Streetwise Professor

A few thoughts regarding the Amaranth matter.

First, the good. A large hedge fund blows up, losing $6 billion in a matter of days, and the market just chugs along with no problems. Quite a contrast to the tumult that accompanied the demise of LTCM 8 years (to the month) earlier.

Now, that said, we shouldn’t get too complacent about this. For one thing, although the dollar value of Amaranth’s loss dwarfs that of LTCM (which lost about $2 billion in equity), the market is just much bigger today. It remains to be seen whether a fund with the same relative size as LTCM could implode without wider fallout. For another, LTCM’s problems occurred during a time of—indeed were caused by—a general financial crisis sparked by a de facto Russian default. This caused a rush for liquidity, and since LTCM was long illiquid instruments and short liquid ones, it was devastated. Its losses, combined with the fact that it was counterparty to most major financial institutions, threatened to make a bad situation worse. In contrast, Amaranth’s travails occurred during relatively quiescent times in the broader financial markets—although natural gas markets were indeed highly volatile and unsettled. It still remains to be seen whether a major hedge fund collapse in the midst of a financial crisis could touch off an acute systemic problem.

Second, the bad. The Amaranth episode proves again, as if further proof was needed, the danger of the “superstar trader” complex. Gas trader Brian Hunter reportedly made Amaranth $800 million in 2005. Whereas historically the fund had kept a close watch on its traders, requiring them to operate out of its Greenwich, CT offices, Amaranth let Hunter set up his own little empire in Calgary. Moreover, it is plausible that Hunter’s past success made the fund’s management loath to question his judgment in putting on the massive spread trade that apparently brought down the house. For you slow learners out there: big winners need more supervision and oversight, not less.

Third, the ugly. Not that we should be surprised, but the usual suspects in DC immediately leapt into action to use the Amaranth situation to justify yet again (yet again . . . ) their tiresome claim that the OTC energy markets are a threat, and that additional regulation is required. One failproof way to identify quackery is if the doctor always prescribes the same “cure” (nostrum is more like it) regardless of the patient’s symptoms. If anything even remotely untoward happens in the OTC energy markets, Drs. Feinstein, Levin, and Coleman (see, it’s not a purely partisan game) always prescribe greater oversight of electronic OTC trading platforms (read ICE) and the mandatory reporting of large OTC energy derivative positions. Possible manipulation—position reporting. Large investor loss—position reporting. Energy prices go up—position reporting. Energy prices go down—position reporting.

What, pray tell, would the CFTC have done with additional information in the Amaranth case? Since Amaranth’s positions posed no plausible manipulative threat in the immediate term (as they were 2007 gas positions) the CFTC could not have used the information to facilitate a manipulation investigation. Nor was fraud a remotely likely problem. Furthermore, CFTC is not in business to keep adults from losing money by speculating the wrong way. Perhaps the agency might have directed inquiries to Amaranth’s FCMs to determine whether the positions posed a threat to the financial viability of these firms and their other customers. Since there have been no reports that any FCM was seriously injured by Amaranth’s difficulties, however, it is unlikely that such inquiries would have led to any CFTC action that would have had the slightest effect on developments.

Even with regard to matters clearly within the CFTC’s ambit—notably, the prevention of manipulation and fraud—it is highly unlikely that position reporting is all that helpful. Position reporting might—and I emphasize might—facilitate early intervention to prevent a manipulation. As I’ve written in the past, notably in my book on manipulation (now #1,565,885 on Amazon after reaching the low-500,000s in late-August!), however, prevention is inefficient as compared to ex post deterrence. As Judge Easterbrook put it, an undetected manipulation is an unsuccessful manipulation. Highly anomalous price movements are the hallmark of manipulation. Transparent exchange prices, and prices on transparent electronic OTC platforms like ICE, provide the most reliable information regarding manipulation. Anomalous price movements—and the complaints of traders harmed by them—can trigger further inquiry to determine whether a manipulation has plausibly occurred, or is in process. Position information can be requested and obtained at that time. Why incur the cost of routinely collecting and analyzing masses of information about positions, most of which is almost completely irrelevant to detecting, deterring, or preventing manipulation? Put differently, a large position may be a necessary condition for manipulation, but it is clearly not a sufficient one. It is more efficient to utilize scarce enforcement resources to examine circumstances in which the primary indicia of manipulation—anomalous prices—are present, than to scrutinize big positions even when price distortions are not evident.

Ironically, raising the cost of doing business on transparent electronic platforms would likely force business into less transparent ways of transacting. This would reduce the availability of reliable price data that is of essence in any manipulation case.

To those who might say: “well, by the time that prices become distorted it’s too late—we need to catch these things ahead of time” I reply: just how, exactly? All manipulations are associated with big positions, but many big positions are not associated with manipulation in any way. One needs to worry about both type I and type II errors, false positives and false negatives. Raising the costs of accumulating large positions may reduce the frequency of manipulation—but it can also constrain the accumulation of large positions for legitimate business purposes. This is costly. A rifle shot approach directed at particular markets where the signs of manipulation are manifest is more efficient than a shotgun approach like that advocated by Sens. Feinstein, et al.

So I venture a daring prediction: the next time the energy market catches a cold, the flu, colitis, or any other ailment known to man or beast, the Capitol Hill Medicine Show will prescribe its Sure-Fire Senatorial Position Reporting Cure.