Streetwise Professor

Perpetual futures are all the rage these days. Few things in the futures space have attracted as much attention as “perps,” in particular in the aftermath of a surge in crude oil perpetual futures trading on Hyperliquid over the weekend when the US and Israel unleashed their bombing campaign against Iran–a time when the major exchanges were closed. Below is a policy piece I prepared for ICE that examines the economics of perps. The basic conclusion: they are suitable primarily for a retail trading niche which represents a small fraction of incumbent exchanges’ business.

The Economics of Perpetual Commodity Futures

Introduction

Perpetual futures (“perpetuals” or “perps”) were developed initially to solve specific security problems in trading cryptocurrency (“crypto”). From their birthplace in the crypto markets, perpetual futures have moved into the trading of virtually every major asset class, including inter alia equities, equity indices, and currencies. And now they are making inroads into commodities like oil and corn. The Iran War triggered broader awareness of this latter trend: the volume of a crude oil perpetual futures contract traded on Hyperliquid soared to $1.7 billion with the onset of the war.[1]

This, in turn, has sparked considerable debate over how perpetual futures will affect the traditional conventional commodity futures markets, including ICE and the CME. Herein I present an economic analysis of perpetual futures. [2] The primary conclusions are:

• Due to their design, perpetual futures are ill-suited for market participants who account for a preponderant share of trading on incumbent exchanges. These are large commercial and financial entities who use traditional futures contracts to transfer risk. Crucially, the spot price mimicking structure of perpetual futures does not align with the risks that commercial hedgers manage.
• Instead, perpetual futures are tailored to small “retail” traders. As a result, perpetual futures are likely to be a niche product that is attractive to this clientele.
• The competitive impact of perpetual futures on commodity derivatives markets will depend on whether these contracts attract retail volume from incumbent exchanges, or instead disproportionately attract traders who would not trade on these exchanges.

Commodity Perpetual Futures

Perpetual futures emerged in the cryptocurrency market to solve a particular problem: recurrent thefts of cryptocurrency held by exchanges trading actual crypto (“spot exchanges”).[3] Introduced by BitMEX in 2013, perpetual futures avoided the security issues that had plagued spot exchanges because they were cash-settled instruments that did not allow, require, or countenance the delivery of crypto assets, or the custody thereof.

Incumbent crypto exchanges traded crypto assets on a spot basis, in much the same way that the NYSE or Nasdaq trade equities on a spot basis. Perpetual futures were designed to mimic spot trading but to avoid the security issues just described. Specifically, with perpetual futures, on a periodic basis throughout the day a perpetual futures exchange determines a price from an “oracle” that takes the prices from spot exchanges. The perpetual futures exchange then compares the price of its perpetual contract (for Bitcoin, say) to the price derived from the oracle. If the prevailing price on the exchange’s perpetual diverges from the oracle price (a measure of the spot price of the instrument), the exchange determines a “funding rate.” If the perpetual price is above the oracle price, the contract long pays the funding rate, and the short receives a funding rate payment.

This is intended to, and has the effect of, causing the perpetual price to track the spot price prevailing on spot exchanges. A perpetual price above the spot price incentivizes sale of the perpetual to capture the funding payment, thereby driving the price: conversely, a perpetual price below the spot price incentivizes a purchase of the perpetual, again to capture the funding payment, thereby driving up the price. These sales and purchases tend to drive the perpetual price towards the spot price, thereby causing the perpetual price to track spot prices closely. In this way, a perpetual futures trader can obtain exposure to the underlying spot price as could be obtained directly on a spot exchange, but without the security risks posed by trading on a spot exchange.

Market participants soon realized that perpetual futures offered other advantages.

First, unlike conventional futures contracts, perpetual futures have no fixed expiration date. Thus, whereas trading traditional futures requires those who wish to hold a position over a contract expiration date must “roll” these positions on or before the expiration date, this is unnecessary for a perpetual future. For example, with conventional futures, a long must sell the expiring contract and buy a later-expiring contract to maintain a long position, whereas a trader long the perpetual need not do anything. This economizes on transactions costs. 

Second, like futures but unlike spot transactions, perpetual futures incorporate leverage. For example, perpetual exchanges offer 10x, 20x, and sometimes as much as 50x leverage.

Third, like conventional futures, perpetual futures are easier to short than actual cryptocurrencies.

Fourth, perpetual futures offer 24×7 trading. In contrast, at present, conventional exchanges trade for less than 24 hours a day, and on weekdays.

As a result of these various features, perpetual futures have come to dominate crypto trading. A recent JP Morgan study estimates that perpetuals account for 90 percent of crypto derivatives trading (with conventional futures traded on exchanges like the CME representing the rest), and that perpetual futures volumes exceed spot exchange volumes.

Perpetual futures differ from conventional futures in other ways. Unlike conventional futures traded on ICE or CME, many perpetual futures are not centrally cleared.

Moreover, and relatedly, perpetual futures often have an “auto-liquidation” feature. As an example, on Hyperliquid, as on a traditional cleared market, the exchange sets an initial margin level and a maintenance margin level: these levels effectively determine leverage, with lower margins being associated with higher leverage. If the market moves against a trader and the loss drives the trader’s account equity below the maintenance margin level, Hyperliquid reduces or closes the position by engaging submitting an offsetting market order into the exchange limit order book, for example, selling when a long’s account equity is insufficient.[4] If the trader’s equity falls below two-thirds of the maintenance margin level, the position is transferred to a “Liquidation Vault,” which essentially internalizes the offsetting transaction.[5] In extreme circumstances, when the market liquidation fails and the Liquidation Vault cannot safely absorb the position loss, the exchange may trigger “Auto-Deleveraging,” whereby profitable positions on the opposite side of the market can have their positions reduced. This is effectively a “tear up” procedure.

Auto-liquidation mitigates credit risk in leveraged instruments, but can have destabilizing effects. For example, a large price increase likely results in large auto-liquidations of short positions, which tends to cause prices to increase further. In the case of perpetual futures, the price change will manifest itself primarily in the form of an increased spread between the perpetual price and the spot price it is intended to track, leading to large funding payments that require access to funding liquidity. Liquidity strains can exacerbate this mechanism.[6]

Commodity Perpetual Futures

Although perpetual futures developed in crypto markets to address crypto-specific problems, their market success has spurred the extension of the concept to a wide variety of other underlying instruments, most notably commodities such as crude oil. With respect to commodities specifically, perpetual futures differ in salient dimensions from crypto perpetual futures and even perpetual futures on other non-crypto-underlyings, such as equity indices.

There is one overriding reason for this difference: there are no transparent and liquid spot markets as there are for cryptocurrencies and many other financial assets. Thus, it is impossible to create commodity perpetual futures that track (as a result of funding payments) a spot commodity price, because for all practical purposes such a thing does not exist.

Instead, existing commodity perpetual futures are designed to track the prices of liquid futures contracts, such as CME NYMEX WTI Crude Oil Futures and ICE Brent Crude Oil Futures. With that difference, commodity perpetual futures operate similarly to the crypto perpetuals described above.

Specifically, a perpetual futures exchange obtains the price of the futures it is tracking from an oracle, and sets funding payments based on the difference between the perpetual futures price and the oracle price. For example, on 3 August 2026, Hyperliquid receives the price of September 2026 WTI Crude Oil Futures on an hourly basis from its oracle.[7]  As described above, it determines a funding payment based on the difference between the WTI perpetual futures price at that time and the Crude Oil Futures price determined from the oracle. Further, as already described, funding payments incentivize market participants to make transactions that tend to diminish the difference between the perpetual futures price and the price of the underlying futures contract.

As a result of this mechanism, the perpetual futures price tracks a futures price. But what futures price? The underlying futures contracts expire, meaning that the perpetual futures exchange must periodically shift the identity of the underlying futures contract whose price the perpetual future tracks.

There are many ways to do this. One way would be to shift at the end of trading of a particular futures contract, which would be 2:30 p.m. Eastern Time on the last trading day of an expiring contract, at which time the tracking would shift from the just-expired contract to the now front-month contract.

Due to the nature of commodity forward curves, where prices of adjacent futures contracts can differ substantially (a subject I return to below), such a mechanism would lead to abrupt changes in the perpetual futures price. Exchanges have therefore adopted other mechanisms that result in a smoother transition.

Hyperliquid, for example, has a five-day roll period running from the fifth to the tenth business day of the last month of trading of a contract.[8] On the fifth day, the reference price equals the price of the next expiring (front month) contract. On the fourth day, the reference price equals .8 times the front month price and .2 times the second month price. On each successive day, the weight on the front month contract falls by 20 percent, and the weight on the second month contract rises by that amount. This continues until on the tenth business day of the month, at which time the reference price equals 100 percent of the second month contract price. This mechanism effectively smooths out the effect of differences between front month and second-month underlying prices on the price of the perpetual.

The Economic Function of Commodity Futures

Futures markets serve two primary purposes: risk transfer and price discovery. Risk transfer relates to hedging: those who wish to reduce their exposure to the price of a particular commodity can take an offsetting exposure through the futures market, thereby transferring their risk either to a hedger with a mirror image risk exposure, or to a speculator who is willing to take on the risk in the expectation of earning a profit. Price discovery is a valuable byproduct of futures trading undertaken for hedging or speculative purposes. Those with private information (about fundamentals, for instance) trade on that information, for instance buying when their information suggests that the current price is too low. These privately informed trades tend to move prices in the direction of the private information that motivates them, thereby causing prices to reflect this information. The aggregation of private information in futures prices through this mechanism is valuable, because more informative prices guide better resource allocation decisions.

Different types of market participants have different reasons for trading. In commodities, large commercial entities’ trading is largely (though not exclusively) for hedging purposes. For example, commodity trading firms hedging the price risk of oil inventories or oil producers hedging the prices of their anticipated production are important market participants. Large banks (swap dealers) also use futures markets to hedge the exposure they incur when providing over-the-counter hedging instruments (e.g., swaps) to their clients (which could include firms like the oil producer just mentioned). Speculators now typically consist of large institutions, including hedge funds, family offices, commodity trading advisors, and financial institutions. In addition to large commercial and institutional entities, smaller entities such as individual retail traders also participate in the futures market.

Although imperfect for a variety of reasons, the Commitment of Trader (“COT”) Reports produced weekly by the US Commodity Futures Trading Commission (“CFTC”) provide a useful breakdown of futures trading activity by type of trader. These COT reports disclose the quantity of contracts held by several categories of traders, including Producer, Merchant, Processor, and User (“PMPU”); Swap Dealer; Managed Money; Reporting Traders[9] who do not fall in one of the previous categories; and non-Reporting Traders. Moreover, the COT breaks down positions by long and short, and in the case of Swap Dealers, Managed Money, and Reporting Traders, by spread positions as well (something I discuss further below).

Table 1 reports the shares for long positions for six major commodity futures contracts, and Table 2 does the same for short positions.[10] The main takeaway is that large entities dominate, with small traders holding 5 percent or less of the positions in all of the commodities except corn. Thus, the main function of the traditional futures markets is risk transfer among large commercial and financial entities. This is an important fact when considering the potential role and impact of commodity perpetual futures.

Table 1

Contract	PMPU	SwapDealers	ManagedMoney	OtherRpt	NonRpt
COFFEE C	21.84	12.78	29.90	7.03	5.35
CORN	25.11	16.48	14.83	8.53	8.19
COTTON NO. 2	23.28	21.09	13.43	13.40	4.99
NAT GAS ICE	49.44	8.49	13.77	3.48	0.60
NAT GAS NYMEX	13.40	10.33	12.06	3.39	3.57
WT PHYSICAL NYMEX	32.43	3.25	9.12	7.18	3.64

Table 2

Contract	PMPU	SwapDealers	ManagedMoney	OtherRpt	NonRpt
COFFEE C	41.49	20.52	4.70	6.23	3.97
CORN	41.79	1.09	15.14	4.60	10.50
COTTON NO. 2	24.84	4.45	35.12	6.66	5.14
NAT GAS ICE	24.59	48.51	0.77	1.62	0.29
NAT GAS NYMEX	15.31	2.37	13.21	9.25	2.62
WT PHYSICAL NYMEX	18.70	25.56	4.93	3.63	2.80

The Economic Role of Commodity Perpetual Futures

The structure of perpetual futures means that they are not well-suited to achieve the purposes of futures markets described above, at least for a very large proportion of market participants. Specifically, they are not useful to large commercial hedgers or large speculators (i.e., those supplying risk capital to the market). Instead, they are most suitable for small speculators. In servicing this niche, perpetual futures might undermine the price discovery function of established futures markets.

The most telling indication of perpetual futures’ trader clientele is contract size. The Hyperliquid WTI Crude Oil contract (linked to the CME Crude Oil Futures price) is for one barrel of crude oil, in contrast to the standard CME contract which is for 1,000 barrels. The CME offers smaller contracts, and these are explicitly focused on the retail segment of the market. [11]

Such small contract sizes are impractical for large hedgers, who often hold positions in the millions of barrels. For example, in 2025, the average PMPU long in Crude Oil Futures held a position of 10.3 million barrels, and the average PMPU short’s position was 5.5 million barrels.

These average positions dwarf the entire open interest and volume of the Hyperliquid contract. On the day of the writing of this, Hyperliquid’s Crude Oil 24 hour volume in its 20x leverage contract was a mere 1.03 million barrels, and open interest only 2.13 million barrels. Volumes and open interest for other Hyperliquid commodity contracts is similarly de minimis compared to commercial position sizes.

The very nature of perpetual futures also makes them ill-suited for commercial hedging. They are designed to track a proxy for commodity spot prices—the nearby futures price—but hedgers typically are not hedging spot exposures. Instead, they hedge specific production, inventory, transportation, or consumption commitments occurring at identifiable future dates. A producer expecting to market crude oil six months hence typically hedges using contracts maturing near the anticipated production date. A grain elevator holding inventories evaluates storage opportunities by comparing prices across delivery months.

This relates directly to an important feature of commodity futures markets that distinguishes them from financial futures: the fact that there is trading for numerous contract expiration dates, sometimes stretching years into the future. Although trading volume and open interest is largest for nearby contracts, trading volume and open interest for deferred months is material.

This is reflected in the fact that “calendar spread” trading is extremely active in commodity futures markets.[12] This is illustrated in Table 3, which shows the fraction of open interest accounted for by calendar spread trades in the five contracts analyzed above. These shares are very large. By design, perpetual futures cannot accommodate spread trades. Thus, they are of limited utility to the large numbers of swap dealers and managed money firms who trade large volumes of spreads.[13]

Table 3

Contract	SwapDealer	ManagedMoney
COFFEE C	517	834
CORN	1450	2026
COTTON NO. 2	1110	1516
NAT GAS ICE	27172	17902
NAT GAS NYMEX	4682	5929
WT PHYSICAL NYMEX	10284	5480

The auto-rolling feature of perpetual futures is also attractive to small retail traders. This feature reduces transactions costs: a trader can hold a position in the nearby without incurring the commissions and liquidity costs associated with making offsetting trades in an expiring and first deferred contract.

It bears noting that the auto-rolling feature of perpetual futures does impact the timing of cash flows as compared to a strategy of successively rolling conventional futures contracts. It is well known that the cumulative payoff to a collateralized position in the nearby contract that is rolled periodically equals the change in the spot price (measured by the nearby price) of a commodity from the date the strategy is initiated to the date it is terminated. A perpetual future generates the same payoff over an identical holding period. However, with a conventional rolling strategy, the cash flows at the time of the roll do not depend on the difference (spread) between the nearby and first-deferred contracts at the time of the roll, whereas the cash flow on a perpetual future does. As noted above, the perpetual price at the time of the roll is a function of both the nearby and first-deferred prices, and thus depends on the spread between them. If calendar spreads are large, that is, the market is in a large backwardation or contango, the perpetual price can change dramatically over the roll interval even if the underlying futures prices do not change.

This has important implications for margining and auto-liquidation. Auto-roll during a period of large backwardation or contango generates large perpetual price changes, which in turn generates large mark-to-market gains and losses, and large adjustments to margin balances. Since such changes can trigger equity shortfalls (especially in high-leverage perpetual futures), they can also trigger automatic liquidations even if the underlying futures prices change little. This is not the case for conventional futures.

In sum, perpetual futures are most attractive to retail traders, rather than the large commercial and financial firms that dominate conventional futures markets. This means that perpetual futures are competing for only a relatively small share of traditional exchanges’ customer base.

However, this could have implications for price discovery. The foregoing suggests that perpetual futures will fragment/segment order flow in much the same way as dark pools, payment for order flow, and other off-exchange trading mechanisms do in equity markets.

Since retail order flow is unlikely to be privately informed, such segmentation changes the composition of order flow in ways that can impede price discovery. Although at first blush it may seem that stripping out uninformed order flow should make futures prices more informative, the opposite is true. The subfield of finance known as “market microstructure” shows that informed traders trade less intensively when uninformed order flow declines. Therefore, such declines tend to reduce the informativeness of prices, i.e., to degrade price discovery.

The importance of this cannot be predicted with any certainty, especially given the recentness of the development of perpetual futures, but some factors can be identified. One factor is whether perpetual futures will primarily divert retail traders from traditional exchanges, or will instead attract new traders who would not otherwise trade on such exchanges. The larger the importance of diversion vs. attraction the bigger the adverse impact on price discovery. But if the main effect of perpetual futures is to attract new participants to the markets (due for instance to small contract sizes, or lower commission and account setup and maintenance costs), the effect on incumbent exchanges and price discovery on them will be modest. To the extent that diversion does occur, the relatively modest shares of trading accounted for by retail traders will limit the impact on price discovery.

Summary

Perpetual futures are the new hot thing in commodity markets. They have achieved prominence lately primarily due to a surge in oil perpetual futures trading during the Iran War. This attention exaggerates their importance, and their likely future place in the commodity derivatives landscape.

Why? Because their very design makes them unsuited for hedging of commodity price risk, which is the primary function of commodity derivatives markets. Specifically, by design perpetual futures track a spot price (or in commodities, a proxy for the spot price), but commercial hedgers are primarily exposed to price risks further out on the forward curve. Moreover, calendar spread trading is important in commodity derivatives markets, and spot-focused perpetual futures cannot support such trading. Moreover, existing perpetual futures contracts are far smaller than the contracts that are traded in large volumes on traditional exchanges.

Thus, perpetual futures are tailored to a specific clientele—small “retail” traders who account for a relatively small share of traditional exchange volumes. Although perpetual futures may divert some of this volume from traditional exchanges, they may also facilitate the entry of new traders who would not trade on traditional exchanges. The ultimate competitive effect, and the impact of perpetual futures on the performance of commodity derivatives markets, will depend on the relative importance of these two effects.

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[1] Will Canny and Al Boost, Iran war volatility is driving oil trading boom on Hyperliquid, says JP Morgan. CoinDesk (20 March 2026).

[2] I offer no analysis or opinions regarding the legal status of perpetual futures under the Commodity Exchange Act.

[3] “Perpetual Futures and the Illusion They Were Built to Escape.” John Lotian News, 22 June 2026.

[4] See https://hyperliquid.gitbook.io/hyperliquid-docs/trading/liquidations for a detailed description of the process. The exchange can profit or lose by trading out of the positions taken into the liquidation vault.

[5] Some perpetual futures exchanges do not first attempt to liquidate the position in the open market, but internalize all liquidations.

[6] Below I discuss how the nature of commodity perpetual futures can inherently lead to large price changes during “roll” periods even when underlying market prices are not volatile.

[7] I focus on Hyperliquid because its public disclosures of its methodologies and trading protocols are the most complete and detailed.

[8] This procedure mimics that of some commodity futures exchange traded funds.

[9] Each futures contract has a reporting level. Those holding positions in excess of the reporting level must report them.  Those whose positions fall below the level are not required to report.

[10] The numbers do not sum to 100 percent due to the exclusion of calendar spread positions. Due to their importance, I discuss calendar spread positions separately below.

[11] The CME also offers a “mini” contract for 500 barrels, and a “micro” contract for 100 barrels. The CME has recently announced it will launch a 10 barrel contract. See Financial Times, Oil market opens up as retail traders pour in (4 July 2026).

[12] A calendar spread trade involves simultaneous purchase and sale of futures contracts on the same underlying commodity but with different delivery dates. For example, in natural gas, a February-March calendar spread purchase involves buying a February contract and simultaneously selling a March contract.

[13] Commercial traders in the PMPU category also trade spreads in large volumes, and hold large spread positions, even though the COT reports do not report such positions.

Kashyap, Stein, Wallen, and Younger have attracted a lot of attention with their recent Brookings paper, “Treasury Market Dysfunction and the Role of the Central Bank.”  Their pathbreaking findings: (a) Treasury basis trades are systemically risky; (b) the rapid growth in the amount of US bonds and notes outstanding increases this risk; and (c) Fed intervention is required to prevent the systemic risk in basis trades from crystalizing.

Wow! Who knew?

Oh, right. I did. Five years ago. (First draft, 7 August 2020). (The lack of a citation is very bad form, guys).

A year and a half ago I provided an answer to a question that most analyses of the basis trade begged: why does it exist in the first place? My answer: constraints on money managers ability to buy cash Treasuries directly, especially leveraged purchases. They achieve implicit leverage through futures, which is mirrored by the explicit leverage of basis trading hedge funds.

Kashyip et al tart up their paper with a simple model. The most important component of this model is money managers’ demand for long futures, but that is really assumed, not derived from a model that specifies the underlying constraint. They merely say: “In our model, asset managers pay the basis for the convenience of holding Treasuries off balance sheet.” Whence that “convenience” arises is left to our imaginations. (They also say “there are specific stories we have in mind” but apparently they’d have to kill us if they told us).

The only real contribution of the paper is their proposal that the Fed engage in hedged bond buying to absorb a (margin induced!) unwind by hedge funds. But that’s just a particular way of doing this: “As a consequence, the soundness of the U.S. financial system continues to depend on the prompt and effective intervention of the Fed as lender of last resort, with all the attendant moral hazard problems.” (They do discuss the moral hazards inherent in their proposal).

By way of faint praise, I do acknowledge that they don’t advance clearing as a nostrum. But I am somewhat startled by this statement: “Although clearing may have significant benefits, these benefits are largely orthogonal to the issues of concern here.” Especially since they also acknowledge that “when volatility increases margin requirements can increase as well, potentially triggering forced unwinds.”

Orthogonal? Hardly: margining, of both the futures and repo legs of a basis trade, is THE source of instability. It is at the heart of these issues. “Can increase”? Does increase. “Potentially triggering forced unwinds”? That’s exactly what triggers forced unwinds.

Their proposal–again, not really novel–that the Fed intervene is necessitated by two things: clearing, and the constraints that induce money managers to launder leverage via futures, rather than take leverage on their balance sheets. Meaning that they let off clearing and regulation far too easily.

Cocoa has been on a wild ride for the past year.

So wild that Bloomberg has a separate category for “The Cocoa Crisis.” Contributing to the recent hysteria is news that Hershey has requested “special permission to buy over 90,000 tons of cocoa.” Evidently the chocolate manufacturer has requested a position limit exemption from the CFTC. (Links to the “Cocoa Crisis” coverage are in the article).

Note that exemptions, specifically for hedging, are explicitly recognized in the relevant regulations, and are granted routinely, so this is not really exceptional. Not knowing the exemptions granted to Hershey in the past it is difficult to know whether the magnitude of the exemption is extraordinary.

The article is confusingly written. In commodities subject to limits, there are different kinds of limits. These include single month and all month limits outside the “spot month” and “spot month” limits. Spot month limits kick in sometime prior to expiration. In cocoa, it is my understanding that the spot month limit kicks in on First Notice Day, which for the next ICE Cocoa contract (“CC”), March 2025 (“CCH5”) is 24 February, 2025.

The article implies that the exemption requested is for the spot month:

The maker of Reese’s Peanut Butter Cups wants to take a position that will allow it to purchase more than 90,000 metric tons of cocoa on ICE Futures US, said the people, who asked not to be identified because the information is private. The request to the Commodity Futures Trading Commission equates to about 5,000 20-foot containers and is more than nine times the amount the exchange currently allows.

The spot month limit is 1,000 lots, so 9,000 contracts would be 9x the spot limit. The single month/all month limit is 4,900 contracts, so the requested exemption would be less than 2x the single/all month limit.

I am somewhat skeptical that the exemption request is related to the spot month given that spot exemption requests can occur closer to FND, and the magnitude is so large relative to ICE cocoa certified stocks (currently only 1,604 lots) that granting such an exemption would be problematic. Particularly problematic would be “purchas[ing] more than 90,000 metric tons of cocoa on ICE Futures US” if that means acquiring that much physical cocoa via the delivery process.

But Hershey did that in 2020, and exchange cocoa is supposedly at a discount to the cash market. The cash market discount begs the question: why? Are apples being compared to apples in terms of quality, location, etc.?

Acquiring 90,000 tons–or 25 percent of that amount– would require bringing in large amounts of cocoa to exchange warehouses. That in turn would require acquiring cocoa on the cash market (at a supposed premium), getting it to ICE warehouses, grading it, etc. So it’s hard to believe that cert cocoa is an economical source of supply for Hershey in the quantities mentioned in the Bloomberg article.

The price movement in 2020 sure as hell looks like a squeeze, but neither ICE nor the CFTC took action, so maybe Hershey figures it can do it again.

Unlike 2020, this time the spread didn’t take off:

The March-May 2025 spread did spike in mid-December, but only narrowed slightly after the publication of the Bloomberg article on 8 January. (Perhaps somewhat confusingly, an increase in the spread is referred to as “narrowing”. “Wider” means a bigger carry: “narrower” means less carry or more backwardation).

Here’s 2020 for comparison:

I certainly believe that big commercials can sometimes bamboozle ICE and the CFTC, especially when it comes to telling just so stories about how its economical to take delivery. So it’s not inconceivable that Hershey is trying to do that here, and that they will succeed.

The are other curious things in the article. For example: “A spokesperson for the Pennsylvania-based company said Hershey has a ‘rigorous’ procurement process and that it is ‘well covered’ on its cocoa needs for 2025.” If “well covered” means that Hershey has supply contracts sufficient to meet its anticipated physical needs, why would it need to take delivery? If “well covered” means that they supply contracts are fixed price, Hershey wouldn’t need to hedge using futures. So the company’s statement obfuscates rather than informs if it is intended to ease fears that the company could be hammered by a high and rising cocoa price in 2025.

As I noted before, the epic price rally has put cocoa in the news frequently. Another example is this Reuters article from last month. In brief, the high and volatile cocoa prices have driven speculators from the market, leading to thinner, less liquid markets.

A couple of comments.

First, the exit of hedgies has not caused prices to decline, which implies that they were not the ones that caused the high prices in the first place as has been frequently claimed (as is usually the case when prices move a lot–“round up the usual suspects”).

Second, the reduction in speculative capital makes the price more sensitive to bigfooting by commercials. Like Hershey. Just sayin’.

Third, this demonstrates clearly the effects of clearing and margining. Volatility and high flat prices increase margins and thereby the cash needed to maintain positions. Since cash liquidity can be costly, this raises the cost of providing both long term and short term market liquidity, which leads to the exit of speculative capital that has occurred in cocoa. This in turn increases volatility all things equal. That is, the margining mechanism creates a positive feedback loop that can be detrimental to market performance.

Not to say that the credit risk mitigation benefits of margining don’t outweigh these market liquidity costs. Just pointing out that mitigating credit risk is not cost free.

Given the decline of liquidity and the possibility that a large commercial may lean on the delivery process, the cocoa market is worth keeping an eye on.

As an aside, some years back there were squeezes in cocoa in March. I used to teach my commodity trading course in Geneva in March, and I joked to my students that I should buy CC calendar spreads before heading to Geneva. (I now teach there in April). This March might be particularly interesting.

And of course there was the big Armajaro corner in cocoa in July 2011.

All in all, cocoa can be a source of material for those interested in how er “technical factors” affect pricing. Including me. So I guess you could say I’m coo coo for cocoa:

(A flashback to my youth).

There is a bit of a kerfuffle in futures world about the CME winning approval from the Natinoal Futures Association (NFA) to operate its own brokerage firm (futures commission merchant “FCM”). The industry is pretty unified in its opposition to this “vertical integration” by the CME that will put it into competition with some of its customers.

(Once upon a time I worked on the 15th floor of the tower on the left).

I think this will turn out to be much ado about nothing. Yes, CME has the right to open an FCM, but whether it will, or how big it will be if it does, is very much open to doubt.

Recall that the CME launched this initiative in response to FTX’s adoption of this model. (The fact that the CME obtained approval almost exactly 2 years after FTX went kaput tells you a lot about the speed at which regulators work). FTX is no more, and no other exchange, crypto or otherwise, has adopted the model. So there’s no perceived competitive threat from an integrated exchange, which reduces (and perhaps eliminates) the CME’s need to bring the FCM to life. It likely pursued the application after FTX’s demise as a precautionary measure.

If that’s right, the FCM will remain on the shelf.

And I think it will because it’s hard to make a business case for it. Let’s consider the various economic rationales for such integration.

One commonly asserted one is to leverage monopoly power. Commonly asserted, and wrong. The one monopoly rent theorem implies that except under very special (and usually quite contrived) circumstances, a monopolist (which CME arguable is in most of its products, and in clearing) can extract all the rents from its market power by pricing its own product, and cannot increase profit be obtaining market power upstream or downstream.

Regulated monopolists have sometimes integrated to circumvent rate regulation. For example, ATT owned its equipment supplier Western Electric. ATT operated under rate of return regulation, but could circumvent that by purchasing equipment from its subsidiary at inflated prices.

That doesn’t apply to CME. It is a regulated monopolist but not subject to rate of return regulation.

Integration can also be a way of circumventing price controls. That’s also not an issue here.

Vertical integration can mitigate transactions costs when there are bilateral monopolies (at least after the “fundamental transformation” that occurs when the upstream and downstream firms make relationship specific investments). The FCM sector is pretty fragmented and competitive, and does not fit this “scorpions in.a bottle” template.

Another reason for vertical integration is double marginalization. This occurs when both the upstream and downstream firms have some market power. Each charges a price above marginal cost, and in general the all in price exceeds the joint profit maximizing price.

Again, the FCM sector, though more concentrated than it was historically, is still highly competitive. It’s not impossible that FCM prices (commissions and data charges) exceed marginal cost, but not by much.

But it is not outside the realm of possibility that CME believes that the more concentrated FCM industry could use a little price competition. An exec at Interactive Brokers apparently thinks so: “If they’re going to undercut our pricing and offer cheaper market data then that will be a problem.” (It’s quite interesting that market data is mentioned. That’s a big deal in the modern electronic world).

Pro tip: “we don’t like the fact that they may compete with us on price” is not a public spirited rationale for opposing a competitor’s or potential competitor’s action.

I consider this to be the most likely reason for CME to activate an FCM and operate it seriously. And that would not be a bad thing. Although the impact on the ultimate customer is likely to be modest because lower FCM prices would permit CME to jack up its price. But the combined CME+FCM price would be lower if there is indeed double marginalization going on. That would benefit the ultimate customer.

Another reason for integration would be for the CME to secure better information on the costs of supply and the demand for FCM services. This could help it optimize its pricing.

The one potential real concern about CME’s move is that it is a self-regulatory organization that polices FCMs, and that it might favor its own or try to raise its rivals’ costs through exercise of its oversight facilities. But note that the NFA, which granted approval, regulates FCMs (under CFTC auspices).

In sum, absent competition from a new integrated FTX copycat, I don’t see a compelling business case for the CME to turn on the lights to its newly approved FCM, or at least to operate one at a scale that would compete seriously with the bank-owned big boys. (Funny how that form of integration gets little comment or scrutiny, eh?). The reason that it might–to stimulate price competition in the FCM space and mitigate double marginalization–would benefit customers, though perhaps not by much. The self-dealing issue is ameliorated considerably by the fact that the NFA regulates FCMs. (Indeed, political economy considerations, namely pressure from other NFA members, might make the NFA be harder on the CME).

So all in all, nothing to get hot and bothered about.

The increasing concentration of the futures commission merchant (FCM)/clearing broker business has been a pronounced feature of the world derivatives markets in recent years. This has raised concerns among at least some regulators, including CFTC commissioner Summer K. Mersinger. In a speech generally rah-rah-ing clearing mandates, Commissioner Mersinger did raise one discordant note. Specifically, implementation of the Basel III standards would contribute to further concentration in the FCM/CB space:

Second, the Basel III Endgame Proposal would weaken the clearing system by exacerbating the downward trend in the number of entities offering client clearing services.  In January 2004, there were 177 futures commission merchants (“FCMs”) registered with the CFTC.  Twenty years later, as of January 2024, there are 62 FCMs registered with the CFTC, representing a 65% decline. But over the same period, there has been a dramatic increase in customer funds held at FCMs to support derivatives trading.  In January 2004, FCMs held over $87 billion of customer funds.  Today, that smaller number of FCMs is holding five-and-a-half times that amount of customer funds—$490 billion.  And of that customer money, approximately 60% is concentrated in the top five FCMs. [Footnotes omitted.]

This is a problem because

Third, a further decline in the number of FCMs would create systemic risk. In addition to concentration concerns, a decline in the number of FCMs would raise serious challenges regarding the portability of customer positions should a clearing member fail.  Consider this potential scenario: a clearing member defaults, and its customers’ positions need to be ported to a different clearing member; however, porting those positions proves difficult or even impossible because the Basel III Endgame Proposal has both decreased the number of clearing members and reduced client clearing capacity at the remaining clearing members.  This outcome of the Basel III Endgame Proposal would increase systemic risk, not reduce systemic risk.

It’s a shame nobody saw this coming.

Oh wait. Someone did. Thirteen years ago: “Moreover, this means of facilitating connections of end users to multiple CCPs tends to encourage the concentration of client business in a small number of clearing member firms. This concentration has systemic implications.”

(See also here, from the Chicago Fed.)

On this blog, I have also written on numerous occasions how various aspects of Dodd-Frank contribute to consolidation among FCMs. Regulatory overhead is a largely fixed cost, which contributes to scale economies and hence concentration. Moreover, diversification effects and the need for big balance sheets to intermediate large derivatives positions also contributes to concentration. Note that the OTC dealer market has always been quite concentrated for these reasons, and this concentration has migrated to the cleared world as clearing of OTC derivatives has been mandated.

Commissioner Mersinger did not identify the causes of increasing concentration that has already occurred among FCMs: her speech focuses on how the Basel III End Game may make this problem even more acute. But she does not recognize that the central clearing that she lauds in her speech is a major driving force of the trend she laments: “But recent policy proposals in the United States risk upending the success we have experienced through the efforts of the G-20 and the move to central clearing.” In other words, central clearing good, but you are screwing it up, Basel.

I said Basel! Not Basil!

In actual fact, regulation generally, and clearing mandates specifically, have been the major driver of market structure in the post-Frankendodd era. It’s good that regulators are starting to recognize the systemic risks inherent in this structure. It’s disappointing that they don’t recognize that what they praise lavishly (and pat themselves on the back for) is the underlying source of the problem.

Gary Gensler has been a menace to the market system for as long as he has been in government. Those of you who have followed this blog for a long time know that I relentlessly criticized him during his tenure as CFTC chairman. He apparently took notice, because he banned me from the CFTC building. I also consider it extremely likely that he was the moving force behind the 2013 NYT supposed hit piece on me–for which I should probably thank him, because on net that has turned out to be a major positive.

Gary Gensler. (Though this is how I like to think of him.)

At CFTC, Gensler was merely an Igor implementing the Frankendodd creation of his congressional masters. As head of the SEC, however, Gensler has become a full-fledged Dr. Frankenstein, stitching together regulatory monsters that threaten to stalk the landscape leaving economic devastation in their path.

I have already written several times about the SEC’s misguided Treasury clearing mandate. But that is only one of Gensler’s Monsters. There are many others.

Perhaps the most monstrous is the SEC’s proposed rule on climate-related disclosures. This would mandate that public companies disclose their carbon emissions–and those of their suppliers. This is at best vast speculative endeavor, and and worst an impossibility. It’s main concrete effect will be to provide a pretext for lawsuits against companies targeted by activists who will allege that the companies’ calculations were wrong, or were lies because alternative internal calculations came up with numbers that differed from those reported in their 10Ks.

The regulation would also require companies to make fulsome disclosures of their climate risks. Another speculative endeavor that cannot produce any meaningful or useful information. It requires each company to characterize the interaction between one complex system–climate–and another complex system–the economy–to predict the adverse consequences of this interaction for it, a small part of the economic system allegedly impacted by climate. Prognostications about climate are themselves wildly uncertain–indeed, arguably the biggest risk is model risk. Predicting how climate will impact economic outcomes at the company level under myriad possible climate scenarios is a mug’s game.

And indeed, it is even worse than that. For there is another element to the problem–government policy. This introduces an element of reflexivity that is particularly devilish. Government policy will respond to climate and economic outcomes as well as interest group pressure, and will affect economic outcomes (though whether these policies will actually affect climate outcomes is dubious). This is arguably by far the biggest risk that companies face.

Meaning that if the regulation comes into force, I recommend the following boilerplate disclosure for all companies: “We face the risk that some government agency will adopt a boneheaded policy that will dramatically raise our cost of doing business or eliminate the markets we service.”

This will also be a boon to lawyers. “Company X failed to disclose the risk associated with [insert climate scenario here] described in [poorly executed paper published in obscure journal].”

I could go on. But in Congressional testimony John Cochrane did a lot of the heavy lifting for me, so I direct you there.

And I ask: how will this information improve the allocation of capital? It is more likely that this will just add noise that impedes efficient capital allocation, rather than actionable information that improves it. The hive mind of investors is likely far more adept at evaluating the effects of the climate-economics-policy nexus than the managers of corporations.

I further note that this obligation’s burdens are greater for small companies than big ones. Meaning that it will likely lead to exit and consolidation, and greater concentration. Which other parts of this administration–notably Lina Khan’s FTC–think is a great evil. Ironic, that. Ironic, but not humorously so.

Moving right along, the trendy Gary has targeted the New Thing, Artificial Intelligence. In public statements Gensler has made the at least somewhat plausible argument that interactions between very similar AIs can produce destabilizing positive feedback mechanisms. But the SEC’s proposed AI regulation instead focuses on potential agency problems:

Today’s predictive data analytics models provide an increasing ability to make predictions about each of us as individuals. This raises possibilities that conflicts may arise to the extent that advisers or brokers are optimizing to place their interests ahead of their investors’ interests. When offering advice or recommendations, firms are obligated to eliminate or otherwise address any conflicts of interest and not put their own interests ahead of their investors’ interests. I believe that, if adopted, these rules would help protect investors from conflicts of interest — and require that, regardless of the technology used, firms meet their obligations not to place their own interests ahead of investors’ interests.”

The SEC remedy for this litany of horrors?

But under the guise of minimizing conflicts of interest, the SEC now proposes requiring advisers and broker-dealers to write new internal procedures and to log all uses of technologies relating to predictive data analytics for agency review. If left unchallenged, the new rules would hamper the American financial industry’s world-beating innovation.

The definition of what must be disclosed is comprehensive:

“an analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes in an investor interaction.” 

This would basically encompass EVERY analytical function performed by covered entities, including e.g., quant traders’ algorithms, portfolio optimizers, and on and on and on. Basically any use of statistical methods is implicated (note the reference to “correlation matrix”).

Perhaps the “investor interaction” language will limit this to principle-agent applications (as bad as that would be), but it is so broad that it is highly likely that the SEC will interpret it to cover, say, an HFT firms algorithms to predict and analyze order flows. That involves “an investor interaction.”

This all brings to mind previous regulatory initiatives to require disclosure of all trading algorithms–something that was mercifully killed.

And what will the SEC do with this information? This would represent a massive amount of highly technical information that the SEC would not have the capacity or expertise to analyze proactively, and information that would metastasize inexorably. Hell, even storing the information would be a challenge.

Again, like the climate reg, this seems all pain no gain. This disclosure would entail massive cost. And for what? To find an agency violation needle in a massive informational haystack? Agency violations (such as trading ahead) that could not be detected using existing methods?

But that’s not all!

Gensler also looks askance at exchange volume discounts. Why? Because NO FAIR:

“Currently, the playing field upon which broker-dealers compete is unlevel,” said SEC Chair Gary Gensler. “Through volume-based transaction pricing, mid-sized and smaller broker-dealers effectively pay higher fees than larger brokers to trade on most exchanges. We have heard from a number of market participants that volume-based transaction pricing along with related market practices raise concerns about competition in the markets. I am pleased to support this proposal because it will elicit important public feedback on how the Commission can best promote competition amongst equity market participants.”

Volume discounts are obviously pervasive throughout the economy in the US and indeed the world. So why should these be somehow so nefarious in stock trading as to require their elimination?

Let’s apply some economics–which alas is an alien concept to Gensler. There are two basic reasons for volume discounts.

One is that it is cheaper to service bigger customers. In which case volume discounts are efficient, and banning them would be unambiguously bad.

Another is that it is a form of price discrimination. For example, big intermediaries may find it easier/cheaper to shift business between exchanges than smaller intermediaries, in which case their demand for the services of a particular exchange would be more elastic than the demand of the smaller firms. Exchanges would then rationally charge lower prices to the more elastic demanders.

The welfare effects of this type of price discrimination are ambiguous, making the case for banning it–even if it can be established that the volume discounts are demand-elasticity-driven discrimination vs. cost-based discrimination–ambiguous as well.

With respect to “concerns about competition,” well, elasticity-based discrimination requires that inter-exchange competition not be perfect in the textbook sense. But if that is what is driving the volume discounts, outlawing them treats a symptom of market power rather than market power itself, and how “imperfectly competing” exchanges will price when they can’t price discriminate is very much an open question–and exactly why the welfare effects of price discrimination are ambiguous.

Gensler seems to be channeling discredited Robinson-Patman like logic that protected the high cost against competition from the low cost. That is anti-competitive, not pro-competitive.

These are only some of the monsters the Frankensteinian Gensler is assembling in his DC laboratory. I could go on, but you get the idea.

There is hope, however. Whereas Gensler’s CFTC actions were largely rooted directly in very specific statutory directives, his work as Dr. Frankenstein is based on extremely expansive interpretations of the SEC’s statutory authority dating back to the 1930s. Such expansive interpretations–not just by the SEC, but many other agencies–are currently being challenged in the courts, including cases pending before the Supreme Court.

It is possible therefore, and indeed to be fervently hoped, that the Supreme Court will hand down decisions that demote Gensler back to Igor implementing very specific Congressional mandates, and end his career as regulatory Frankenstein.

And the benefits of such decisions would extend beyond reining in the SEC, for as bad as it is that agency is probably not the worst offender–the EPA probably is, but the competition for this dubious honor is intense. The administrative state–the American Mandarinate, as I like to think about it–needs to be culled. And with extreme prejudice, and as soon as possible.

The Treasury basis trade continues to be in the news, with one of the biggest basis traders–Citadel’s Ken Griffin–complaining that the SEC should regulate hedge fund basis trading, but should instead make sure that banks aren’t supplying too much leverage to . . . well, hedge funds mostly. This seems like a raising rival’s costs gambit. No doubt restrictions on leverage would hit Griffin’s competitors harder, whereas SEC regulation might have a more even impact.

Regardless, one question that hasn’t been asked in all the to-ing and fro-ing about Treasury basis trades is why they exist at all, let alone why they get so big. This graph (courtesy of FTAlphaville, based on CFTC data) provides a major clue:

Note the mirror image between leveraged funds (mainly hedged funds) and asset managers (ostensibly non-leveraged funds–the reason for the “ostensibly” will become clear shortly).

To the extent that hedge funds’ short positioning reflects basis trades, the graph suggests the following. Hedge funds take a leveraged market neutral position, buying bonds, funding them via repo, and selling futures. Futures are in zero net supply: the graph shows that the longs on the other side of the hedge funds’ futures short are asset managers.

Most asset managers do not, and in some cases even cannot, take leverage directly. So for example they are constrained in their ability to just buy Treasuries with borrowed money (e.g., via repo). But the basis trade allows them to lever up via futures. So in some sense, the basis trade is just an additional link in a chain of intermediation. Laundering leverage, if you will.

(A more complete picture might add swap dealers to the picture. Some managed money, such as leveraged ETFs, enter into swaps with dealer banks. The dealer banks in turn can hedge by taking offsetting futures positions.)

The hedge funds expect to earn a small margin on the trade–on average, though there is risk. The market is pretty competitive, so to a first approximation that margin (the difference between the actual futures price and the theoretical futures price derived from bond prices, bond vols and correlations, and repo rates) equals hedge funds’ marginal cost of supplying this intermediation. The asset managers on the long side of the futures trade are willing to pay “too high” a futures price (relative to bond prices) because this is a cheaper way of achieving a leverage target than via the available alternatives.

The March 2020 experience shows that the basis trade can be a fragile one that creates some systemic risk: this is why regulators are concerned about basis trades now, to Ken Griffin’s chagrin. Providing this leverage intermediation/laundering creates tail risks for the hedge funds that do so. This raises the question of whether there are regulatory constraints that inefficiently constrain the ability of asset managers to take leverage more directly, rather than via a longer dealer (or money market) to hedge fund to asset manager chain. If so, such constraints could give rise to unnecessary (systemic) risks.

If regulators are concerned about the systemic risks in basis trades, they should take a systemic approach–and understand more fully why basis trades exist in the first place, and why they have periodically become so large. Looking at individual links in the chain (hedge funds, or by Griffin’s lights, banks) can be misleading because it begs the question of why the chain exists in the first place. The link that is driving the process is likely the one that has escaped discussion so far–the asset managers at the end of the chain. Why do they want leverage and why is the basis trade the most cost effective way of supplying a lot of it? Could it be the most cost effective because other, more directly intermediated sources of leverage are unduly expensive because of regulatory or institutional constraints? Definitely worth regulators’ attention.

The market for United States Treasury securities (notes and bonds) has been a source of concern for some years, dating back to the Treasury “flash” event of 15 October 2014, but especially in the aftermath of the “dash for cash” during the March 2020 Covid scare. The relentless selloff of Treasuries in the past year plus has contributed to the angst.

This has led the SEC to propose various changes to the structure of the Treasury market. The most important of these is mandated central clearing of most Treasury cash trades and repos. Well, since Gigi is back in the clearing saddle, I guess I have to mount up too.

The main justifications of the mandate come from Darrell Duffie and various collaborators at the New York Fed (notably Michael Fleming). The IMF has also produced an analysis outlining justifications of the mandating of clearing.

Just as with the Frankendodd clearing mandates, the case for Treasury clearing is very weak.

The basic argument is that Treasury market liquidity has eroded, and that clearing will enhance market liquidity. The supposed main cause of the decline in liquidity is that primary dealers face balance sheet constraints that limit their ability to intermediate the Treasury market.

In the Duffie paper and the Duffie, Fleming et al paper he cites, the main evidence of the deleterious effects of balance sheet constraints comes from the “dash for cash” in March 2020. Summarizing a variety of measures of market liquidity using principal components analysis, they show that liquidity usually varies inversely with market volatility, but liquidity declined far more than predicted by volatility alone in 2020. This was due, it is claimed, to the fact that dealers were not able to increase their holdings of Treasuries due to balance sheet constraints. Their ability to make markets was therefore constrained.

There is a big problem with this analysis. Dealers ended up holding far more Treasuries because Covidmania caused a sharp drop in the demand to hold Treasuries by hedge funds and others–they wanted to substitute cash for Treasuries. Part of the demand drop was accommodated by a price decline, but evidently dealers’ demands did not drop as much as the demands of non-dealers: thus, there was a major portfolio adjustment, with hedge funds etc. reducing their holdings and dealers absorbing as much of these sales as their balance sheets allowed.

Thus, this was a structural change in demand that led to major portfolio adjustments. Yes, the portfolio adjustments were accompanied by a decline in conventional measures of liquidity (bid-ask spreads, depth, etc.) but this decline in liquidity was a consequence of the underlying shock, and clearing of cash Treasuries or repos would have had little, if any, impact on this decline. Even if clearing increased dealers’ balance sheet capacity (something I discuss further below), given the underlying Covid-driven (and Covid policy-driven) demand shock it is highly likely that this incremental capacity would have been fully utilized as well and liquidity would have been about as bad.

This extraordinary shock that led to strained dealer intermediation capacity is different than the types of shocks that dealers typically intermediate. The role of Treasury liquidity suppliers–be they dealers or prop trading firms–is the same as the role of liquidity suppliers in any other market, be it stocks or currencies or commodities: to utilize inventory adjustments (balance sheet) to absorb temporary, temporally uncorrelated, and largely cross-sectionally uncorrelated investor (buy side) demand shocks. The dash for cash was a long-lasting shock highly correlated across major investors in Treasuries. It was a systematic shock that led to a long lasting adjustment in dealer portfolios, whereas market makers absorb idiosyncratic shocks that do not require long lasting adjustments to dealer portfolios.

That is, the kind of portfolio adjustments that occurred in response to Covid were fundamentally different in nature from the kind of portfolio adjustments that firms undertake to make markets. A long term transfer of risk rather than a short term transfer.

Therefore, using the dash for cash as the basis for policies intended to improve Treasury market liquidity is fundamentally misguided.

Be that as it may, it provides the underlying logic advanced for clearing mandates: improving liquidity requires increasing dealer balance sheet capacity, and clearing can supposedly do that.

How can clearing improve balance sheet capacity? The mandate defenders offer that hardy perennial as a justification: netting. For both cash Treasuries and repos, the argument goes, netting out offsetting exposures reduces the amount of capital and cash that dealers require to intermediate. For cash transactions, Duffie, Fleming et al estimate that netting would reduce daily settlement volumes substantially (70 percent in March 2020 according to their figures). This, and other factors, allegedly result in freeing up of dealer balance sheet capacity.

This analysis begs an important question: since dealers would internalize the benefits of more economical use of balance sheets that would result from clearing, why is it necessary to mandate it? Why don’t dealers and other market participants voluntarily utilize clearing more extensively in order to economize on the use of a scarce resource–balance sheet? After all, historically voluntary adoption of clearing in the stock market (e.g., NYSE clearing and CBOT clearing in the 19th century) was specifically intended to reduce settlement volumes by netting. In the case of the CBOT, the clearinghouse netted payment obligations but did not mutualize credit risk on derivatives transactions or impose margins (which were negotiated bilaterally).

The alleged failure of profit-motivated entities to reduce cost (from inefficient use of balance sheets) suggest that this does not come for free: at the margin there must be some cost for clearing that is greater than the putative benefit. That is, profit maximizers will balance marginal private benefits and marginal private costs. The benefits of netting from clearing are private, and thus the current degree of penetration in clearing likely reflects an efficient balancing of these marginal benefits and costs. The advocates of a mandate surely have not shown otherwise.

I further note that, as I wrote repeatedly during the Frankendodd era, netting redistributes default risk rather than reduces it. It is by no means clear that the distribution of default risk under central clearing/netting is more efficient than that under bilateral clearing.

Put differently, the advocates of clearing (both cash and repo) have not identified a “market failure”, e.g., a benefit from clearing that market participants do not internalize. Such a failure is a necessary (but not sufficient) condition for regulatory intervention such as a clearing mandate.

With respect to repo clearing, another supposed benefit is the disparity of margins (“haircuts”) in the repo market. Haircuts for some counterparties are low, but for others they are higher. Central clearing would impose uniform, value-at-risk (“VaR”)-based margins.

The operative theory behind central clearing is that the “loser pays”, namely the resources (margin, default fund contribution) posted by a counterparty is sufficient to cover any losses in the event of that counterparty’s default. Ideally, counterparty credit risk in central clearing is zero, though in reality some always remains.

Well, this begs another question: is the optimal amount of counterparty credit risk/default risk zero (or close to zero) in all transactions? Relatedly, is it optimal not to permit the pricing of counterparty credit risk, where the price varies by the creditworthiness of counterparties, with high credit quality entities paying smaller haircuts than lower quality credits? Central clearing makes pricing independent of creditworthiness, whereas bilateral arrangements that advocates of clearing dislike allow pricing of credit risk that reflects assessments of creditworthiness of counterparties.

Since credit risk mitigants (including margins/haircuts) are costly, and since market participants trade-off the costs and benefits of credit risk and its mitigants, allowing choice and competition on this dimension has strong justifications. Certainly the advocates of mandatory Treasury clearing have not identified a “failure” in this market that justifies regulatory intervention in the form of clearing mandates.

Put differently, clearing mandates force market participants to a corner solution–clear everything, and impose margins that make counterparty credit risk de minimis. The existing state of the market, where market participants can choose to clear with a CCP or not, reveals that they strongly do not prefer the corner solution. Furthermore, the advocates of clearing have failed to identify any market failure that implies that the interior solution/equilibrium is inefficient and can be improved by mandating the corner solution.

And the advocates have yet again failed to recognize the trade-off inherent in clearing: that is, the trade-off between counterparty credit risk and liquidity risk. This despite the fact that the reality of this trade-off has been made abundantly clear (no pun intended) repeatedly in the past–and including in particular the Treasury market basis trade turmoil during the dash for cash.

The real issue in Treasury markets right now, and the real threat to their stability, is the massive deficits in the United States, and the resultant increase in Treasury security issuance and Treasury securities outstanding. It is deficits and issuance that are driving the massive increase in the size of Treasury markets, and the consequent strains on the ability of dealers and others to intermediate the swollen market.

This is a challenge that no rearranging the market structure furniture on the deck of SS Treasury Titanic will fix. Furthermore, the economic case for mandating clearing of Treasury cash and repo transactions is laughably weak even if one overlooks that fact that clearing does not get at the real problem. But it appears that Gigi (cheered on by the Fed) will mandate a corner solution that makes the market less efficient, not more.

In March, 2020 the Federal Reserve injected massive amounts of liquidity into the markets in response to a blow-up in Treasury basis trades. I wrote about it here.

In recent weeks, the Fed, the BIS, and the BoE have raised red flags about the renaissance of this trade and the resulting potential for systemic risk a la 2020. Not all are convinced. Goldman Sachs in particular is in Alfred E. Neuman mode: What? Me worry?

FT Alphaville quotes Goldman’s rates strategy team as follows:

We do not think the trade poses a major risk to Treasury markets in the near term . . . Leverage in the system is materially lower than it was in 2019/20 as a result of a series of [initial margin] increases (and price declines). The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near term, we expect to migrate to a less volatile rate regime.

This assessment is based on a fundamental error that I went on about ad nauseam in the post-Great Financial Crisis clearing debate, specifically, concluding that if leverage goes down in one part of the system it goes down systemically. Wrong. Wrong. Wrong.

Yes, the ostensible purpose of higher margins is to reduce leverage in the margined trades. But especially for the hedge funds and other sophisticated entities who engage in the Treasury basis trade at scale, they can substitute one form of leverage for another.

As a first approximation, a fund has a leverage target or a level of debt capacity, it can fund the higher margin in the less leveraged futures trade by increasing leverage elsewhere. The funds will typically evaluate leverage holistically, not on a trade-by-trade basis.

It is therefore fundamentally logically flawed to conclude that “leverage in the system” (which is in fact source of systemic risk) has declined because it has gone down in one piece of it.

If there are constraints on funds’ ability to offset mandated leverage reductions in one type of trade by increasing leverage elsewhere, that would increase the cost of engaging in that type of trade and would impact the scale of that trade. But what has alarmed the central bankers is exactly that the scale of the trade has increased and now exceeds its 2020 level:

Note that leveraged funds’ Treasury futures shorts are currently substantially larger now than in 2020. Thus, despite higher margins, the scale of the trade is subsantially larger–and it is the scale–and the concentration–of the trade that poses systemic risks.

This bigger scale could be because raising margins doesn’t really constrain the ability of funds to lever up to engage in basis trades. Or it could be that even though the higher margins raise the cost of the trade, the spread has widened sufficiently to offset, or more than offset the higher cost. For example, constraints on dealer balance sheets that impair liquidity in the cash market could depress cash prices relative to futures prices.

Goldman’s errors don’t end there. One thing that could spark a margin spiral is an increase in initial margins that induces mass liquidations that lead to changes in the basis that lead to large variation margin obligations–something that Goldman doesn’t mention.

Alfred E. chimes in again here: “The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near term, we expect to migrate to a less volatile rate regime.” That is, Goldman’s conclusion is essentially based on a very benign view on Treasury volatility.

There are myriad reasons to take a different view. The US’s acute fiscal situation and the accompanying periodic debt limit dramas. The constrained balance sheets of dealers that limit their ability to supply liquidity to the Treasury market. The prospect for an extremely chaotic election year. And geopolitics, with now two major disturbances ongoing (Ukraine and Israel/Gaza) with one continually on the boil in the background (China/Taiwan). And highly unsettled geopolitics with a feckless and befuddled administration at the tiller.

That is, it isn’t the level of margins that really matters. It is the possibility that margins may increase due to higher volatility. Goldman/Neuman isn’t worried. I think that’s unduly optimistic. Furthermore, an assessment of systemic risk must be based on the likelihood that Goldman’s don’t-worry-be-happy opinion is wrong.

And remind me: did Goldman predict the increase in Treasury volatility in 2019 or 2020? Stuff happens. Unknowns and unknowns and all that.

Furthermore, higher volatility->higher IM->liquidation of basis positions->margin spiral isn’t the only potential source of systemic risk. Other economic shocks can cause leveraged funds to slash positions and leverage, leading to liquidations of basis positions and the triggering of a margin cascade. That is, there is the possibility of fire sales.

These shocks can be systematic–a broad decline in stock or bond markets–or concentrated at a few funds, or even one, due to bad trades in other markets.

The 30 25 year anniversary last month of the LTCM collapse brings the latter to mind. Bad bets on convergence trades forced LTCM to liquidate and delever. Understandably, it attempted to unload its most liquid positions–including short Treasury futures. Treasuries had a massive rally on LTCM day that was not matched by a similar rally in the underlying, less risky Treasuries.

A squeeze–not unheard of in government debt futures markets–can also impose losses on basis trades, leading to liquidations that can exacerbate the price impact. Or a Treasury flash crash (in yields, and hence a flash spike in prices) like on 15 October 2014.

In sum, size does matter. Basis trades have become big again, and the factors that lead Goldman to parrot Alfred E. Neuman are hardly persuasive. From a systemic risk perspective, basis trades represent dry tinder that can explode into flame. Can does not mean will. But the possibility is there, and the effect if the right spark hits the tinder depends on the size of trade. The big scale and concentration of this trade thereby justify far more concern than Goldman expresses.

The Fed and the SEC have expressed concerns about Treasury “basis trades” wherein a firm purchases a cash Treasury security funded by repo-ing it out and sells Treasury futures. Their concern is somewhat justified. As mentioned in the linked article, and analyzed in detail in my paper in the Journal of Applied Corporate Finance (“Apocalypse Averted“) the spike in the cash-futures Treasury basis caused by COVID (or more accurately, the policy response to COVID) caused a liquidity crisis. The sharp basis change led to big margin calls (thereby creating a demand for liquidity) and also set off a feedback loop: the unwinding of positions exacerbated the basis shock, and thereby reinforced the liquidity shock.

This is just an example of the inherent systemic risk created by margining, collateralization, and leverage. The issue is not a particular trade per se–it is an inherent feature of a large swathe of trades and instruments. What made the basis trade a big issue in March 2020 was its magnitude. And per the article, it has become big again.

This is not a surprise. Treasuries are a big market, and leveraging a small arb pickup is what hedge funds and other speculators do. It is a picking-up-nickels-in-front-of-a-steamroller kind of trade. It’s usually modestly profitable, but when it goes bad, it goes really bad.

All that said, the article is full of typical harum-scarum. It says the trade is “opaque and risky.” I just discussed the risks, and its not particularly opaque. That is, the “shadowy” of the title is an exaggeration. It has been a well-known part of the Treasury market since Treasury futures were born. Hell, there’s a book about it: first edition in 1989.

Although GiGi is not wrong that basis trades can pose a systemic risk, he too engages in harum-scarum, and flogs his usual nostrums–which ironically could make the situation worse:

“There’s a risk in our capital markets today about the availability of relatively low margin — or even zero margin — funding to large, macro hedge funds,” said Gensler, in response to a Bloomberg News inquiry about the rise of the investing style.

Zero margin? Really? Is there anyone–especially a hedge fund–that can repo Treasuries with zero haircut? (A haircut–borrowing say $99 on $100 in collateral is effectively margin). And how exactly do you trade Treasury futures without a margin?

As for nostrums, “The SEC has been seeking to push more hedge-fund Treasury trades into central clearinghouses.” Er, that would exacerbate the problem, not mitigate it.

Recall that it was the increase in margins and variation margins on Treasury futures, and the increased haircuts on Treasuries, that generated the liquidity shock that the Fed addressed by a massive increase in liquidity supply–the overhang of which lasted beyond the immediate crisis and laid the groundwork for both the inflationary surge and the problems at banks like SVB.

Central clearing of cash Treasuries layers on another potential source of liquidity demand–and liquidity demand shocks. That increases the potential for systemic shocks, rather than reduces it.

In other words, even after all these years, GiGi hasn’t grasped the systemic risks inherent in clearing, and still sees it as a systemic risk panacea.

In other words, even though I agree with Gensler (and the Fed) that basis trades are a source of systemic risk that warrant watching, I disagree enough with GiGi on this issue that the apocalypse that could result from our complete agreement on anything will be averted–without the intervention of the Fed.