(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.
Historically the big oil traders–Vitol, Trafigura, Gunvor, Mercuria–have been in the asset light category. (Glencore transitioned to an asset heavy mining entity with a supersized trading arm before the white paper was published–more on that below). Recently, however, they have gone on something of an asset acquisition binge, buying refineries in particular, as this recent Bloomberg piece describes. Which raises the question: why?
The standard consultant story is that assets have optionality. This is a superficial and incomplete answer. First, the fact that an asset has optionality says nothing about who is best positioned to own the asset and exercise the options. In the case of a refinery, is it better for an integrated oil company to own it? An independent refiner? A commodity trader? Any of these can exercise the options. Which gets the most option value?
Second, it is often possible to acquire the right to exercise optionality via contract rather than ownership. A ship (tanker or bulk carrier) is the best example of this. Ships have extensive optionality in terms of route, timing, and sometimes cargo. Time chartering a ship gives the charterer the ability to tell it where to go when and carrying what: ownership isn’t necessary to exercise these options. Off-take agreements from a mine or well also confer rights to exercise options (e.g., whom to sell the output to) without requiring the purchase of the mine or well.
With respect to commodity traders as optimal owners of assets with optionality I’ve been playing around with a formal model, the intuition for which is fairly straightforward. Physical commodity traders operate in bilateral markets rather than centralized ones. Prices and values are not transparent. Traders are essentially price entrepreneurs who search for and discover cheap supplies and high value buyers. Their intimate market knowledge of profitable trade opportunities may allow them to exercise real options, like the real options inherent in a refinery (especially regarding choice of crude input and the product slate), more efficiently than someone with poorer information.
But that still doesn’t fully answer the ownership question. The trader could obtain the optionality through a tolling agreement, for example. (These are not unknown in the oil business. I recall that when JPMorgan was in the commodities business, it had tolling agreements with refiners).
Further, why is it more efficient for a trader to buy the refiner, rather than the refiner to buy or build trading expertise? BP and Shell in particular are renowned for their trading expertise, and even a laggard–Exxon–has moved into trading.
Since this is also a relatively new development, one must also ask “why now?” (And to its credit, the Bloomberg article does just that). Has traders’ comparative information advantage increased recently? That’s a hard proposition to test, but I am skeptical.
As Bloomberg points out, this buying spree comes in the wake of boom years in commodity trading, and the big traders are awash in cash. (As the billions in bonus payments to traders shows). This is most likely the proximate cause of the acquisitions.
What this says about the efficiency/optimality of the acquisitions is unclear. I can tell two stories with opposite conclusions.
The first story is that this is a classic free cash flow problem. Companies with cash burning a hole in their pockets are prone to blowing it on unprofitable investments, including acquisitions. This was a driver behind the leveraged buyout boom in the 80s: leveraging up gives cash to stockholders and precommits the company to use cash flows to service debt rather than fritter it away in bad investments. In the oil industry, this was T. Boone Pickens’ game. (Academic research has shown that in the 80s E&P companies’ well drilling was a negative NPV activity).
If this is the driver behind commodity trader refinery acquisitions, it would imply that these purchases are inefficient. (I note that some earlier trader ventures into refining, like Gunvor’s, turned out badly).
The other story is that trader firm ownership structures, adopted for value maximizing reasons, constrained their ability to invest in physical assets like refineries. The major independent oil traders are private firms. One of the downsides of private ownership is that a private firm cannot tap public equity markets to fund acquisition of durable assets. Relatedly, it may constrain the ability to secure long term debt to finance long term assets. As a consequence, long term assets (like refineries) must be funded with retained earnings. In this case, even if traders can exercise real options more efficiently than an oil major or independent refiner, the higher capital costs inherent in their ownership structures makes it uneconomical for them to acquire refineries.
Arguably the main reason for Glencore’s transition to a publicly traded firm was that its decision to go asset heavy into mining was incompatible with private ownership. It needed to rely on the capital markets to fund this new strategy.
Against this cost of private ownership (limited diversification is another) is the benefit: a better alignment of the interests of managers and owners, because the managers are the owners and the owners are the managers. One reason this structure has clearly had survival value in commodity trading is that many of the other risks–especially commodity price risks–can be transferred via derivatives markets rather than the equity markets.
The cash flow gusher of the last few years loosens the constraint imposed by ownership structure. Thus, in this story, traders can have their cake and eat it too. They can remain private, and reap the benefits of better incentives, but can invest in fixed assets that were previously unaffordable. In this story, the positive cash flow and balance sheet shock enhances efficiency rather than reduces it (as in the free cash flow story).
Which story is correct? I have no strong opinion, but I will say that the governance benefits of private ownership do mitigate the free cash flow problem. So I guess I would lean towards “efficient.”
One must also recognize that it takes two to tango. These transactions have a seller too, of course. Meaning that “why are traders buying?” is not the only question: “why are oil companies selling?” is also important.
About a decade ago traders acquired downstream marketing operations, especially in developing markets like Africa, from oil companies. In that case, the development of liquid markets for refined products reduced the transactions cost benefits of ownership by the oil companies: the development of these markets mitigated the bilateral monopoly problems that occurred in relatively small downstream markets served by local refineries. That reduced the benefits of ownership for the oil companies, creating gains from trade by selling to the traders.
Perhaps something similar is going on today in refining, especially for relatively “simple” (“non-complex“) refineries in Europe and Asia. When I have a chance, I will look into the complexity index for the refineries the traders have acquired. With the entry of substantial high-complexity refinery capacity in the Middle East and elsewhere, I would not be surprised if a major driver behind these transactions is that refiners want to shed their less complex operations because they have a comparative advantage in operating bigger, more expensive, and more complex refineries.
Which, ironically, have more optionality: complexity translates directly into optionality.
In sum, the trader refinery acquisition boomlet is an interesting development. It raises intriguing economic questions that I have just sketched out here. Could be interesting fodder for an aspiring researcher–like my Université de Genève students (hint hint, nudge nudge).
UMass-Amherst associate professor Isabella Weber is a darling of the Eurocrats (and presumably of Davos). Per her own telling, she is a superstar:
Her first book How China Escaped Shock Therapy: The Market Reform Debate is the winner of the Joan Robinson Prize, the International Studies Association Best Interdisciplinary Book Award and the Keynes Price and has been recommended on best book of 2021 lists by the Financial Times, Foreign Policy, Project Syndicate, ProMarket and Folha de S.Paulo among others. The book has been translated into five languages. Isabella has become a leading voice on policy responses to inflation and has advised policy makers in the United States and Germany on questions of price stabilization. For her public policy work she has been profiled in the New Yorker, recognized as one of TIME100 Next, Bloomberg’s 50 Ones to Watch, Germany’s 100 women of 2022 and Capital 40 under 40 and has been awarded the Kurt Rothschild Prize and the 2024 Hans-Matthöfer Prize. For her work on China’s market reforms she has won the International Convention of Asia Scholars’ Ground-breaking Subject Matter Accolade and the Warren Samuels Prize for Interdisciplinary Research in History of Economic Thought and Methodology. Isabella is an Open Society Foundations Ideas Fellow.
www.isabellaweber.com
She is also an idiot.
The evidence for this proposition is profuse: just look at any one of her opeds or articles. Rather than bore you with her corpus, I will just focus on one of her most recent retchings, on a subject that is clearly in one of my lanes–commodity storage, commodity prices, and speculation.
Weber and her co-authors Merle Schulken, Lena Bassermann, Lena Luig, Jan Urhahn (no changing names to protect the guilty on SWP!) recently released a “policy paper” called “Buffer Stocks Against Inflation.” (NB: “policy paper” is a tell for lack of rigor. The tell is quite accurate here). The Guardian shared Weber’s deep thoughts from the paper in a long article. (NB: another accurate tell).
The gravamen of the argument:
Weber’s new paper, published on Thursday, looks at how grain prices spiked in 2022 as Covid snagged supply chains and Russia invaded Ukraine. The price hikes helped to drive record profits for corporations while pushing inflation higher and increasing global hunger. In the paper, Weber and colleagues call for the creation of buffer stocks of grain that could be released during shortages or emergencies to ease price pressures.
The Guardian.
And what is the root of this volatility? Can you say speculation? I knew you could:
Speculation causes prices to swing wildly even though the prices are often detached from the physical reality of the commodity. While Russia’s 2022 Ukraine invasion led to temporary local threats of physical grain shortages, the global supply of grain always remained well above levels to meet demand in the medium term, the paper notes.
The Guardian
The need for a government-run storage system presumes that private storage is inadequate or inefficiently small. Of course Weber et al don’t even attempt to demonstrate this. And no, volatility–including extreme price movements like those following the invasion of Ukraine in 2022 is not sufficient to demonstrate inadequate storage.
Optimal storage is the solution to a dynamic optimization problem. This solution frequently involves “stockouts” when storage is drawn down to near zero. Prices tend to be highly volatile in such circumstances. Recent events in the cocoa market are a near textbook illustration of this. This is a characteristic of an efficient market, though it is all too often taken (by people such as Weber) as prima facie evidence of inefficiency. If you say that, you are betraying your ignorance.
These episodes can be avoided only by holding excessive stocks. This is wasteful because (a) storage is costly, and (b) it means that some resources that are produced are never consumed. Paying money to hold something you never use (and which was costly to produce) is obviously dumb.
Specifically, the invasion of Ukraine clearly increased economic uncertainty. The rational response to this is to increase storage of commodities (including corn and wheat) affected by this uncertainty. The only way to increase storage is to reduce consumption. Therefore, the increase of uncertainty alone caused an increase in price over and above the effect of the invasion on output or trade. This creates the outsized price movements that give Weber and her ilk the vapors.
Weber also seems to overlook the fact that government stocks are substitutes for private stocks, and that increased government stockholding will result in decreased private storage. Meaning that government stocks are bigger than the amount by which such a policy increases stocks.
Government stockholding also injects a new form of uncertainty into the market. Private stockholders have to forecast what the government stock policy decisions will be. When will they accumulate stocks? When will they release them? Will the decision be driven by economics or politics? If the latter, political uncertainty is an important consideration. And it could have particularly detrimental impacts on private stockholding. The main benefit of holding stocks is the ability to sell them at a high price under tight supply and demand conditions. Release of excessive stocks by the government during such conditions seriously undermines the incentive for private entities to hold stocks.
Wright and Williams also show that the details of government policy and uncertainty about them plague such schemes. One important point that they make is that government storage policies are subject to time inconsistency problems (a la the important work of Kynland and Prescott in the ’70s) (also referred to as subgame imperfection). That is, a government may design an efficient policy but cannot commit to it. Under some circumstances the government will find it desirable (for it!) to deviate from the policy. Thus, the abstract existence of an optimal policy does not mean that it can be implemented in practice. Moreover, trying to figure out when time inconsistency is going to kick in is a source of uncertainty that feeds back to private decisions.
Weber’s writing betrays no contaminating exposure to economic analysis like Wright and Williams’.
In Wealth of Nations Adam Smith pointed out some of the irrationality of government policies regarding storage. In the laws he discussed, English governments thought that private traders were holding excessive stocks, and punished such “hoarders” and “engrossers.” Which obviously undermined the incentive to accumulate inventories in the first place.
Yes, these policies are different from the one that Weber advocates, but they illustrate how political forces lead to highly destructive interference in storage decisions.
Weber has no theory of how speculation distorts prices or causes excessive volatility. She has no evidence that it does. But no problem! She blames it anyways.
I guess she is proving her green credentials by recycling discredited ideas.
You’d think that a policy paper would include analysis of the recommended policy in practice. In Weber’s case, you’d be wrong.
Looking at Weber’s corpus you will see that all of the disqualifying defects described above are rife. She is a sworn enemy of markets, but her analyses betray zero careful analysis of how markets actually work, or what causes their problems. She is a huge fan girl of government intervention, but never contemplates the possibility of government failure, being instead a slave to the Nirvana Fallacy.
Her latest work on storage is arguably a minor sin compared to some of her other transgressions against good economics. Most notably, she is a major advocate of comprehensive price controls as a means of controlling inflation.
One would not be wrong to call her Gosplan Girl.*
But of course this is why she is a rock star in Brussels. EU bureaucrats run the gamut from dirigistes to full on commies, and gobble up her garbage like it is going out of style.
Which, unfortunately, it is not. Which is why the EU is a stagnant economic wreck which will only get worse if it embraces the deep thoughts of Isabella Weber.
*Izabella Kaminska at The Blind Spot pointed out the Gosplan analogy to me.
Might the copper market suffer a similar squeeze [to the Hunt episode of 1980]? Until now, I would have been confident in saying no. But speculators are about to get an easy and completely legal way to dominate the market for the red metal — a development that regulators seem far too relaxed about.
Bloomberg
Why not worry, let alone panic? Many reasons.
First, I don’t know where Javier has been, but this is hardly a new development. There have been physical copper ETFs around for over a decade: I addressed a similar moral panic that erupted when that was introduced. There are also physical ETFs in other metals. The scare scenario has not transpired in all that time.
As I say every time I teach about speculation (as distinct from manipulation), what is necessary for it to distort prices is that it must somehow distort the physical market, that is, distort supply or demand. The doom scenario outlined (“As more money pours into the new fund, more copper will need to be stockpiled as backing”) seems to envision a distortion in supply. Specifically, uneconomically withholding stocks from the market.
First of all, that scenario assumes really dumb money. I mean really dumb. Buying shares in an ETF that will turn around and buy physical copper and add to inventories at a time when inventories should fall (thereby causing spot prices to be too high) means buying high and selling low. Indeed, the market is likely in backwardation under those circumstances, and in that case prices tend to trend down–and everybody can see this. Not a good investment strategy! One almost guaranteed to lose money. Yes, maybe there are lemmings, greater fools, etc., but such people would be perfect short bait. (Though maybe Roaring Kitty will make copper ETFs a meme investment!)
The Hunts (mentioned in the article) are example of how irrational stock building and holding ends in tears. As I joke in class, the Hunts are the poster children for the old joke: “Want to make a small fortune in commodities? Start with a large fortune.” All because they propped up the price of silver by accumulating ever-expanding quantities of physical silver.
Another example that may be even more on point is the International Tin Council, which tried to imitate OPEC in the worst way–and succeeded. Rather than restrict output (a la OPEC) it tried to inflate prices by offering to purchase tin at supercompetitive prices. It ended up accumulating vast amounts of tin in storage, and when the money to keep buying tin ran out the price collapsed and the ITC suffered huge losses–and almost brought the LME down with it. (This is the so-called “Tin Crisis,” not to be mistaken with the LME’s “Nickel Crisis” of 2022).
In my 2012 post on physical metal ETFs, I wrote that one mechanism that would also limit the potential distortionary effects was that if such an ETF were uneconomically maintaining excessive physical stocks, someone could buy shares of the ETF, and tender them in exchange for physical metal, and then liquidate the stocks so obtained. That is, the ETF’s management could not unilaterally withhold stocks from the market.
If you look at the Sprott prospectus, you might conclude that use of that mechanism is highly restricted: there is an option to exchange shares for metal, but it can be exercised only on a semi-annual basis.
However! Elsewhere the prospectus says:
The Trust will have the ability to optimize the value of the Trust through Copper optimization transactions, including the use of futures, warrants, CME or LME warehouse receipts, and other financial instruments [swaps? options?] to complement the Trust’s Copper procurement strategy, so long asthese transactions provide value to the Trust.
So this isn’t a pure copper piggy bank for shiny pennies or the cathodes you can make them from. If the fund is managed to maximize value, it will trade its physical copper optimally, and reduce stocks when the price signals indicate this is optimal. For example, it could sell inventories outright and replace the copper exposure with futures with deferred expiration dates. Or it could engage in spread transactions that are common on LME, e.g., selling cash and buying three month or 15 month or whatever futures.
In this respect, the ETF is really more analogous to a hedge fund. It’s managers have a lot of trading discretion within the copper space. In this respect it is very different than other commodity ETFs (e.g., the US Oil Fund) which have virtually no discretion.
Indeed, it is my sneaking suspicion that the fund’s restriction on withdrawals of metal is due precisely to the fact that it will essentially be engaged in fractional reserve banking, as it were. That is, its potential obligations to deliver will exceed its holdings of physical metal because its “optimization transactions” will involve accumulation of large paper positions, and its notional tonnage will exceed substantially its actual physical holdings. This restriction is analogous to the restrictions on withdrawals that hedge funds impose on investors–another point of tangency between this ETF and hedge funds.
Furthermore, even if the money is dumb and the managers are too (or are like Scrooge McDuck and just enjoy frolicking in their shiny stash), it can only distort supply to the extent its physical holdings are somehow pivotal, and/or there isn’t a lot of competition among those holding copper stocks. If total stocks should fall by X, as long as enough others collectively hold more than X they can supply that copper to the market even if the Sprott fund ignores the price signal and keeps a death grip on its physical holdings.
As for “cornering,” here Javier is playing fast and loose with a loaded term. The word (and squeeze, also used in the article) connotes manipulation. Manipulation is intentional conduct. Under US law in particular, it is conduct that involves a specific intent to cause “artificial prices.” (The Frankendodd revisions of the Commodity Exchange Act and CFTC regulations issued pursuant thereto have new provisions that arguably weaken the intent requirement, but it remains in Section 9).
Yes, an ETF that can take physical ownership can corner whereas a purely futures ETF that cannot own physical cannot. (I’d also note that a fund that holds ONLY physical metal cannot engage in market power manipulation either, or at least is guaranteed to lose money if it tries). But using the “optimization transactions” in futures to manipulate a market crosses a legal line, and indeed, a line that has been in place for over a century. That is something regulators (and market participants who have private right of action under the CEA) would be very unrelaxed about.
Moreover the incremental manipulation potential posed by this ETF is likely small. Manipulations have occurred in copper, and the industrial metals, from time immemorial. Remember Sumitomo? There have been other though less severe and shorter lasting cases of likely manipulation on the LME in the decades since. The proximate cause of the Panic of 1907 was a copper squeeze. Right now with all of the hedge fund money out there, as well as the big physical players, the potential for market power manipulation is omnipresent. Sprott will be a minnow in this ocean that already has a lot of big sharks.
I also chuckle at this concern about cornering. I excoriated Javier Blas severely for his failure to see that yes, a hedge fund–Armajaro–cornered the cocoa market in 2010. Indeed Javier seemed to have a man crush on the eventually disgraced head of the fund, Anthony Ward (AKA “Chocfinger”). One of my posts suggested they get a room. (Ward’s karma came a few years later when he bet wrong in the cocoa market, and Armajaro–which had taken delivery of enough beans to make billions of Hershey Bars in 2010–was sold for less than the price of one of these).
So I reprise my 2012 Alfred E. Neuman persona: What, me worry? Well, certainly not about a physical copper ETF.
This Brokers, Bagmen, and Moles podcast really took me back. It tells the complex and convoluted tale of the FBI sting operation on the floors of the CBOT and CME, and the trials that followed in the 1987-1990 period.
I worked for an FCM (located in the CME building at 30 S. Wacker) during one year that the sting occurred. Leo Melamed appears prominently in the podcast (and not in a good way, I might add): I frequently saw him in the elevator there. I had just started teaching at Michigan in January 1989 when the Chicago Tribune (to the fury of the FBI and DOJ) broke the story of the investigation. In something of a Walter Block moment, I wrote a paper (not published, nor even submitted) explaining, and to some extent justifying, the conduct that put some traders in jail (though not the right ones, from the perspective of podcast producer Anjay Nagpal).
I hadn’t thought about that paper in a long time, but the podcast resurrected it from the recesses of my memory. In a nutshell, as described in the podcast, a major aspect of the allegedly fraudulent conduct engaged in by floor brokers and locals revolved around the issue of “out trades.”
Out trades were an inherent feature of floor trading. Out trades were mistakes. Two traders could trade, and agree that they traded with one another, but disagree on the price. Those were relatively easy to resolve. Bigger problems occurred when, say, ABC said he sold to XYZ and XYZ said he didn’t buy from ABC. Or when ABC said he sold to XYZ and XYZ said he sold ABC.
These types of errors were endemic in the bustle and commotion of the pits. And they were often material. In essence, if an out trade occurred when a broker traded for a customer, and the error was detrimental to the customer, the broker had to make up the loss. In the case of ABC being a broker, and the price moved down subsequent to the time the trade should have occurred, and the broker corrected the error by selling for the customer at the lower price, ABC had to pay the customer the difference. If the error worked in the customer’s favor, he got to keep the benefit.
Especially in volatile markets and for big orders, six figure errors were not unheard of, and five figure errors were pretty common.
In essence, brokers were short a random number of options (the randomness being due to the unpredictable nature of out trades). This was a cost of doing brokerage business, and could be an appreciable cost.
And this was the hook for my paper. The bulk of the allegations against the traders was that in the aftermath of an out trade, a broker would make a trade with a local (i.e., an independent floor trader) that was profitable to the broker, but unprofitable to the local. This local was called the “bagman,” hence the middle word in the title of the podcast (and a book). The broker would later pay back the local by making off-market trades that cost customers money but were profitable for the local. For example, selling to the local at a price below the best bid in the pit.
When I first read the allegations, this struck me as an insurance arrangement, and hence the paper was titled (if I recall correctly–I’m looking for an old copy) “Broker Fraud as Out Trade Insurance.” In essence, the losses from out trades were spread out among all (or least many) of the broker’s customers. The bagmen were like insurance companies: eating a loss was a claim. The profits from off-market trades were the premiums. The customers paid the premiums in the form of unfavorable trading prices. (I also argued that broker associations, also controversial, were in large part an insurance arrangement).
My argument was that this was plausibly an efficient arrangement, as it led to a more efficient sharing of out trade risk, where out trade risk is inherent to open outrcry trading, just as fire risk is inherent to owning a house or accident risk is inherent to driving.
So were customers hurt? Well, if these practices were indeed insurance, customers actually benefited. A more efficient sharing of out trade risk reduced the cost of supplying brokerage services. With a highly competitive market for brokerage services, this lower cost would be passed on in the form of lower commissions, or better service, or more perks (like picking up bar tabs or losing more to the customer on the links).
Of course, it was almost certain that some of this type of trading was not undertaken to insure out trade risk. Some brokers no doubt took advantage of the widespread nature of the practice (where its ubiquity was driven by its putative efficiency) to rip off customers on some trades. However, as I argued in the paper, the ultimate effect of that kind of behavior on customers was mitigated by competition among brokers. The ability to harvest those kinds of illicit profits reduced the reservation commission that brokers charged.
(In making this argument, I riffed on an example from (then) Donald McCloskey’s price theory/micro text. He argued that the practice whereby shipyard labor cutting wood on sailing ships pocketed and sold shavings from the wood they cut had little impact on the cost of building or repairing ships, because labor market competition reduced wages by an amount commensurate with the value of the wood thus taken. McCloskey used this to illustrate the idea–originating with Adam Smith–of compensating wage differentials).
So the argument was basically not only was this not worth a federal case (or what was at the time the most expensive FBI investigation in history), it was arguably efficient, or at most a victimless crime (in equilibrium, anyways).
Other allegations included things like trading after the close. Again, in many cases this could be viewed as efficient, and beneficial to customers: trading at the close was often insanely chaotic, making it impossible to execute all orders before the bell rang.
Labor unions know that one of the most effective ways of disrupting a production process is to “work to rule”, i.e., adhere strictly to every agreed upon rule. In any tightly coupled system (e.g., an assembly line, an airline operating on a schedule, or a trading floor), allowing for some play in the joints–some departures from strict adherence to the rules–can allow it to operate more efficiently. Strict adherence to the rules would likely have interfered substantially with the efficiency of the floor trading process.
Or think of the mess that an NBA game would be if refs called every foul. “No harm no foul” is a reasonable way to call a game.
To the outrage of other defendants–who claimed that nothing untoward happened on the floor–the lawyer for two defendants (a guy named David Durkin, interviewed in the last episode of the podcast) argued that yeah, this stuff happened all the time, and it wasn’t fraud. He didn’t make exactly the same argument as I did, but his argument rhymed with mine. That is, the intent of these violations of the rules was not to defraud, which would be necessary to achieve a criminal conviction. (The argument was not tested at trial. For perfectly understandable reasons, guys facing RICO charges and 20 years in Club Fed took a deal and pled out for terms of 8-10 months. One could argue that the relatively big delta between the deal and the penalty if they had lost reflected the government’s assessment that the argument could have indeed been persuasive to a jury.).
Take it as you will. All I can say is that nothing in the podcast made me change my mind from what I came to believe 35 years ago. (Time flies!)
The podcast delves deeply into the genesis of the investigation. This material was pretty new to me. I had heard nothing previously to challenge the public explanation that ADM’s Dwayne Andreas was ticked off (no pun intended) at being ripped off by the floor, and sicced the FBI on the exchanges. But after listening to the podcast, like Nagpal I find it unpersuasive. Would that really be sufficient motivation for the DOJ and FBI to launch such an ambitious investigation? (Perhaps they didn’t realize how hard it would be, and doubled down once they got in–the sunk cost fallacy at work.). Was it really aimed at the exchanges themselves, or the bigwigs there? Was it really launched to investigate mob money laundering? After all these years, these remain open questions, despite Nagpal’s dogged efforts to answer them.
The podcast also featured extensive interviews with various traders–some convicted, some not, and some not even charged. Those brought back memories of the floor in all its glory, color, character, and characters. And the accents! Having been away for years, the distinctive Chicago accents were truly noticeable and entertaining: at the time, as a fish in those waters, they would have seemed to be normal.
My only criticism of the podcast is in its attempt to draw Big Lessons. Nagpal’s big lessons were: (a) this conduct was rife; (b) it was fraudulent and harmed customers; (c) it was so rife that bigwigs–notably Leo Melamed–participated in it; (d) the fact that the bigwigs skated was a travesty of justice; and (e) the episode demonstrates the fundamental flaws in exchange self-regulation.
Here Nagpal gets preachy. Though in the last episode (in which Durkin plays a prominent role) he does start to wonder whether the bad stuff really wasn’t so bad after all, and that some of the bad guys really weren’t that bad.
As someone who wrote a lot about self-regulation in the 90s in particular (in large part due to the experience of dealing with it in the aftermath of the Ferruzzi episode), I am surely not in the self-regulation hallelujah chorus. However, I vigorously disagree with Nagpal’s contention that putting the futures exchanges under the aegis of the SEC would represent an improvement (not least because stock exchanges regulated by the SEC are also self-regulatory organizations). In the case of the investigation of the floor, the assumption that self-regulation failed presumes that the conduct was truly predominately fraudulent: as argued above, that’s debatable.
And yes, exchange governance is political–as discussed in detail in my 1995 and 2000 JLE articles. But government regulation is politicized too.
Overall, though, those are quibbles. In laying out in detail the complex facts, and letting the principals speak at length, Brokers, Bagmen, and Moles sheds considerable light on a long forgotten but epochal moment in the history of Chicago’s exchanges. It’s a kind of unvarnished history and I hope that others make similar contributions before the old floor traders, like old soldiers, just fade away like the sound in the pit after the closing bell.
Not surprisingly given its avatar, the Biden administration is a picture of drooling incoherence. This is especially true when it comes to energy policy and the Russo-Ukrainian War and especially the intersection of these.
Case in point. The administration constantly asserts that it is a vital US interest for Ukraine to prevail and Russia to lose. Secretary of State Blinken went so far as to promise that Ukraine would join Nato, despite the fact that this is akin to waving a red flag in front of a bull (in the form of Putin). Ukraine must win! We must provide massive military aid! UKRAINE MUST WIN! FREEDOM AND OUR DEMOCRACY ARE AT STAKE!
But not if it raises the price of gasoline in an election year, apparently. In recent months one of Ukraine’s most successful gambits has been drone attacks on Russian oil refineries. These attacks focused on distillation units, the disabling of which sharply cuts refinery output. As a result, Russian refined product output is supposedly down around 10-15 percent, exports of gasoline have been banned for six months, and the country is desperately seeking imports of gasoline from Kazakhstan. This is a serious economic blow to Russia, and also crimps military efforts which are obviously dependent on fuel supplies.
Further, the impact is likely to be long lasting because repairs depend on foreign parts and foreign expertise that Russia cannot readily obtain due to sanctions.
These attacks are also mirror images to Russia’s relentless bombardments of Ukrainian energy facilities, especially electric power generation.
Especially given the trivial resources devoted to the campaign (which is carried out using drones), this is arguably one of the most effective measures that Ukraine has implemented in the two plus years of war.
So given the allegedly existential stakes in a Ukrainian victory, the administration is gung ho in its support for these attacks, right? Right?
Wrong! The administration, first in the form of the execrable Ichabod Crane doppelgänger Jake Sullivan, then in the form of the utterly embarrassing Secretary of Defense Lloyd “AWOL” Austin, is intensely pressuring Ukraine to cease its campaign against Russian refineries.
Why? Because it might raise gasoline prices. It’s an election year dontcha know:
Defense Secretary Lloyd Austin warned that Ukraine’s recent attacks on Russian oil refineries risk impacting global energy markets https://t.co/3LgO2UfzHg
The incoherence is only compounded when you consider the administration’s antipathy for fossil fuels in its obsession over climate change. The administration thinks that fossil fuels are really, really bad, m’kay, and wants to reduce sharply their use. What better way to do that but to make them more expensive?
Now that I mention it, none, actually. Demand curves slope down. So for the climate change obsessed, burning Russian refineries and the consequent increase in fuel prices is a good thing. A great thing, according to the theory of the second best! And something that harms our alleged arch enemy to boot! What could be better?
Well, what could be better to someone who thinks logically is the real question. The freak out over the refinery attacks is clearly symptomatic of people who refuse to think logically. People who apparently elide the word “foolish” from Ralph Waldo Emerson’s epigram that “a foolish consistency is the hobgoblin of little minds.”
The administration’s draining of the Strategic Oil Reserve is another example of its foolish inconsistency.
There are many other examples. One that also checks the Russia and energy boxes is the insane pause on US LNG development approvals. This will also “impact global energy markets,” and not in a good way. And in particular not in a way that helps those whom we hope will help Ukraine.
When European natural gas prices reached stratospheric levels in the immediate aftermath of Russia’s invasion of Ukraine, Biden proclaimed that the US had Europe’s back, and would replace Russian gas with good ol’ ‘Merican LNG.
Suckers!
The administration’s obsession with keeping down the most visible price of energy (that paid at the gas pump) also clashes starkly with an array of other policies that will dramatically increase the cost of energy. The push towards electrification of everything, with the electricity generated by renewables, is just one example. Renewables are not cheap. They are expensive. Hella expensive–just look at how much higher electricity costs are in jurisdictions here (e.g., California) and abroad (e.g., Denmark and Germany) where renewables penetration is highest. Driving up demand (e.g., by penalizing the use of ICE vehicles) of a high cost resource is a recipe for higher energy costs. Much higher.
The force feeding via vast subsidies of high cost efuels and hydrogen will also inflate energy costs, though here (not coincidentally) the cost will be concealed in your tax bill and higher interest rates (required ot get people to buy US debt).
In sum, to call Biden administration energy policies “schizo” is an insult. To schizos. It is full spectrum contradiction and incoherence that simultaneously strives to lower energy costs and raise them, and to protect Russia while demonizing it.
Corruption is bad, uhm-kay, but the rather lurid focus on the traders is unbalanced and gives a misleading impression of the real root of this evil. It takes two to tango: in these situations, the briber and the bribe taker. Here the bribe takers are the real drivers, and they derive their power from the simple fact that they are agents of nationalized companies. That is, the “root causes” here are the nationalization of resources, and the creation of national companies that control access to resources. Yet the bribe payers get most of the attention.
The firms that have been charged and plead are not a random selection of trading companies. Instead, they are the biggest oil trading companies–Vitol, Trafigura, Gunvor, and Glencore. Not grain traders or softs traders or even the metals, natural gas, or power trading operations of these companies. Why? Because whereas national oil companies are common, traders dealing outside oil markets are typically not dealing with national companies.
Between approximately 2007 and 2018, Glencore and its subsidiaries caused approximately $79.6 million in payments to be made to intermediary companies in order to secure improper advantages to obtain and retain business with state-owned and state-controlled entities in the West African countries of Nigeria, Cameroon, Ivory Coast, and Equatorial Guinea. (Emphasis added.)
The fundamental problem here is that South American and African countries with oil tend to be extremely corrupt. Indeed, they are likely corrupt in large part because they have oil. It is also likely that national oil companies are the norm in such places precisely because they provide a structure that allows elites to appropriate oil resource rents (via bribery and various tunneling schemes).
Levying substantial penalties on trader will reduce these companies’ derived demand for corruption, and this will reduce bribery income of kleptocrats. But if the big guys leave, or sharply reduce their activities in these countries, their place will be taken by dodgier outfits who will pay bribes. The recent experience with Russian and Venezuelan sanctions shows that eliminating illicit transactions in oil is devilish hard.
The incentive is immense. According to the DOJ, Glencore paid about $80 million over 11 years to get access to oil flows that generated hundreds of millions in profit–roughly a 5-to-1 ratio. Basically what will happen is that the dodgier outfits will pay lower bribes to get these benefits, with the lower bribes being a compensating differential for the legal risk.
Nationalization was originally adopted because international oil companies (IOCs) were allegedly exploiting nations with oil resources. Even if that was indeed true, nationalization merely changed the identity of the exploiters from the IOCs to local elites who obtained power by force, or yes corruption, or both. Further, nationalized companies are notoriously inefficient and putting them in charge has reduced the value of oil resources, further reducing the benefits that the citizens of these nations (as opposed to the elites) derive from these resources. (To get an extreme example of the grotesque inefficiency of nationalized companies, look at PDVSA especially starting with Chavez over 20 years ago. But wherever you look, the inefficiencies are manifest.)
In sum, bribery by major oil trading firms is just another symptom of an underlying disease–resource nationalism. The focus on the payers of bribes, rather than on those who demand and receive them, obscures that fundamental truth.
The review will take months and then will be open to public comment which will take further time, Energy Secretary Jennifer Granholm told reporters in a teleconference.
This policy, if one can dignify it with such an appellation, is a sop to the ecoloonies upon whom the administration depends for support:
The growth [in LNG exports] has set off protests from environmentalists, part of Biden’s base. Activists say new LNG projects can harm local communities with pollution, lock in global reliance on fossil fuels for decades, and lead to emissions from burning gas and from leaks of the powerful greenhouse gas methane.
In brief, the administration (regime, really) wants to kneecap the remarkable energy revolution of the past 20 years, which has seen technological innovations that have turned the US from a nation worried about where its next MMBTU would come from to a natural gas production powerhouse, and which have allowed others to share in its bounty with the world.
But you see, to the ecoloonies that’s the bad news. Really bad. Climate change, dontcha know.
But even evaluated on those (dubious) terms, the policy is demented. Because the ecoloonies don’t understand basic economics. They are myopic, linear thinkers who are incapable of analyzing the ultimate impact of their policy.
In their thinking, less LNG exports from the US equals less fossil fuel consumption equals lowers carbon emissions equals saving the polar bears. Even overlooking the (again dubious) last step in the logical chain (hey, I’m a a generous guy) the analysis is flawed. Where it definitely breaks down is the third, and arguably the second, steps.
Yes, reducing US natural gas output (by choking one source of demand) will reduce world natural gas production. But the resulting higher world price will induce higher output by competing producers (e.g., Qatar, Australia, PNG, Africa, etc.), resulting in a net decline in world gas production smaller than the decline in US production–and it is world production that matters when considering “well mixed” GHGs. Further, some production that would have otherwise been exported will be consumed domestically instead, meaning that a given decline in exports does not result in an equal decline in production.
But more importantly, the rise in the price of gas relative to other fuels–notably coal–will induce substitution towards those fuels. Since those fuels are more carbon intensive than natural gas, it is possible, and indeed likely, that the net effect of the policy would be to increase the output of GHGs.
So at the very least, the amount of reduction in GHGs resulting from this policy will be far smaller than the reduction in US LNG exports that it will cause, and plausibly will result in an increase of GHGs.
Well played! All pain, no gain!
But the economic idiocy of ecoloonies is an old story by now. Perhaps you’ve read of the recent finding that the ban on “single use” plastic bags in New Jersey led to a tripling of consumer plastics consumption because of the substitution effects that the ban induced. Again, myopic, linear, one-step ahead thinking led to a policy that produced perverse results.
The foregoing analysis focuses on only one dimension–GHG output. But one also has to consider the cost incurred to achieve any GHG gains (if there are any, that is). But trade-offs (costs vs. benefits) is not something that ecoloonies do. They are monomaniacs, and monomaniacs don’t evaluate trade-offs.
This policy will also shtup European allies, whom in the aftermath of the Russian invasion of Ukraine Biden promised would receive bountiful supplies of US gas.
To paraphrase Animal House: “You fucked up, Europe! You trusted Biden!”
The administration pinky swears that
the pause would not hurt allies, saying the plan will come with exemptions for national security should they need more LNG.
Yeah, because it’s just like turning the faucet on and off, right?
If you believe what they say, you are truly an idiot and probably believe they’ll respect you in the morning.
But none of this should be a surprise. After all, this is an administration that is infested with members of the “elite,” and which counts on the “elite” for its support. According to a recent Rasmussen poll:
An astonishing 77% of the Elites – including nearly 90% of the Elites who graduated from the top universities – favor rationing energy, gas, and meat to combat climate change. Among all Americans, 63% oppose rationing.
Face it. They hate your guts and want you to suffer. This “pause” on LNG exports is just another manifestation of their hatred.
In the coming year the Supreme Court will rule in two cases that could result in the imposition of substantial constraints on the administrative state. Since federal administrative agencies are progressive pets, the prospect has the left freaking out. And I do mean freaking out.
The first case is Securities and Exchange Commission v. Jarkesy. Here Jarkesy is challenging the legitimacy of the SEC (and by implication other agencies) relying on internal administrative law judges (“ALJs”) to decide enforcement actions brought by the agency. Jarkesy argues that such cases should be tried in Article III courts (i.e., in federal court).
The Constitutional basis for his argument is compelling. Agencies flout the separation of powers: they combine legislative, executive, and judicial functions. In the case of enforcement actions like that against Jarkesy, the SEC brings the charges against the defendant/respondent, prosecutes the case, and if the agency uses an ALJ, tries the case and renders the judgment and assesses the penalty. The case is brought under regulations adopted by the agency in a quasi-legislative role (supposedly under powers delegated by Congress–an issue that is relevant in the other case I will discuss).
Jarkesy argues that being subordinate to, and accountable to, the agency, ALJs are not independent are subjecting him to their judgment violates his Constitutional rights, and in particular his right to due process.
As an empirical matter, Jarkesy has a compelling case. I recall that in an antitrust case, Justice Potter Stewart opined that the “only consistency” in such cases is “that the government always wins.” (That was in the 60s.). And that was before Article III courts. That is even more true in cases before ALJs in agencies like the SEC and FERC. (When is the last time a FERC ALJ decided against the agency in a big matter?)
Jarkesy therefore wants the trier of fact to be an ostensibly independent Article III federal court. He doesn’t want to have his fate decided by an ALJ who is effectively beholden to the commissioners who run the agency who are bringing the charges and prosecuting them.
Reasonable, no? But not to the progs. They are losing their sh!t over the prospect. Case in point, this article in the Atlantic–which is always a reliable barometer of prog opinion.
According to author Noah Rosenblum, this would represent The End of the World as We Know It.
It would “destroy the government”!!!!!!!! (He says this like it’s a bad thing!–JK).
Rosenblum’s argument veers between the hysterical and the dishonest.
This part in particular cracks me up:
Jarkesy’s second claim—that the internal adjudicator who first heard his case held too much independence—is especially galling. These adjudicators should be independent; the alternative would be to put their regulatory powers at the political whim of whichever administration might be in charge.
The relevant question is “independent from whom?” The very essence of Jarkesy’s argument is exactly that ALJs are creatures of “whichever administration may be in charge.” “The political whim of whichever administration might be in charge” is precisely the problem, not the “alternative.”
Article III courts are about as independent of the current administration (whether it be the presidential administration, or the commissioners of an agency) as is possible–and that’s by the Founders’ design. ALJs are definitely not.
Rosenblum loses control over his bowels at the thought that allowing those accused by federal agencies be judged by, you know, federal judges will gut the ability of agencies like the SEC to prosecute financial crimes:
The SEC was created as an independent agency in 1934, after the financial crash of 1929, to thwart the sort of market manipulation that preceded the Great Depression; Congress has granted it additional powers over the years to continue protecting financial markets. Responding to catastrophes and guarding against market manipulation is exactly the kind of work that Congress should empower the executive branch to do. Requiring Congress to legislate in response to every new fraud some crook might dream up would not be a good use of its time. And there’s no reason to think that delegating authority to police markets runs afoul of the Constitution.
Requiring those who “police markets” to prove their cases beyond the relevant burden of proof (preponderance of the evidence in a civil case) to a truly independent trier of fact does not permit manipulators and fraudsters to run rampant, any more than requiring your local police and prosecutor to prove charges before a judge allows murderers and rapists to run rampant.
Given the stakes in federal securities cases, which can easily run into the tens or hundreds of millions, if not more, requiring prosecuting agencies to clear such a hurdle is eminently reasonable.
What is Rosenblum so afraid of? These people would be prosecuted before Article III courts under the same laws and regulations that they are currently prosecuted before ALJs. A decision adverse to the SEC in Jarkesy would not eliminate the Securities Act, or the Exchange Act, or the SEC regulations adopted pursuant thereto. It would just require the SEC to prove cases brought under those acts and regulations in an Article III court rather than on the agency’s home court.
Rosenblum’s ultimate argument is that Jarkesy is a scumbag:
George R. Jarkesy Jr., a right-wing activist and conservative-radio talk-show host.
Heaven forfend that such a MAGA man should have rights! Oh! The humanity!
The kind of ad hominem chickenshit to which the left routinely resorts to today, and uses to stamp “QED!!!!” on its argument. By doing so, Rosenblum betrays the substantive weakness of his arguments.
I note that many seminal Supreme Court cases involving fundamental Constitutional rights have involved scumbags. And the Supreme Court ruled–rightly–that scumbags have rights too.
It is interesting to note that the CFTC now brings most of its manipulation cases–you know, “exactly the kind of work that Congress should empower to the executive branch to do”–in Article III courts. Now, as it happens, there is a tangled and unrepresentative story behind this, namely that the CFTC ALJs proved to be particularly dysfunctional and inveterately opposed to the agency’s enforcement staff. (I have intimate knowledge and experience regarding this history.). But the why is no matter. The reality is that an agency can bring manipulation cases (and fraud cases, for that matter) in federal court. Requiring the SEC (and other agencies) to do so will not “destroy the government” or allow wrongdoers to run rampant.
Indeed, the CFTC’s experience in federal court–most notably, its loss in the DRW/Wilson case–demonstrates the virtue of forcing agencies to play in the big leagues. It reduces the probability of Type II errors, i.e., false convictions.
I also note that there are rights of private action for certain federal securities, antitrust, and commodities law violations. Here private plaintiffs can bring cases in federal court against alleged malfeasors. I believe that such private rights of action are more reliable deterrents of bad conduct than agency actions, for a variety of reasons. (Again, this observation is based on considerable experience and observation.)
The other case that has the progs’ undies in a bunch is FDA v. Alliance for Hippocratic Medicine. This case threatens to demolish so-called “Chevron deference,” a reference to the case Chevron v. Natural Resources Defense Council in which Justice Scalia (!) on behalf of the court opined that courts should defer to agency judgements in cases in which Congress did not unambiguously delegate authority. That is, when there are “gaps” in a statute pertaining to a regulatory agency, Article III courts should defer to agency decisions regarding on how to fill those gaps.
The gravamen of Blinder’s argument is that agencies are experts, and we should defer to their expertise: we are not worthy to challenge them, nor are federal judges!
This has been the mantra of progressives since, well, the Progressive Era. Blinder is channeling his inner Woodrow Wilson. (Scary thought, that.)
There are two major problems with this. The first–and arguably less important–is that their “expertise” is vastly exaggerated. I mean vastly. Again based on extensive personal experience, I conclude that this is definitely the case when it comes to complicated markets (e.g., electricity, commodity derivatives). And yes, I realize that these complexities challenge federal judges, but the relevant question is who is better to resolve these issues: on that, I come down firmly on the side of the judges.
The second is what economists call “agency problems”–which in the present context can be called Agency problems. That is, the progressive view endorsed by Blinder (and Woodrow Wilson et al) is that agency decision makers are acting in the public interest.
This view has been laughable since the 1960s when Stigler posited “capture theory,” and then others like Sam Peltzman and Gary Becker looked at how the regulatory sausage is really made. The Public Choice literature has also utterly discredited the public interest view.
In a nutshell: regulatory agencies have their own agendas and own incentives that are not aligned with the public interest, for myriad reasons.
As valuable and insightful as they are, even the Peltzman-Becker-type analyses are inadequate. They are best suited to model the regulatory laws legislatures pass. They posit a decision maker looking to maximize political support (“votes”). That makes some sense when modeling legislatures that are somewhat accountable to an electorate. But the problem raised by Chevron deference is that regulatory agencies are incredibly insulated from such electoral feedback. If you view Congress as an agent of the public, agencies are agents of agents of the public. As a result, their incentives are extremely attenuated, and they have considerable scope to implement their own agendas regardless of whether they comport with the public interest or not.
Here’s my Cliffs Notes theory of regulation: a large unaccountable bureaucracy combined with Hayek’s “why the worst get on top.” Ideologues with agendas are attracted to agencies with power over their agendas. Ensconced in power, they are largely immune from external check. So ensconced, they wreak havoc, the public be damned.
People, I give you–the EPA.
That’s why deferring to these agencies is disastrous. Their “expertise”–really their specialization in subjects of particular interest to the ideologues who infest them–is positively dangerous when given free rein.
I hope that the Supreme Court decides in Jarkesy’s favor, and also hacks away at Chevron deference. That said, I realize that the Supreme Court usually splits the baby, and that ringing decisions that drastically curtail the scope of agencies’ powers are unlikely. Meaning that the war against the agencies–or more accurately, the war of the agencies against us–will continue.
This argument consists of two parts. The first being that the crude oil futures markets have been disrupted. The second being that the CTAs are the cats behind the disruption. Both plinths are defective.
Insofar as disruption is concerned, Bloomberg claims “Trading oil has perhaps never been more of a roller coaster ride than it is today.” Further:
Just in the past two months, prices threatened to reach $100 per barrel, only to whipsaw into the $70s. On one day in October, they swung as much as 6%. And so far in 2023, futures have lurched by more than $2 a day 161 times, a massive jump from previous years.
Bloomberg
Never more of a roller coaster ride? Well, let’s do something crazy. Like look at historical data.
The conventional measure of the wildness of the ride is volatility. The annualized daily volatility of crude oil during the alleged Rule of the Bots (the last two years) is 41.62 percent. The historical volatility (2010-2020) is 41.2 percent. (This omits 4/20/20 and 4/21/20, the day of the negative oil price and the following day.) Excluding the COVID months of 2020 produces a somewhat lower vol of 36 percent, not that much smaller than in the last two years. Further, extended excursions of realized volatility to above 40 percent are not unusual in the historical record. So to say that oil prices have been more volatile recently than has historically the case is categorically false.
With respect to the big daily moves, the Bloomberg analysis is fatally flawed because it looks at dollar price moves: big dollar price moves are more likely when prices are high than they are low, and by historical standards oil prices have been high in the last several years. It is appropriate instead to focus on percentage price changes (which is how vols are calculated, btw).
Rather than count the number of times an arbitrary threshold (like $2/bbl) is breached, it is more rigorous to look at a statistical measure of the frequency of extreme events: the “kurtosis.” Kurtosis bigger than zero means a distribution has fat tails relative to a Gaussian (“normal”) distribution, i.e., extreme moves up or down are more likely than under a normal distribution. The bigger the kurtosis, the more likely extreme moves are, i.e., the fatter the tails of the distribution.
Looking at the kurtosis of daily percentage changes rubbishes the Bloomberg analysis. The kurtosis in the last two years is 4.15, whereas from 2010-2020 it was 27.9! That is, the frequency of extreme daily price moves in years of alleged CTA disruption is far, far smaller than was the case prior to their alleged emergence as the dominant force in the. markets.
Interestingly, the kurtosis of dollar price changes is not that different between eras: 6.9 post-2020 vs. 7.2 2010-2020. So even extreme dollar price moves are less frequent in the alleged CAT era than previously. The difference is smaller, which demonstrates the need to take into account the level of prices in an analysis of “extremes.”
So the predicate for the article–that oil prices have been unusually volatile and unusually susceptible to extreme moves in the past couple of years–is not supported by the data.
As for the alleged causal factors, the dominance of CTAs is not evident in the data. CTAs are included in the “Managed Money” category of the CFTC’s Commitment of Traders Report. Here is a graph of the net position of Managed Money going back to 2006:
There was a peak in 2017-2018–a drilling boom in the US, to which I will return shortly–followed by a decline–a drilling drought–followed by a rebound to levels comparable to the 2017-2018 levels. Indeed, managed money net positions have actually been relatively low in the past year (with the exception of a recent spike) as compared to the post-2015 period as a whole. Certainly no Alice to the moon spike in CTA presence apparent here.
Bloomberg claims that the CTAs have become dominant in large part due to a sharp decline in producer hedging:
That coincided with the collapse of another source of futures and options trading: oil-production hedging. During the heyday of shale expansion about a decade ago, drillers would lock in futures prices to help fund their growth. But in the aftermath of the pandemic-induced price crash, a chastened US oil industry increasingly focused on returning cash to investors and eschewed hedging, which can often limit a company’s exposure to the upside in a rising market. By the first quarter of this year, the volume of oil that US producers were hedging by using derivatives contracts had fallen by more than two-thirds compared with before the pandemic, according to BloombergNEF data.
It should be noted that this claim that CTAs have achieved greater dominance due to an ebbing of hedging is implausible on its face. Futures are in zero net supply. If producers have reduced their net positions, necessarily non-hedgers–including CTAs–must have reduced their net positions.
Hedging has indeed declined. In the oil market, much (if not most) producer hedging is via the swaps market rather than direct producer participation in the futures market. Banks buy swaps from producers, and then hedge their exposure by selling futures. Here is a chart of net Producer and Merchant Plus Swap Dealer exposure from the CFTC COT data:
Note that there was a big increase in hedging activity (by this measure) in 2017-2018 that was reversed, followed by a partial resurgence, but in the last couple of years hedging activity has indeed ebbed, and reverted to its 2016 levels.
But note that this pattern of hedging mirrors closely Managed Money net positions. As is necessarily the case. If there is less hedging, speculators necessarily hold smaller positions. Meaning that this statement is nonsensical:
The recent wave of dealmaking by US oil producers threatens to further accelerate the decline in hedging. And it’s highly likely that CTAs will continue to fill the vacuum left by those traditional market players.
It’s not as if CTAs–or speculators generally–are “fill[ing] a vacuum.” If hedgers reduce positions, speculators do too.
The Bloomberg writers may dimly glimpse the truth, though they don’t realize it.
How did CTAs come to become so dominant? Like many current phenomena, the answer starts in the depths of the pandemic.
As shutdowns engulfed the world in 2020, fuel consumption collapsed by more than a quarter. All hell broke loose in the crude market. The benchmark US oil price briefly dropped to minus $40 a barrel and investors were in wholly new territory. Some funds that took longer-term views based on supply-and-demand fundamentals quickly pulled out.
Such bear markets proved to be “extinction events” for traditional funds, which made way “for algo supremacy,” the bulk of which are CTAs, said Daniel Ghali, senior commodity strategist at TD Securities. Russia’s invasion of Ukraine gave the CTAs another foothold. Spiking volatility in the futures market drove many remaining traditional investors to the exits, and open interest in the main oil contracts tumbled to a six-year low.
So if CTAs have indeed become more prevalent, it is because they have supplanted other speculators who exited the market. Futures are risk transfer markets. If some of those who previously took on the risk from hedgers have exited the market, either hedgers must hedge less or other speculators must step in. It seems that both things have been happening.
That’s not some ominous development–it’s markets at work. And CTAs shouldn’t be damned–they should be praised for stepping into the breach.
And another paragraph in the Bloomberg article suggests at what is actually happening here:
The unpredictability of this year’s market swings haven’t been kind to human traders, many of whom are making less money on oil than they did last year when they raked in record gains, according to market participants.
What is likely driving this story is whinging by the traditional specs, who have been outcompeted by the bots. “No fair! They are making money and I’m not! They must be cheating.”
Reminds me of my epigram from my manipulation book, where riffing on Ambrose Bierce’s Devil’s Dictionary I wrote something to the effect that a market is manipulated when it moves against me.
Again, this is markets at work. The fact that bots are doing well relatively to trad specs means that they are better at predicting market movements, or have lower costs of bearing risk, or both.
It does not mean that they are making the markets move.
So this Terminator Tackles the Oil Market narrative is really nothing more than Luddism. A new technology outcompetes the old. The incumbents complain. End of story.
