Streetwise Professor

In my recent post on position limits, I suggested that at most spot month limits are justified as a means of constraining market power manipulation. It is important to note, however, that setting spot month limits at levels that approximate stocks in deliverable position may not be sufficient to prevent the exercise of market power during the delivery period, with the resultant deleterious effects on prices.

The basic motivation for position limits equal to stocks is predicated on a model of manipulation that makes particular assumptions about market participants’ beliefs. I pointed out the importance of this assumption in my 1993 Journal of Business article on market power manipulation. In one model of that paper, I assume that market participants believe that a large long who takes delivery will resell what is delivered, and will not consume it. In the other model, market participants believe that the large long will consume (or otherwise withhold from the market) some fraction of what shorts deliver to him.

Under the first set of beliefs, it is indeed a necessary condition for profitable manipulation that a long’s position exceed inventories in deliverable position. It is this kind of manipulation that spot month limits pegged to inventories can prevent.

However, under the second set of beliefs, a large long with a position smaller than inventories in deliverable position can exercise market power and inflate prices. Spot month limits based on inventories cannot prevent this type of manipulation.

I recently completed a paper that incorporates this insight into a standard signalling model. In the model, there are two kinds of longs: (a) “strong stoppers,” who have a real demand for the deliverable commodity, place a higher value on it than others, and who will consume at least some of what is delivered to them, and (b) manipulators, who have no real demand for the deliverable and who will resell what is delivered. Shorts do not know which type is standing for delivery.

In the model, a long submits an offer to sell his futures position at a specified price prior to expiration. The strong stopper submits an offer above the price that would prevail in the absence of a strong stopper (reflecting his high valuation of the commodity). I show that under different out-of-equilibrium beliefs there is a pooling equilibrium in with the manipulator mimics a strong stopper, and submits a high offer price at which he is willing to liquidate.

In the pooling equilibrium, the shorts deliver a quantity that exceeds the quantity that they would deliver if they knew the long was a strong stopper: this reflects the fact that they realize that the manipulator will resell what is delivered, and the shorts can repurchase it at a depressed price. However, in this equilibrium the manipulator sells some of his futures position at a supercompetitive price, and earns a supercompetitive profit even though he has to “bury the corpse” of a manipulation.

Crucially, the manipulation can succeed even if the long’s position is smaller than inventories, as long as the flow supply curve is upward sloping at such quantities. The flow supply curve can be upward sloping merely due to the theory of storage: an anticipated depletion of stocks increases the value of the remaining inventory. Therefore, if shorts anticipate a positive probability that a long will consume what is delivered, the theory of storage implies that the supply of deliveries is an increasing function of the futures price at expiration.

Thus, a futures position in excess of inventories in deliverable position may be a sufficient condition to exercise market power, but it is not a necessary one. If shorts are uncertain about a long’s motive for taking delivery, and some longs are strong stoppers who will consume what is delivered and thereby deplete inventories, manipulators can mimic strong stoppers and extract a supercompetitive price even with a position smaller than inventories.

One implication of this analysis is that reliance on spot month position limits is not sufficient to prevent market power manipulations. Additional measures, what I have called “ex post deterrence” since my 1996 Washington and Lee Law Review article, are also necessary. In my earlier work I argued that they are necessary because it was unlikely that position limits could adjust to reflect inevitable changes in inventories. This new paper shows that even if they could so adjust limits, they would be inadequate. Market power manipulation facilitated by fraud (i.e., falsely pretending to have a real demand for the commodity) can occur even if position limits prevent a long from obtaining a position during the delivery period that exceeds stocks in deliverable position.

This analysis also implies that equating “deliverable supply” with “inventory in deliverable position” is wrong. The supply available at the competitive price may be smaller than inventories–and indeed, far smaller than inventories–when shorts do not know the “type” of long standing for delivery.

The traditional model of deliverable supply is predicated on a view of manipulation shaped by the big corners of history, in which there was little doubt about the motivations of a large long. But as the court in the Cargill case noted, “[t]he methods and techniques of manipulation are limited only by the ingenuity of man.” Exploiting shorts’ ignorance about his motive for taking delivery, a long can ingeniously exercise market power even with a position smaller than deliverable supply.

This is a possibility that is only dimly recognized in the existing regulatory structure in the US. Most importantly, it implies that a reliance on preventative measures like position limits alone is inadequate to reduce efficiently the frequency and severity of market power manipulation. Ex post measures are required as well.

When my grandfather was barely 17, his mother signed a paper saying he was 18 (he was a hillbilly with no birth certificate, which gives rise to another story I may tell sometime), and he left Burr Oak, Ohio to join the Navy. He went to electrician’s school, and was assigned as an electrician’s mate on a submarine, the USS K-2 (submarine #33 in the US Navy), on which he served in 1921-22. (The K-2 was laid-up the next year.)

As you can see, she was a tiny thing, displacing 400 tons on the surface, and a little over 500 tons submerged.* My grandfather’s stories of his service on her were pretty harrowing. 1920s submarines were not for the faint of heart.

Even so, if given the choice, I would serve on the K-2 circa 1920 than on a modern Russian sub. Since Soviet days, the Soviet/Russian sub force has experienced a litany of accidents, many of them fatal: here is a list of those since 2000. The most notable of these incidents, and the one with the highest death toll, was of course the Kursk, about which Putin famously and laconically said: “It sank.”

Well, this week Putin didn’t have to say exactly those words about another sub, but there was a fatal incident aboard a Russian boat, reported to be the Losharik, reputedly a super-deep diving research and intelligence vessel.

Given the very secretive nature of the sub’s purposes and missions, and the inherent secretiveness of the Russian state, we know very little beyond a few details. These include that there was a fire that killed 17 aboard. (The standard crew of this class is estimated at 25, so arguably the fire killed 2/3s of those on board.) That the surviving crew was able to seal off the affected compartments, and eventually extinguish the blaze. And that’s about it.

It’s one thing for a dry dock carrying a decrepit hulk like the Kuznetsov to sink. It’s another for one of the most elite units in the Russian Navy to suffer such a catastrophic event. It does not speak well of the condition and readiness of the Russian Navy generally.

There are also some curious details. Reportedly 7 of the 17 killed were captains “of the first rank” (the equivalent of an O-6 in the US Navy). I know the Russian Navy (especially the nuclear sub force) is officer-heavy (and indeed, the entire complement of the boat is apparently officers), but that’s an insanely high number. Most US major combatants (including SSNs, SSBNs, and DDGs) are commanded by commanders (O-5), and others have a single captain, who is CO. What were 7 (or more) captains, plus two Heroes of Russia, doing on board? Was it holding some sort of ceremony? Or was it engaged in activities that were of intense interest to the higher ups?

Another possibility is enlisted ratings, and even junior and mid-grade officers, are not deemed sufficiently qualified and trustworthy to crew such an important vessel. But if they are not given substantial responsibility as lieutenants, how can one be confident in the captains? Is the Russian Navy so paranoid about security that they don’t trust anyone but the very senior, to serve on top-secret ships?

Also, are senior officers the best suited to handle the vital, but more narrow tasks that western navies entrust to well-trained, specialized ratings? If not, depending on the very senior to perform these tasks may increase the risk of things like fatal fires.

I doubt we’ll learn much more about the Losharik. But what we do know, especially in light of the record of Russia’s silent service, reinforces the very real perception that anyone in that service plays a submerged version of Russian Roulette every time his boat casts off.

*My grandfather took dozens of photos in his time on the K-2. I am going to digitize them and will post them when I do.