Streetwise Professor

I have been a close observer of manipulation since the mid-1980s, when the Japanese were squeezing the 30 year while I was devising interest rate hedging strategies for the clients of the FCM I worked for.  Since then, I have examined, intensively and forensically, manipulations in soybeans, Brent, Bunds, Treasuries, canola, copper, aluminum, propane, natural gas, WTI, and other things.  I have researched every major manipulation that I could identify, dating back to the 1860s.

I have heard all of the lame alibis, sometimes directly from the manipulators’ mouths, sometimes from the mouths of their mouthpieces.  Excuses from the likes of them are to be expected.  It is disappointing, however, to see the Financial Times regurgitate their tripe.

Yesterday the FT ran an editorial that recycled many of the tired tales that manipulators tell in defense of Anthony Ward’s actions in the cocoa market.  None of it is exculpatory, in the least.

To start with, the FT opines:

Armajaro breached no rules when, in pursuit of its view that cocoa prices would rise after a poor harvest, it snapped up contracts to purchase cocoa beans on the Liffe futures exchange. These gave it the right to take physical delivery of the beans if it chose. What stirred the controversy was that Mr Ward exercised that prerogative over 24,100 contracts. These amounted to about 7 per cent of annual world production.

Yes, the old “I had the contractual right to do what I did” defense.  But a market power manipulation involves the opportunistic use of this contractual right to distort prices and the flows of a commodity in commerce.  This action degrades the effectiveness of futures contracts as a risk shifting and price discovery mechanism, and leads to wasteful use of the commodity.  If “contractual right” trumps everything, then rules against corners are a nullity.  If that’s the way the game is played, maybe I should start The Corner Fund and go to town.  I’ll hire the FT to flack for me.  But I probably won’t even have to hire it: it seems it’s willing to do it for free!

The FT continues with another old standby: the “They had it coming to them for walking in this neighborhood alone dressed in shorts like that” story:

There is no doubt that his decision caused agony for some on the other side of the contracts. A number of cocoa traders use Liffe to hedge against falls in the prices of the stocks they hold. They suffered because they not only hedged their beans – but their holdings of cocoa powder and butter also. These were ineligible for delivery against the contracts, thus forcing the hedgers to settle contracts for cash at penal premiums or to buy sufficient beans to close the trade.

It is hard to see how Mr Ward can be blamed for this. The hedgers did not need to run a mismatch risk. They could have found other ways to insure their exposures – such as entering into a derivative with a bank. That would have been more expensive, but would also have been safer.

But the whole point of centralized markets is to concentrate liquidity, thereby permitting out-of-position hedgers to reduce risk with maximum flexibility while incurring low transactions costs.  They willingly trade basis risk for transactions costs.  That is no reason to excuse opportunistic actions that exacerbate basis risk.  The risks of being cornered induce hedgers to take costly preventative measures, such as investing collecting information about the activities of other traders that is socially wasteful because it is merely intended to reduce the risk of being the source of a wealth transfer, or using markets where transactions costs are higher.

Beating me to the punch, Tullet Prebon’s CEO T.C. Smith skewers the FT’s fatuousness–and hypocrisy:

Many commentators maintain that one lesson of the financial crisis is that all over the counter derivatives should be traded on exchanges.

I wonder how the revelation in your editorial, that the cocoa consumers who attempted to hedge their powder and butter through the imperfect mechanism of the Liffe futures in cocoa beans would have suffered much less if they had taken out OTC contracts with banks which precisely hedged their risk, fits their theory.

They can file your editorial with the reports on the as yet unexplained “Flash Crash” of May 6, in which Apple’s shares traded at one cent per share and $100,000 a share within 20 minutes.

But then, why let the facts get in the way of their theory? It will all be safer and more transparent when everything is on exchange.

Couldn’t have said it better myself.

The FT then plays three card monte and attempts to distract attention from the real issue:

It has been suggested that Mr Ward’s conduct was akin to cornering, and thus led to a disorderly market. But this is a hard case to sustain. Disorderly markets occur when two-way prices cease to be made – thus making cash settlements impossible. But the open interest on the cocoa contract fell in the weeks prior to expiry.

That is, shall we say, an idiosyncratic definition of “disorderly market.”  In fact, in many corners trading activity can reach a frenzy.  There are two-way prices, but the prices are far above where they would be in a competitive market, and the “cash settlements” are at essentially extortionary prices.  Apparently that’s hunky dory with the FT.  And even in cornered contracts open interest typically falls.  In fact, that’s almost always true.  Indeed, it often falls the most when the cornerer makes money by liquidating futures at supercompetitive prices.

The FT then suggests that the quiet word among gentlemen approach is preferable in such matters:

However, squeezes can be managed. Liffe tries to do this by directly stepping in where necessary to guide the activities of traders. This approach, which has been compared to being summoned to the “headmaster’s study for a quiet word”, effectively substitutes for a detailed rule book. The flexibility it provides can be valuable so long as the market is actively policed.

Yeah.  That works, except when it doesn’t.  And the London markets provide numerous examples of it not working.  Remember Sumitomo, and the LME’s rather, shall we say, prone, not to say accommodating, posture in dealing with Hamanaka right to the end?  Or all of the Brent shenanigans that occurred over the years?

And in that vein, a shout out to LIFFE, for validating my 1995 JLE article arguing that exchanges were unlikely to act against manipulation.  It would be hard to write a letter that does a better job at missing the elephant in the room.

Perhaps due to space limitations, the FT does manage to overlook some of the standard lines from the manipulator’s manual.  But a couple of commentors over at SeekingAlpha fill the void.

In this case, it appears that Armajaro already had customers for the cocoa delivered to it.  See!, the commentor says, there is real demand, real customers.  Well, if you know anything about manipulation, you know that the biggest danger is related to burying the corpse of the manipulation: that is, selling the massive deliveries that you take to squeeze the market.  A clever fellow bent on manipulating the market pre-arranges the funeral.  If the reports about forward sales of old crop cocoa to processors are correct, that was done in this case.  So, rather than being exculpatory, such sales are actually evidence of manipulative intent.

(I’d be interested to know who is making the deliveries.  It would be telling if any of the deliveries were made by those who had contracted to buy from Armajaro.  It would also be interesting to know more of the details of those contracts, not just the pricing terms but any other features in the contracts relating to use or marketing of the cocoa, and the delivery locations for the contracts.)

The other common excuse, again seen in my SA comments, is that the stuff that is delivered will be consumed.  Well, duh.  It’s not like the guy is going to eat it all himself, or burn it, or build houses out of cocoa beans.  It is going to be consumed.  But manipulation distorts consumption pattens–the timing and location of consumption.  The stuff is consumed, but in the wrong place at the wrong time, and too much of it is shipped around to the wrong places.  The fact that the delivered cocoa will eventually be consumed does not imply that the deliveries are efficient.

All in all, none of the arguments raised in Armajaro’s defense are even remotely exculpatory, and some are actually adverse.  A final judgment would require a full forensic and econometric evaluation of prices, pricing relationships, price-quantity relationships, and movements of cocoa.  Time permitting I hope to do some of that.  But at this juncture, there is sufficient evidence to conclude that there is a colorable case against Armajaro, and that the arguments raised in its defense are risible.

Taking huge deliveries in a large backwardation is consistent with manipulation.  This is especially true when one party takes all the deliveries.  Delivery economics are pretty straightforward, and if they work for one party they tend to work for several.  One firm taking all of the deliveries is suspect.

Moreover, the purported rationale for the trade–an expectation of a small new crop in the autumn–does not explain why the old crop price richened relative to the new crop price.  If the real motivation was a view that the market did not appreciate sufficiently the likelihood of a small crop, then the trade should have been to go long the new crop and cash in if and when that view was validated.  Taking delivery into a big backwardation, and seeing the backwardation actually increase as result of the deliveries, is not a sensible way to play an anticipated shortage in the new crop.  The backwardation across crop years screams: “don’t carry over inventory into the new crop year.”  So current inventories do nothing to alleviate future shortages (because the spreads signal that all of the cocoa should be consumed before those shortages arise).  (As an example of how the market should work in response to anticipation of a crop shortfall, during the big US drought of 1988, the old crop-new crop spreads for corn and soybeans snapped into a huge carry; indeed, the spreads exceeded full carry charges measured using official storage rates.  The warehouses in Chicago were filled to the top with grain and beans. That’s because the market realized that it was desirable to carry over old crop supplies in larger quantities than usual to alleviate the anticipated shortfall in the 1988-1989 crop.)  (Ferruzzi told the same lame betting on a new crop shortfall story during its bean manipulation in 1989.)

The rise in the London price relative to the NY price is also what you’d expect to observe in a corner.

I’m not rushing to judgment.  But neither should the FT .  Its unseemly haste to play Ward’s mouthpiece, its heaving up of tired excuses made for manipulators from time immemorial, and its complete lack of any skepticism, are not befitting a premier financial publication.

In addition to his other sins, John Maynard Keynes sowed confusion in his analysis of commodity forward curves.  He appropriated language from the markets–backwardation and contango–and misused the terms in a way that has left a trail of confusion ever since.

Unfortunately, even the estimable Izabella Kaminska of FTAlphaville has succumbed to this muddle, as has Joelle Miffra at EDHEC.

Here’s the issue.  As used in the markets, “backwardation” describes a situation in which the price for future delivery is below the price for immediate delivery, or more generally, the price for delivery at T’ is below the price for delivery at T<T’  “Contango” is the reverse: prices for nearby delivery are below prices for deferred delivery.  That is, contango and backwardation refer to the relation between traded prices for different delivery dates, where the prices are quoted simultaneously.

That’s not how Keynes used the term.  He used backwardation to refer to a situation in which the expected spot price for a future date is below the current futures price for the contract expiring on that date.  That is, rather than comparing two traded prices for different delivery dates, he compared a traded futures price to the price expected to prevail at a future date.  This difference between a futures price and an expected spot price is a risk premium. The expected spot price is a mathematical construct, and is not observable.

Izabella and Miffra also utilize the basic Keynesian hedging pressure explanation for contango and backwardation.  Here’s Izabella:

The background here is that the long side of the curve in commodities was traditionally always set in backwardation (the opposite of contango, when futures prices are lower than spot). This was because the curve had developed as a financial method for producers to hedge downside risk — meaning most of the risk befell those going long on the opposite side of the trade.

It consequently also meant that those going long demanded compensation for taking that risk — something which was achieved via the backwardation premium at rollover.

However, with the long side increasingly focused on wealth preservation rather than speculation, the risk along the curve has over the last five years or so shifted to the short side — resulting in a contango structure.

Et voila, the most rewarding ‘have your chocolate cake and eat it’ trade in all of history may have become the consequence. For, if you have the means to go physically long the commodity and short the paper, you can quite literally have it all.

You can gather contango yield (which is attractive in a low interest rate environment), whilst also speculating on the appreciation of the underlying price.

This is basically a hedging pressure story a la Keynes.  Hedging pressure and speculation affect risk premia, which doesn’t translate directly into the shape of the visible forward curve.  For instance, you can have a market, like that for an equity forward or a bond forward, that is always at full carry (contango) because the asset is always in positive supply, but for which the risk premium can be of any sign, and can change sign over time, without the shape of the forward curve changing.

Markets can be in backwardation or contango, properly defined, if risk premia are zero, positive or negative.

A little (relatively) simple math.  Consider a commodity or asset that is always in positive net supply (no stockouts).  It has a risk premium of u.  The risk free rate of interest is r.  The current spot price is S.  The forward price, due to traditional arbitrage considerations, is F=(1+r)S: it is in contango.  The expected spot price is E(S)=(1+r+u)S.  If u>0, E(S)>F.  If u<0, E(S)<F.  Neither the sign nor the magnitude of u affect the forward curve.  Arbitrage considerations drive the visible forward curve.  Risk allocation considerations drive the risk premium.

The Keynes explanation is also a little long in the tooth, even as a theory of risk premia.  It implicitly assumes that markets are fragmented, and that speculators do not hold positions across many markets.  Perhaps that was true at one time, but it is certainly not true today (consider hedge funds).  With diversified investors and integrated markets, the risk premium in any commodity is driven by economy-wide risk prices.  For instance, if you believe in CAPM (not that I do, just using this as an illustration), you believe that the beta of the commodity price with respect to the market portfolio drives the risk premium, and hedging pressure matters not a whit.  David Hirschleifer generalized things in the late-80s, with a model where speculators incur fixed costs to participate in a market.  In this case, speculators are not perfectly diversified, and hedging pressure can matter.  But market wide risks matter too.  The more integrated the markets, and the more diversified the commodity players, the less hedging pressure matters in driving the risk premium.  And markets have certainly become more integrated lately, much to the chagrin of some traditionalists.

At best, the Keynes “normal backwardation” story is a useful pedagogical tool that should be used as the start of an examination of the determinants of risk premia in commodities, and certainly not the last word.  It is most useful as a foil, than as a proper explanation.

Contango and backwardation in the visible curves are driven in the first instance by intertemporal allocation considerations.  Storage can be used to allocate a commodity over time.  The forward curve should adjust to give people an incentive to make that allocation optimally.  When future availability is expected to be low, relative to current availability, storage is optimal: forward curves move into contango to provide the incentive to undertake that storage.  If current availability is low relative to what is expected in the future, you would like to bring the commodity from the future to the present.  That’s not possible, so the best we can do is not store.  Backwardation punishes storage, and provides the incentive to consume today rather than carry inventories of a scarce commodity to a future date when it is expected to be less scarce.

Market power can also affect forward curves.  Corners create artificial near-term shortages, leading to backwardation.  The crucial thing is that if the short-term shortage is real, inventories should be low, but artificial shortages are often associated with large inventories.*

If you want to understand the curve, first focus on these intertemporal considerations.  And don’t mix up the visible–the observable forward curve–with the invisible–risk premia.  Keynes did, and has befuddled a lot of people since, and not for the first time and not about only that.

* My 1996 book on manipulation and several of my papers show how manipulation affects the forward curve and forward curve-inventory relations.  Holbrook Working discussed this in detail in the 1930s in his work on the wheat markets.  I have a book forthcoming (draft chapters available online) that is all about the implications of intertemporal resource allocation for the shape of forward curves.

This is not the summer for the corner Starbucks.  This is the summer for the Starbucks corner.  First, there was an episode in coffee.  (Yeah, Arabica, not the kind of stuff you’ll usually find at Starbucks, but work with me here.)  And now, cocoa.  There were huge deliveries stopped on LIFFE’s cocoa contract, which calls for delivery in various European warehouses.  There are reports that a single trader stopped all the deliveries.  The name mentioned in this episode is Anthony Ward.

The cocoa market has moved into backwardation and there are reports of a large differential between European and US cocoa prices.  (I haven’t had time to run the data yet.)  The coexistance of a backwardation with large stocks is frequently symptomatic of a manipulation–a corner.

Stories say that Ward is speculating on short crops in the coming season.  But if that’s true, he could profit on that view without taking delivery.  He could just buy futures, and if he’s right, the futures price will rise and he can profit by liquidating his futures position.  Also, if he believes that there will be a shortage in the new crop, that view is best acted on through a purchase in the new crop contracts, not taking delivery.  Furthermore, a looming shortage in the new crop should lead to a rise in the new crop price relative to the old crop price in order to encourage the holding of stocks to meet future shortages.  The reverse has happened: rather than the curve moving to contango, it has become severely backwardated.  Thus, non-manipulative explanations are hard to credit.

The commodity markets, especially for the softs, are relatively small compared to the amount of money that can be amassed by hedge funds and others.  This means that the markets are potentially vulnerable to manipulation.  It looks like that’s going on in the Starbucks commodities this summer.  Look out, sugar!

I have long been fascinated by Black Friday, 24 September, 1869.  On that day, a massive corner in gold collapsed, throwing the American financial system into chaos.

My initial interest in the subject stemmed from my interest in corners: the opening paragraph of my book on manipulation (#2,306,956 on Amazon!  Available on Kindle!) uses the story of the collapse of the Fisk-Gould gold corner as the hook into the subject.  The episode shows how corners work; how they can fail; and interestingly, illustrates some of the game theoretic aspects of corners.  Specifically, Fisk and Gould were in a prisoners’ dilemma, and in the event, Gould ratted out on Fisk, selling when prices were driven up at the end by a surge of Fisk buying.  When Fisk stopped buying, the price collapsed, leaving Fisk with a boatload of losses, and Gould with a nice gain.  (Gould was actually selling to his erstwhile partner Fisk in some of his trades.)

But Black Friday also relates to one of my other obsessions–clearing.  Since about 1997, I’ve used the story of Black Friday to show that (a) clearinghouses can fail, and (b) that the consequences of said failure are catastrophic.

Here’s the story in a nutshell.  Gold trading started in the US in 1862, when during the Civil War the US government issued fiat currency (“greenbacks”) and made them legal tender.  Almost immediately, there was speculation on the value of gold vs. paper dollars.  The business began in the streets of New York, but soon became big enough that interested firms and individuals started a Gold Exchange and moved the business indoors.  The business boomed during the Civil War, and the price of gold ebbed and flowed with Union military victories and reverses.

Originally, deals were settled by the delivery of gold to the buyers’ offices in exchange for cash.  This, of course, resulted in robberies, sticky-fingered messengers, etc.  So the Gold Exchange adopted rules permitting delivery of bank certificates signifying ownership of gold in vaults.  That resulted in the a fraud scandal in which a trader counterfeited gold certificates (shades of the CO2 market, circa 2009-2010!).

As a result, in 1866, a Gold Exchange Bank was chartered in New York.  The Bank operated a clearing division.  Each day, traders submitted settlement statements to the Bank.  The bank calculated net pays and net owes in cash and gold.  Traders delivered their net obligation to the clearinghouse, in exchange for net payments owed them.

The Gold Exchange Bank was not a mutual organization, like a modern CCP.  But it did back trades out of its capital.  The Gold Exchange absorbed any losses attributable to the failure of any broker, and made whole those who were owed money on the daily settlements.  Thus, like a modern CCP, it insured against default risk.

The system worked like a charm from its inception in late-1866 until Black Friday.  But on that day, clearances were many times larger than usual: the usual day saw about $80 million in clearances, but (incomplete) records for the 24th indicated clearances of about $350 million.  More importantly, several important brokers–namely those who traded for Fisk–didn’t submit reports, and didn’t pay anything into the clearinghouse.

Chaos ensued.  Those owed money were clamoring for their funds.  But there was a huge whole in the Bank’s accounts.  It owed money to those who profited from the price collapse, but hadn’t received the funds from those who had lost.  It tried to finesse the situation by paying out partial settlements to those owed money.  But a trader filed an injunction stopping the Bank from doing this, and appointing a receiver to handle the settlements.  The Bank was closed for some days while the receiver unwound the tangled mess of obligations.  The Bank ended up losing close to $500,000.

The failure of the clearinghouse brought the New York financial market to a near standstill.  Liquidity dried up, as vast sums sat in the Bank’s vaults awaiting resolution of its obligations: short term money was only available at a rate of 1 percent per day.   The freeze-up of the financial markets brought foreign trade to a standstill as importers and exporters could not obtain the typical finance.

There are other interesting aspects to the story.  For instance, the Bank’s (state) regulators were overwhelmed by the situation.

In a nutshell: a big price move makes some big traders unable to meet their obligations to the clearinghouse.  The clearinghouse has insufficient capital to make up the shortfall, and shuts down.  There are serious, broader market spillovers and impacts on the real economy: that is, the clearinghouse was deeply interconnected with the broader financial markets, and consequently, with the real economy.

An old example, yes, but an illustration that clearinghouses can fail in times of market stress, and that these failures can lead to substantial market dislocations.

The episode also provides some other cautionary lessons.  For instance, collateralization–margining–was common on gold trades.  Indeed, not only was there daily variation margining, traders often posted initial margins (“independent amounts” in current OTC market parlance).  So margining was not sufficient to prevent defaults in the face of large market moves.

In the gold market of the 1860s, the clearinghouse did not collect margins: they were collected by individual traders.  This would differentiate a modern CCP from the Gold Exchange Bank.  However, the episode demonstrates that collection of margins was not sufficient to prevent default, either by deterring default-risky speculation, or by effectively eliminating the credit in any derivatives trade.  (If the net settlements paid and received by the Gold Bank took the margins already collected by the individual traders into account, the fact that the Bank did not collect the margins itself would be immaterial.  In this case, the Bank would be on the hook for default losses in excess of margins–exactly as is the case with a modern CCP.  The historical record that I have examined is not specific on this point.)

In brief: Clearing does not preclude the possibility of Black Days, with defaults and metastasizing financial chaos.

The best primary source on the episode is testimony taken by Rep. James A. Garfield’s House Committee on Banking and Currency in its Gold Panic Investigation.  That document is available on Google Books.  There’s a lot of tedious stuff, a lot of tendentious stuff, but a few (ahem) nuggets that make the read worthwhile, especially using GB’s search capabilities.

One last thing.  In conjunction with more recent events, Congress’s investigation reveals government’s love-hate relationship with clearing.  In the recent Frank-N-Dodd legislation, clearing intended to be the panacea to prevent systemic crises.  In 1925, acting under authority granted by the Grain Futures Act, the Secretary of Agriculture forced the Chicago Board of Trade to adopt clearing in order to clamp down on excess speculation.

In the Garfield investigation, in stark contrast, clearing was routinely damned by many Congressmen as the cause of excessive speculation and a systemic crisis.  As the minority report put it:

We have no doubt that the clearing-house, which is a nuisance to legitimate traffic and commerce, and the Gold Exchange Bank, which was an instrument used for the certification of fabulous amounts not represented by money (the “phantom gold,” which played so conspicuous a part in the drama,) are obnoxious to the sweeping criticisms of the majority report.  The clearing-house gave great facilities for gambling.  Seventy millions a day was its general average, and not half of it legitimate business.

“You can,” says Mr. Fisk, “make more transactions through the clearinghouse with $5,000 than with $100,000 without it.”  Men without means are by it enabled to deal in immense sums of gold, or phantom gold. . . . The gambling hells of Hamburg are Monaco are not more pernicious as temptations.  Their evils are few compared to those inflicted upon all our country and its business by this time and labor saving machine [a description given of clearing by one witness] to facilitate gold gambling.

The majority resolved to tax the clearing system out of business:

That the Committee of Ways and Means be instructed to inquire into the expediency of reporting a bill to levy such a tax on such transactions as those of the Gold Exchange and the Gold Exchange clearing-house, as, in their judgment the interests of the country shall require.

So, depending on when you ask, clearing is either: (a) the savior of the financial system and a deterrent to destabilizing speculation, or (b) a catalyst of destabilizing speculation that threatens the stability of the financial system.  Damned if you do: Damned if you don’t.

The truth is, of course, it is neither.  Which all suggests that considerable caution is warranted in believing financial morality tales spun by Congressmen in high dudgeon, the heroes and villains of which are interchangeable from episode to episode.

Frank-N-Dodd mandates that all cleared swaps trade on either a contract market (i.e., an exchange) or a “swap execution facility.”  There’s been a lot of uncertainty about just what a swap execution facility (“SEF”) is, but the bill provides enough clues to get a pretty good idea.

The short answer: a lot like an exchange.  A whole lot.

Some key points:

• An SEF must permit multiple participants to trade by accepting bids and offers made by multiple participants.  This means that an SEF must be a “many-to-many” execution platform.  A “many-to-one” platform, such as an electronic system in which a bank or broker-dealer posts bids and offers that customers can execute against wouldn’t qualify.
• They must permit “impartial access,” although that term is not defined.  But it suggests a mechanism in which no one can be excluded.  (Here the link to clearing is important.  If anybody is allowed to enter bids and offers that others can execute against, they must be effectively equivalent as potential counterparties.  Clearing standardizes–homogenizes–credit risk across counterparties.)
• The bill specifies that the goal of the section on SEFs is to promote pre-trade transparency.
• SEFs must establish and enforce rules to deter trade abuses.  They must have the capacity to investigate to detect rule violations.
• Relatedly, they must collect information that can be used to establish whether rule violations have occurred.
• They must permit trading only in non-manipulable swaps.
• They must monitor trading to ensure that rules are adhered to.  In particular, they must engage in real time monitoring of trading, and have systems to permit accurate and comprehensive trade reconstructions.
• SEFs must monitor trading in swaps markets to prevent manipulation.
• The bill states that SEFs “shall” impose position or accountability limits.
• SEFs are required to adopt rules to provide for the exercise of emergency authority.
• They are to make public “timely” information on price and trading volume and other trading data, as prescribed by the CFTC or the SEC (for security-based swaps). That is, they must offer “timely” post-trade transparency, but just what constitutes “timely” is an open question.  (Yet another thing on regulators’ plates.)

If you compare this list to the obligations imposed on contract markets (i.e., futures exchanges), you’ll see that SEFs are subject to almost all of the same obligations as contract markets.

In essence, SEFs must be a many-to-many execution platform that is also self-regulating entity that polices for trade practice violations and manipulation.  The combination of many-to-many with “impartial access” and extensive pre-trade and post-trade transparency effectively requires the creation of a public exchange; the mandated link between clearing and SEF execution is also very (futures) exchange-like.

It seems unlikely that “dark pool” like structures would meet these requirements; these are often not many-to-many, frequently don’t permit the making or executing against bids/offers (e.g., crossing networks), and offer limited pre- and post-trade transparency (hence the “dark” in “dark market”).  Traditional dealer-client execution wouldn’t cut it either: that’s not many-to-many.  Moreover, the real time trade monitoring and the ability to engage in accurate and comprehensive trade reconstructions seems to be an insuperable obstacle for voice brokers, meaning that effectively the bill requires the creation of electronic exchanges.

This suggests that (a) market participants will have a very limited choice of methods for executing transactions in swaps, and (b) these choices are far different than market participants have opted for currently.  Congress, in its infinite wisdom, is forcing pretty close to a one-size-fits-all trade execution system on the market.

The lack of diversity in execution methods compatible with the SEF mandate contrasts sharply with the incredible diversity of market participants.  It is well known that these diverse participants would like to have access to a variety of execution methods compatible with their particular needs.  For instance, those wanting to trade in very large quantities often prefer–and often strongly prefer–not to trade on many-to-many exchange-type markets because of information leakage, price impact, front running, etc.  The incredible array of execution platforms in equity markets testifies to this, as does the variety of derivatives execution methods, which range from order driven exchange markets to voice brokered markets to electronic dealing systems to telephone markets.

What is the rationale for restricting choice in execution?  The only hint of a justification is the desire for greater transparency.  But it is well known that  transparency has costs as well as benefits.  Mandating a high level of pre- and post-trade transparency just begs the question of why market participants would systematically choose the wrong level of transparency (i.e., a level that does not maximize the difference between costs and benefits), and why even if some market participants might profit from a sub-optimal level of transparency, competitive forces don’t prevail in overcoming the self-interest of a subset of participants.  Moreover, transparency isn’t the only thing that matters to market participants.  Other aspects of execution affect their costs and benefits as well.  A myopic focus on transparency alone ignores these other relevant dimensions.

The clash between the diversity of market participants and the my-way-or-the-highway SEF rules will result in chronic conflict in coming years.  There will be a demand, and likely a very strong demand, for the creation of alternative execution mechanisms to accommodate diverse trader needs.  There will be conflicts with regulators, and litigation, over whether these alternative mechanisms fall afoul of the SEF requirements.  There will be lobbying for exemptions, exceptions, and new laws permitting the creation of new kinds of facilities.

In 2005, I wrote that there was a 30 years war over securities market structure that was effectively started by the Securities Act Amendments’ mandate of a National Market System in 1975: that is now on its way to becoming a hundred years war (with the fallout from the Flash Crash just being the catalyst for another intense battle in that war).  The SEF mandate will spark a long running battle in derivatives market structure as well.  This is not the end of battles over derivatives market structure: this is the beginning.

The SEF rule is a Procrustean bed: an “arbitrary standard to which exact conformity is forced,” “a scheme or pattern into which someone or something is arbitrarily forced.”  Just why such conformity is optimal in a market with a wide range of buyers and sellers of different sizes, different trading objectives, different demands for immediacy and liquidity, etc., is hard to comprehend.  I understand that the nature of trading markets makes it that they are unlikely to be highly competitive (and I’ve written about that extensively in my academic work), and that as a result some inefficiencies (notably market power) can persist.  But competitive forces do exist, and especially given modern electronic trading technologies, it is possible for these competitive forces to respond to, and accommodate, diverse transacting preferences.

But rather than let market forces work, albeit imperfectly, Congress would rather play Procrustes, forcing traders large and small onto the same type of trading platform.

Where’s Theseus when you need him?

Patrick Pearson is head of market infrastructure for the EC’s financial market regulator.  He apparently hasn’t read the memo declaring that clearing mandates will usher in the era of the Big Rock Candy Mountain:

Central clearing  . . . is a concept so dear to regulators [sic] hearts that it has become something of a mantra — particularly since the demise of Lehman Brothers and the counterparty risks that were brutally revealed by that event.  So when Patrick Pearson . . . stood up to address an ABS conference in London on June 15 his words took some in the audience by surprise.  “Clearing houses don’t reduce counterparty risk,” he stated.  “They simply redistribute it.  Central counterparties (CCPs) can act as a channel for risk.  Their failure s far more dangerous than the failure of one single counterparty.”

. . . .

“If we shift massive amounts of OTC derivatives onto an exchange–are they safe enough to manage the risk? . . . . We don’t know.  There are 13 clearing houses in Europe.  If one defaulted there would likely be multiple defaults of clearing houses across the region.  Just imagine how the markets would react.”

Hallelujah.  How long have I been waiting for a regulator or legislator recognize those basic facts.

The author of this piece, Louise Bowman, recognizes that Pearson has gone off the happy talk reservation and committed the dire sin of telling the truth:

Hang on!  The market has long worked on the assumption that central counterparty clearing will be mandated in Europe — it is just a matter of when . . . . The question is therefore what the highly eloquent Pearson was trying to say.  In addition to questioning whether central clearing reduces counterparty risk he suggested that exchange trading of OTC derivatives might not be adopted in Europe–something that has also been seen as almost inevitable given the regulators’ drive for transparency in this market.

It is encouraging that not everyone in a position of regulatory responsibility has drunk deep the Klearing KoolAid.  It will be interesting to see how things develop in Europe.  It will be especially interesting to see whether an extended debate over clearing and exchange trading mandates lead to rather testy interactions between US and European officials, as alas, KoolAid seems to be the only thing served on Capitol Hill, Pennsylvania Avenue, and 21st St.

Pearson is, so far, pretty much a voice in the wilderness.  One hopes, however, that he catalyzes a more constructive debate on these issues.  There is a growing group of clearing skeptics among academics and practitioners.  Pearson’s outspokeness raises the possibility that the skeptics’ arguments might actually receive a serious hearing at least somewhere it matters.

I have read the derivatives and clearing titles of the Frank-N-Dodd act, so you don’t have to: you can thank me later.

Here are some random thoughts.

First, a good chunk of it is mind-numbing language dividing authority between the CFTC and SEC, and instructing the agencies on how to coordinate and cooperate.  Note to self: if they start rationing anesthetics under Obamacare, read one of these legislative monstrosities.  It will certainly beat biting a bullet and taking a swig of bourbon for inducing a pain-dulling stupor.

Second, the fading of the Lincoln provision is quite artfully done.  I had to read the damn thing several times to figure out just how they did it.  The bill starts out with: “NO FEDERAL BAILOUTS OF SWAPS ENTITIES” and then says with the exception of insured depository institutions.  Pretty big exception.  So where did the exclusion of commodities and equity swaps come from?  Well, the bill permits:

Acting as a swaps entity for swaps or security-based swaps involving rates or reference assets that are permissible for investment by a national bank under the paragraph designated as ‘‘Seventh: of section 5136 of the Revised Statutes of the United States ( 12 U.S.C. 24), other than as described in paragraph (3).”

And what does this “Seventh” paragraph say? It says that banks are allowed to:

Seventh. To exercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes according to the provisions of this title.

So swaps based on rates or reference assets including typical bank activities including borrowing and lending, FX, and  bullion (presumably precious metals) are all OK.  The paragraph specifically precludes trading in stocks, meaning that equity derivatives are out.  Commodities (other than bullion) aren’t mentioned, so they’re not covered by the exception, and must be spun off.  (The ability to trade bullion-based derivatives means that my calculations of the share of bank derivatives business that will have to be spun off were biased upwards, since a decent fraction of bank commodity trading is in gold and silver.)

Third, the bill does an amazing amount of punting on key issues.  The problem is that the punts won’t be fielded by Darren Hester, Billy “White Shoes” Johnson, or Gale Sayers.  Instead, they will be returned by the same shlubs that fumbled so often in the most recent crisis–the existing regulators (think Madoff, Alan Stanford, AIG, and oh yeah, dodgy FSU shell companies.)  If you look at all the things that the CFTC has to do in the next 12 months, you just know the agency will be overwhelmed.

Fourth, two things relating to margins jumped out at me.

The bill states:

MARGIN REQUIREMENTS.—The margin required from each member andparticipant of a derivatives clearing organization shall be sufficient to cover potential exposures in normal market conditions. [Emphasis added.]

But supposedly the whole objective of the clearing mandate is to reduce systemic risk, in part by requiring increased collateralization.  But periods of systemic instability are, by definition, highly abnormal.  So what’s the point of mandating clearing, and then just allowing the CCPs to impose margins just sufficient to cover normal every day price moves?  This language will give CCPs tremendous leverage in fighting off regulatory efforts to increase collateral.  Not that I mind that, but it suggests a complete disconnect between what the legislation promises and what it can actually deliver.  It promises a collateralization mechanism that will reduce the likelihood of chain reaction failures under stressed market conditions, but then only requires the posting of collateral sufficient to cover losses under non-stressed conditions.

The other thing relates to margins on non-cleared derivatives.  The bill gives prudential regulators the power to set margins (and capital requirements) on these trades:

Each registered swap dealer and major swap participant for which there is a prudential regulator shall meet such minimum capital requirements and minimum initial and variation margin requirements as the prudential regulator shall by rule or regulation prescribe.

Meaning that the prudential regulators (e.g., the Fed, OCC, FDIC) can set margin requirements.  Prudential regulators will set margins that will:

be appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant.

This is potentially quite dangerous.  It is a form of price control, and such controls will have perverse effects (as they always do).

In the present instance, I have been critical of clearing mandates in large part because CCPs do not have as good information as dealer banks to set appropriate margin levels.  Regulators will be even less well informed, and at a greater informational disadvantage relative to those trading the instruments.  This is particularly true for the instruments at issue–the exotic swaps that will not be cleared even under a clearing mandate.

Better informed market participants will readily identify which risks regulators have underpriced, and which ones they have overpriced.  They will overtrade the underpriced risks, meaning that defaults risks will be greater than the regulators think.

We’ve seen this before.  The recourse rule that gave very favorable capital treatment to AAA securities encouraged banks to load up on them, with disastrous consequences.  Since the regulators’ pricing errors will apply to all market participants, these errors will have systemic effects, encouraging myriad financial institutions to overtrade the same risks.  As I’ve written before, regulation and legislation create systemic risks because they apply to broad swathes of market participants.  This is another example of that.  Getting the risk prices wrong–as regulators will inevitably do–means creating incentives for all affected institutions to overload on the underpriced risks.

I just came across the blog Deus Ex Macchiato, because its (anonymous) author kindly linked to a couple of my posts.  I took some time going through the blog, and was quite impressed.  It’s very much worth following if you are interested in banking, finance, derivatives, and market infrastructure related issues.  I only wish I knew of it earlier.

DEM is a clearing skeptic–one of a select breed.  The post that attracted my attention lists 10 misconceptions about CCPs.  Spot on.  There are many more, but the ones DEM lists are important indeed.

I consider the name of the blog somewhat ironic, given that I’ve frequently referred to CCPs as deus ex machina, that will descend from the heavens to solve all our systemic risk problems.

A couple of notes to DEM, if you stumble across this:

1. I’ve written a lot more about clearing on SWP and elsewhere than the couple of things you link to, if you’re interested.  I’ve also written working papers that I’d be glad to point you to.
2. I know you’re anonymous, but I’d be interested in sharing thoughts more directly.  You can get in touch with me at [email protected] if that’s of interest to you.  Glad to do it in strict confidence.  Use a pseudonymous email address if that’s more to your liking.

I transfered from the Naval Academy to the University of Chicago as a junior.  I knew that I had gone from the alpha of academic institutions to the omega when I learned soon after my arrival in Chicago of the Lascivious Costume Ball.  No such thing in Annapolis, let me assure you.  How lascivious?  Well, I remember one woman in my dorm who went as Eve, complete with a snake and three strategically placed fig leaves.  (Maybe they were lettuce leaves.  I wasn’t checking that closely.)

What brought that to mind, you ask?  A review of the Office of the Comptroller of the Currency’s data on bank derivatives activities.

No.  Seriously.

Why?  Well, the data make it abundantly plain that the financial regulation bill that emerged from conference gave Arkansas Senator Blanche Lincoln the merest of fig leaves to cover a near complete retreat from her earlier position.

Recall that the original Lincoln plan would have required banks to spin off all derivatives trading activities (or lose their access to the Fed discount window).  The final bill allowed banks to retain interest rate, FX, and some credit trading, and spin off only commodities, equity, and some credit derivatives (as I understand it, CDS on junk securities).  The OCC data shows that the spun off activities are small beer, indeed, compared to the stuff that banks are allowed to keep.

Here are the market values, by category (gross positive values followed by gross negative values):

$ in billions

Q1 2010  Q4 2009  Change  %Change  Q1 2010  Q4 2009 Change  %Change

Interest Rates 3,147 3,121 27 1% 3,052 3,023 30 1%

FX 347 354 (7) -2% 345 344 1 0%

Equity 77 91 (14) -15% 78 90 (12) -13%

Commodity 41 50 (9) -18% 40 49 (8) -17%

Credit 390 437 (47) -11% 370 409 (39) -10%

Total 4,002 4,053 (51) -1% 3,886 3,915 (29) -1%

So, equity and commodity gross positive values total $118 billion, compared to a $4 trillion total–or about 3 percent of the total.  (Gross negative values give a similar share.)  Credit totals $390 billion, but only a relatively small fraction of that will have to be spun off.  This means that based on market values, banks will be required to spin off less than 10 percent of the total value of positions.

Here are the notionals:

Interest Rate Contracts 181,981 179,555 2,426 1% 84%

Foreign Exchange Contracts 17,596 16,553 1,043 6% 8%

Equity Contracts 1,571 1,685 (114) -7% 1%

Commodity/Other 940 979 (39) -4% 0%

Credit Derivatives 14,364 14,036 329 2% 7%

Total 216,452 212,808 3,645 2% 100%

Commodities are rounding error.  Equity and commodities is about 1 percent of notional.  Even adding in all of credit, and you don’t get to 10 percent.

It would be nice to have a risk breakdown, but that’s not in the OCC data.

Regardless, it is clear that the banks kept the big part of the business, and gave up a few minor pieces of the business to provide Lincoln with some political cover.

It’s not a big deal to the banks, but it is a pretty big deal to the commodities business.  Spinning off commodities will make it more expensive for dealers to make markets.  Some may decide it’s not worth the bother.  So this will reduce the liquidity of the commodities derivatives markets, and make it costlier to hedge.

This is just one of several hits to the commodity business in the bill.  Indeed, commodities are arguably the biggest loser.

The bill says the CFTC “shall” impose position limits on OTC commodities.  This will also impair liquidity and raise hedging costs by constraining the ability of speculators to offer risk bearing capacity.  Indeed, the effect will likely extend to exchange traded markets as well, because one factor that was limiting the CFTC’s aggressiveness on energy futures position limits was the fear that tight limits would force more business OTC.  The agency now has the power to shut that escape valve, and thus is likely to impose more draconian limits on both OTC and exchange traded products.

Moreover, the bill adopts the Senate bill’s more restrictive exemption from clearing requirements for end users.  The CFTC has some discretion on crafting this exemption, but the current leadership has made it clear that it is opposed to generous exemptions. More onerous clearing (and hence margining) requirements for end users will further raise the costs they incur to hedge.

In sum: the compromise bill shafts commodities not once, not twice, but three times.  This will force commodity producers, processors, and marketers to bear more risk, and to incur higher costs to manage risks.

And for what?  The spinoff of banks’ commodity business certainly won’t have the slightest effect on systemic risk given the trivial size of the trade relative to the other activities they still undertake.  The niggardly end user exemptions will not affect systemic risk either.  The position limits will not reduce price distortions in the market.

Bottom line: the commodities business will be riskier and less efficient, and there is no corresponding benefit to offset this cost.  All to give a politically desperate senator a fig leaf.

Several reporters have called me to ask about the implications of BP’s travails for its trading operations, and more crucially, for the markets broadly.  Here are some key points:

1. BP probably has the largest energy trading operation of any firm in the world.
2. There is a non-trivial risk of BP going bankrupt as a result of ballooning liabilities associated with the Gulf spill.  Don’t believe me?  Look at the company’s gargantuan CDS spreads.
3. BP’s counterparties are well aware of this, but are adopting a public “what, me worry?” response to any queries about BP’s counterparty risk.  Nobody wants to raise doubts that could be self-fulfilling and spark a run.
4. That said, in private they all are lacing up their running shoes, and putting contingency plans in place.  Nobody wants to be last in line if it looks like the company is teetering towards bankruptcy.  And knowing that the government is first in line to begin with cannot inspire confidence among those who have exposure to BP.
5. Things can move from “what, me worry?” to “Panic! Run for your lives! Devil take the hindmost!” very quickly, and in response to small shocks.  That is, situations like this are inherently non-linear, and small things can spark a run or a cascade that results in the collapse of BP’s trading operation in a stunningly short period of time.  I’m NOT saying this is a certainty.  I’m not even saying it is the most likely outcome.  I am just saying that such an outcome cannot be dismissed.  We’ve seen it happen too many times before.
6. The broader market consequences of a BP failure depend crucially on whether, in the event of a bankruptcy, its positions are in or out of the money.  Enron’s failure, which was not caused by losses on its trading book, was not that disruptive to the energy markets because counterparties generally owed Enron money, rather than the reverse; hence, these counterparties did not suffer losses with consequent knock-on effects.  Moreover, its failure did not cause large market price movements that worsened the company’s losses.  A BP bankruptcy similarly would not be caused by losses on its trading book, but by metastasizing liabilities from the spill.  It is possible that BP could go bankrupt, but there would not be knock-on effects because its trading book is profitable and it doesn’t owe counterparties money.
7. A known unknown is what effect a BP bankruptcy would have on energy prices, and what effect these price movements would have on the amount BP owes its counterparties.  Hypothetically, if its bankruptcy moves energy prices, and these price moves impose losses on BP, its trading partners will suffer some losses as the result of a BP bankruptcy and default.  The problem is, we won’t have any idea what the price response to a BP bankruptcy will be until it happens.

This situation is not an imminent crisis, but bears watching.  If it moves, it will not move slowly, but with stunning speed.