ambitions in Iran: the more insane nationalist elements in Russian (e.g., Zhirinovsky) are quite open in their ambitions to move south into Iran. A nuclear Iran would make those ambitions even less realistic than they already are.

But the main factor, at least in the short to medium term, is oil and gas. A deal that would expedite the elimination of sanctions that have limited Iran’s oil sales, and which have kept its gas almost completely out of reach, would be adverse to Russia’s economic interests. A substantial increase in Iranian oil output would put considerable downward pressrun prices. The elimination of sanctions would open Iran’s vast gas reserves. In not too long, this gas could flow to Europe, where it would compete with Gazprom’s.

It’s hard to see an upside to Russia in a deal. Meaning that Putin will be trying to find a way to scupper it. Which will give Obama an opportunity to accuse the Republicans of being in league with Putin as well as the mullahs.

John Kerry actually said this:”[Kerry] insisted the Obama administration’s diplomatic record with Iran entitles the U.S. to ‘the benefit of the doubt.'” Seriously? The administration that is synonymous with foreign policy failure-the Reset, Libya (including but not limited to Benghazi), Syria, Iraq/Isis, Yemen, to name just the most egregious examples-deserves the benefit of the doubt? Why exactly? Do we look that stupid? It’s like Hoover asking Dean Woermer to give Delta House one last chance at the end of Animal House, while chaos is rampant on the streets of Faber. Or the Apprentice asking the Sorcerer for just one more try with the brooms. He’ll nail it this time! Promise!

I wrote several posts eviscerating Obama’s risible, not to say mendacious, claim that oil transported via Keystone would be exported. Apparently the odor emanating from Obama’s full-of-it-iveness was so obvious that even reliable lefty “fact checker” Glenn Kessler couldn’t ignore it. So he awarded Obama’s Keystone claim a cherished Four Pinnochios. This was pretty good:

When Obama first started making the claim that the crude oil in the Keystone pipeline would bypass the United States, we wavered between Three and Four Pinocchios — and strongly suggested he take the time to review the State Department report.

Clearly, the report remains unread.

Of course it does! It’s not like the truth could trump politics, or anything.

Tonight we learned that while Secretary of State, Hillary was using private email exclusively to conduct professional business. (What was her email? [email protected]?)  Hillary trying to avoid scrutiny of her dealings? How could you suggest such a thing? I’m sure that every message was read and stored for posterity-by the Russians, Chinese, North Koreans, Iranians, and assorted Islamist hackers.

I could go on. But you get the idea.

F. Scott Fitzgerald wrote that “[t]he test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.” By this standard, Obama and his foreign policy team must be far into the right tail of the MENSA distribution, because they are able to hold about 10 opposed ideas in mind.

For instance, the operation against Tikrit is a vital step in the campaign against Isis, but the US is not involved. In part it is not involved because Iran and Shia militias are taking the lead in the offensive there, and the US has grave, grave concerns about growing Iranian influence-control, really-in Iraq and elsewhere in the region (e.g., Yemen). We are so concerned about Iran, in fact, that we are negotiating-I use the term loosely, because it usually involves both give and take, and we are just giving-a deal that would give Iran a clear path to becoming a nuclear power. Once it becomes a nuclear power, of course, it will have dramatically enhanced capability to exert its power in the entire Middle East. Even before it gets the bomb, sanctions will be ended, giving Iran the economic wherewithal to support terrorism and extend its influence the region. (Kerry is in Geneva with his buddy, the Iranian foreign minister Javad. They’re on a first name basis, you see. I wonder if they’re reminiscing about the old days. You know, the American Embassy; the Marine Barracks; Khobar Towers; supplying Iraqi terrorists with shaped charge IEDs to kill Americans. Good times. Good times. The list of topics is endless.)

Meanwhile, Obama has long said that he wants to rid the world of nuclear weapons. Not only is he negotiating a deal that will create a new nuclear power, Iran’s acquisition of the bomb will set off a race by the Saudis, Turks, Egyptians, etc., to get it too.

Further, Obama wants to get the Sunnis in Iraq, and Sunni nations in the Middle East, on board to fight Isis. All the while he is standing aside while Iran and Shia militias, whom the Sunnis hate with the heat of 1000 suns, operate pretty much at will in Iraq.

But I’m not done!  The administration also has a soft spot for the Sunni Muslim Brotherhood (witness its continued hostility to Sisi in Egypt, who tossed out the MB), despite the fact that the Brotherhood views Shia as subhuman.

Another part of the administration policy-supposedly-is to support “moderate” Syrian opposition fighters. Who is the opposition opposed to? Iran’s biggest ally: Assad. What’s more, the first group of fighters that we were supporting were rolled over by an Al Qaeda-linked group, and switched allegiances. In response, Obama’s “Special Presidential Envoy for the Global Coalition to Counter ISIL” (how does he fit that on his business card?) Gen. John Allen (ret.), says that the US will protect moderate Syrian opposition fighters “when the time comes.” I’ll bet that’s a real enticement to enlist. Somehow, I get the vision that the protection that will be offered is an honor guard at a mass burial, because when the time comes it will be too late.

Of course, this is not genius. It is drooling incoherence. The administration has more foreign policy personalities than Sybil. Simultaneously attempting to pursue wildly contradictory, and indeed mutually exclusive, policies, which will inevitably result in a train wreck of historic proportions.

At the root of this is Obama’s Ahab-like pursuit of a deal with Iran. That is the primary source of incoherence. Why he harbors this obsession, I do not know. I cannot think of a good reason. I can think of many bad ones, including some very, very bad ones.

I have written often of the Clayton Rule of Manipulation, named after a cotton broker who, in testimony before Congress, uttered these wise words:

“The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

High Frequency Trading has created the possibility of the promiscuous application of the Clayton Rule, because there is a lot of things about HFT that do not suit a lot of gentlemen at this moment, and a lot of ladies for that matter. The CFTC’s Frankendodd-based Disruptive Practices Rule, plus the fraud based manipulation Rule 180.1 (also a product of Dodd-Frank) provide the agency’s enforcement staff with the tools to pursue a pretty much anything that does not suit them at any particular moment.

At present, the thing that least suits government enforcers-including not just CFTC but the Department of Justice as well-is spoofing. As I discussed late last year, the DOJ has filed criminal charges in a spoofing case.

Here’s my description of spoofing:

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.

Order cancellation is a crucial component of the spoofing strategy, and this has created widespread suspicion about the legitimacy of order cancellation generally. Whatever you think about spoofing, if such futures market rule enforcers (exchanges, the CFTC, or the dreaded DOJ) begin to believe that traders who cancel orders at a high rate are doing something nefarious, and begin applying the Clayton Rule to such traders, the potential for mischief-and far worse-is great.

Many legitimate strategies involve high rates of order cancellation. In particular, market making strategies, including market making strategies pursued by HFT firms, typically involve high cancellation rates, especially in markets with small ticks, narrow spreads, and high volatility. Market makers can quote tighter spreads if they can adjust their quotes rapidly in response to new information. High volatility essentially means a high rate of information flow, and a need to adjust quotes frequently. Moreover, HFT traders can condition their quotes in a given market based on information (e.g., trades or quote changes) in other markets. Thus, to be able to quote tight markets in these conditions, market makers need to be able to adjust quotes frequently, and this in turn requires frequent order cancellations.

Order cancellation is also a means of protecting market making HFTs from being picked off by traders with better information. HFTs attempt to identify when order flow becomes “toxic” (i.e., is characterized by a large proportion of better-informed traders) and rationally cancel orders when this occurs. This reduces the cost of making markets.

This creates a considerable tension if order cancellation rates are used as a metric to detect potential manipulative conduct. Tweaking strategies to reduce cancellation rates to reduce the probability of getting caught in an enforcement dragnet increases the frequency that a trader is picked off and thereby raises trading costs: the rational response is to quote less aggressively, which reduces market liquidity. But not doing so raises the risk of a torturous investigation, or worse.

What’s more, the complexity of HFT strategies will make ex post forensic analyses of traders’ activities fraught with potential error. There is likely to be a high rate of false positives-the identification of legitimate strategies as manipulative. This is particularly true for firms that trade intensively in multiple markets. With some frequency, such firms will quote one side of the market, cancel, and then take liquidity from the other side of the market (the pattern that is symptomatic of spoofing). They will do that because that can be the rational response to some patterns of information arrival. But try explaining that to a suspicious regulator.

The problem here inheres in large part in the inductive nature of legal reasoning, which generalizes from specific cases and relies heavily on analogy. With such reasoning there is always a danger that a necessary condition (“all spoofing strategies involve high rates of order cancellation”) morphs into a sufficient condition (“high rates of order cancellation indicate manipulation”). This danger is particularly acute in complex environments in which subtle differences in strategies that are difficult for laymen to grasp (and may even be difficult for the strategist or experts to explain) can lead to very different conclusions about their legitimacy.

The potential for a regulatory dragnet directed against spoofing catching legitimate strategies by mistake is probably the greatest near-term concern that traders should have, because such a dragnet is underway. But the widespread misunderstanding and suspicion of HFT more generally means that over the medium to long term, the scope of the Clayton Rule may expand dramatically.

This is particularly worrisome given that suspected offenders are at risk to criminal charges. This dramatic escalation in the stakes raises compliance costs because every inquiry, even from an exchange, demands a fully-lawyered response. Moreover, it will make firms avoid some perfectly rational strategies that reduce the costs of making markets, thereby reducing liquidity and inflating trading costs for everyone.

The vagueness of the statute and the regulations that derive from it pose a huge risk to HFT firms. The only saving grace is that this vagueness may result in the law being declared unconstitutional and preventing it from being used in criminal prosecutions.

Although he wrote in a non-official capacity, an article by CFTC attorney Gregory Scopino illustrates how expansive regulators may become in their criminalization of HFT strategies. In a Connecticut Law Review article, Scopino questions the legality of “high-speed ‘pinging’ and ‘front running’ in futures markets.” It’s frightening to watch him stretch the concepts of fraud and “deceptive contrivance or device” to cover a variety of defensible practices which he seems not to understand.

In particular, he is very exercised by “pinging”, that is, the submission of small orders in an attempt to detect large orders. As remarkable as it might sound, his understanding of this seems to be even more limited than Michael Lewis’s: see Peter Kovac’s demolition of Lewis in his Not so Fast.

When there is hidden liquidity (due to non-displayed orders or iceberg orders), it makes perfect sense for traders to attempt to learn about market depth. This can be valuable information for liquidity providers, who get to know about competitive conditions in the market and can gauge better the potential profitability of supply ing liquidity. It can also be valuable to informed strategic traders, whose optimal trading strategy depends on market depth (as Pete Kyle showed more than 30 years ago): see a nice paper by Clark-Joseph on such “exploratory trading”, which sadly has been misrepresented by many (including Lewis and Scopino) to mean that HFT firms front run, a conclusion that Clark-Joseph explicitly denies. To call either of these strategies front running, or deem them deceptive or fraudulent is disturbing, to say the least.

Scopino and other critics of HFT also criticize the alleged practice of order anticipation, whereby a trader infers the existence of a large order being executed in pieces as soon as the first pieces trade. I say alleged, because as Kovac points out, the noisiness of order flow sharply limits the ability to detect a large latent order on the basis of a few trades.

What’s more, as I wrote in some posts on HFT just about a year ago, and in a piece in the Journal of Applied Corporate Finance, it’s by no means clear that order anticipation is inefficient, due to the equivocal nature of informed trading. Informed trading reduces liquidity, making it particularly perverse that Scopino wants to treat order anticipation as a form of insider trading (i.e., trading on non-public information). Talk about getting things totally backwards: this would criminalize a type of trading that actually impedes liquidity-reducing informed trading. Maybe there’s a planet on which that makes sense, but its sky ain’t blue.

Fortunately, these are now just gleams in an ambitious attorney’s eye. But from such gleams often come regulatory progeny. Indeed, since there is a strong and vocal constituency to impede HFT, the political economy of regulation tends to favor such an outcome. Regulators gonna regulate, especially when importuned by interested parties. Look no further than the net neutrality debacle.

In sum, the Clayton Rule has been around for the good part of a century, but I fear we ain’t seen nothing yet. HFT doesn’t suit a lot of people, often because of ignorance or self-interest, and as Mr. Clayton observed so long ago, it’s a short step from that to an accusation of manipulation. Regulators armed with broad, vague, and elastic authority (and things don’t get much broader, vaguer, or more elastic than “deceptive contrivance or device”) pose a great danger of running amok and impairing market performance in the name of improving it.