Streetwise Professor

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

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

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

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

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

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

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

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

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

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

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

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

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

Here’s 2020 for comparison:

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

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

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

A couple of comments.

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

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

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

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

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

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

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

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

(A flashback to my youth).

The structure of financial market regulation has been a source of dissatisfaction since at least the time of the birth of the SEC in the 1930s, and maybe even dating back to the first regulation of futures markets in 1922. Don Wilson of DRW is only the latest of those to express this dissatisfaction.

Since derivatives markets first emerged from their niche in the commodities, and especially agricultural commodities, a lot of the criticism has focused on the bifurcated nature of US regulation, with separate securities and derivatives regulators, the SEC and the CFTC respectively. Why not just have one regulator given the substantial overlaps between securities and derivatives markets? Whereas previous “reform” proposals have been to merge the agencies, Wilson suggests scrapping them both and creating a new unified regulator.

This idea is a hardy perennial and has always struck me as mere org chart shuffling, or furniture rearranging. And that’s the best case. Worse outcomes are very possible.

For one thing, the relevant laws–the Securities and Exchange Acts, and the Commodity Exchange Act–would remain in place, with one commission in charge of implementing both. Many of the conflicts, tensions, and contradictions involving the SEC and the CFTC are rooted in the underlying laws, and would remain post-merger (or replacement with a super agency). The conflicts would become intramural rather than intermural as it were, but would not go away.

For another, I generally favor functional regulation and given the myriad functions of financial markets and institutions subsuming all regulatory oversight to a single agency may well impede functional specialization.

The SEC already represents a good example. In broad strokes the Securities Act relates to securities issuers (e.g., disclosures) and the Exchange Act relates to the trading of securities. Those are two very different functions and only tangentially related. Yet a single regulator oversees both.

The CFTC also has authority over trading per se on some venues.

Both agencies have authority over intermediaries (e.g., broker-dealers, FCMs) and clearing.

Maybe there would be some reasonable rationale for splitting off regulation of issuers from regulation of trading, trading intermediaries, and clearing, and putting these last three in a single silo. But even that is problematic due to path dependence.

We are not starting with a blank slate. The pre-existing statutory division is one historic fact. Another is that derivatives and securities markets have evolved very differently, and that could very much reflect the longstanding regulatory bifurcation.

Is it desirable to move toward uniformity in how derivatives and securities markets are organized and governed, and in essence ignore the historical process that created the current market structures? That’s not immediately obvious given how wrenching and unpredictable the process of achieving uniformity would be–and how rife the unexpected consequences would be.

Moreover, how would the political economy work? There’s no guarantee that the politics of a unified regulator would lead to a more efficient regulatory structure.

Indeed, to me it’s more likely that that rent seeking would rule, and efficiency would be damned. There’s actually a strong argument to be made that competition between regulatory agencies disciplines the rent seeking to some degree. And it can also discipline the ideological fervor of someone like Gary Gensler.

The ongoing drama over crypto regulation is an example. I’m not a crypto evangelist by any means but overall I favor letting market processes determine the outcome. If GiGi was king, or even merely the sole regulator of crypto, that would never happen. Regulatory competition (with the CFTC) constrained Gensler and the SEC, so the market will have the chance to have the final vote.

Indeed, one of Don Wilson’s beefs is very specifically with Gary Gensler. (And oh boy, do I get that!) A regulatory structure with one regulator would make some future GiGi far more dangerous.

Why should regulatory monopoly be looked upon more favorably than private monopoly? Indeed, regulatory monopoly is more dangerous because it cannot be disciplined or undermined by entry. Only the naive who believe in the public interest theory of regulation (and regulators) could believe that a single regulator would act to enhance efficiency rather than exploit its power for often malign reasons.

I have often written that there is a multitude of ways for executing financial transactions that have some common elements because transactors and transactions are heterogeneous. One size does not fit all. (Gensler was something of a one size fits all fanatic at the CFTC). Even though any division will lead to anomalies, conflicts, and regulatory arbitrage, there is enough distinctiveness between say derivatives markets on the one hand and security markets on the other to make separate regulators a better outcome. The division of labor is limited by the extent of the market. The scope of financial markets is so huge that there is considerable division of labor in them, and a division of regulatory labor makes considerable sense too.

Further, although the term “regulatory arbitrage” is typically used as a pejorative, it is not necessarily a bad thing. Indeed, it can be a good thing when market participants use regulatory fragmentation to introduce beneficial innovations that a particular regulator would prevent.

It should also not be forgotten that the SEC and the CFTC are not the only regulatory players in this game. The banking regulators and the Fed are also quite involved, especially on issues relating to intermediaries (who are banks or deeply enmeshed in the banking system) and clearing. Some regulatory fragmentation is inevitable as a result. Just mashing together the SEC and the CFTC will not make the fragmentation disappear.

I say only slightly facetiously that the best effect of regulatory consolidation is that reduced specialization would increase the cost of regulation, leading to less of it. There are no economies of scale, and are in fact diseconomies of scale, at the commissioner level. The bandwidth of the commissioners who are the final arbiters of rules is limited. As a rough estimate, a single commission responsible for double the statutes will have the capacity to produce half the rules as two commissions would. Sounds good to me!

(And no, doubling the number of commissioners would not help. Each commissioner has to weigh in on each proposed rule).

(Less factiously, doubling the workload would empower staff as commissioners would be more reliant on staff to craft rules, and explain them, so rule “output” might not decline that much as the commissioners just end up spending less time on each proposal).

Proposing agency merger or creation of a super agency is almost always a symptom of overall dissatisfaction with regulatory outcomes. But those bad outcomes are usually the result of bad regulators or bad underlying statutes. As noted above, consolidating regulators would increase the power of the bad regulators who will inevitably come along, so be careful what you ask for. And redrawing the regulatory org chart won’t address the statutory problems.

So if you don’t like current regulatory outcomes, don’t focus on the number of agencies and the names on the buildings they occupy: focus on the laws that determine what regulators can do and how they can do it.

Frankendodd was full of bad things, so start with that. Go to a slimmer legal framework that focuses on force and fraud rather than one that attempts to micromanage market macrostructure. Work towards a framework that disempowers would be Gary Genslers rather than the reverse.

Recent Supreme Court decisions, especially Loper, will help by constraining the ability of regulators to go beyond the authority explicitly delegated to regulators by statute. But many of the delegated powers are already too broad, so that needs to be addressed too.

In sum, to fix regulation it is necessary to get to its roots. Its roots are in legislation. Shuffling around who implements the legislative mandates is a superficial response to a deeper problem that originates in the Capitol.

PS. My friend Jeff Carter has a Substack on the same issue. Check it out.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Javier Blas is in a tizzy about a new ETF that will hold physical copper. He shouldn’t be.

He says:

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.

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

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

This is a problem because

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

It’s a shame nobody saw this coming.

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

(See also here, from the Chicago Fed.)

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

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

I said Basel! Not Basil!

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

There’s been a bit of a hullabaloo of late regarding the resurgence of short volatility trades in equities. This comes at a time when volatility is low by historical standards, which has led some to conclude that the shorting of volatility is causing the low volatility.

Wrong, wrong, wrong–or at least the correlation between the two is insufficient to demonstrate causation. This is another example of the error of reasoning from a price/price change.

The “logic” here is particularly dubious for derivatives (“selling vol” is a synonym for selling options) because they are in zero net supply. Quantity bought is equal to quantity sold. So “short volatility trades come roaring back” also means “long volatility trades come roaring back.” Determining what drives what is not immediately obvious.

Here’s another story. Some believe volatility is to cheap and want to buy it. Or some what to hedge volatility risk, and at the current low levels it appears attractive to do so. So rather than pushing into the vol market, shorts are being pulled in.

You can’t tell which is happening just looking at the level of vol and open interest. And here’s the key thing: derivatives are risk transfer markets. What is determined in these markets are primarily risk premia. And so to see who’s pushing and who’s pulling, you need to look at risk premia.

The long pull story should see the vol risk premium rise, specifically implied vols should rise relative to expected future vols (in the physical measure). A crude proxy for this is implied vols rising relative to realized vols.

The short push hypothesis predicts the opposite. It doesn’t predict that the level of implied vol should fall absolutely: it predicts that implied vols should fall relative to realized vols.

And according to CBOE’s vol maven Mandy Xu, it’s the former and not the latter:

Second, if volatility selling strategies were to blame for the low levels of the VIX index, you would expect the volatility risk premium (VRP) to shrink as the implied-realized volatility spread narrows (i.e. the VRP is what option sellers aim to monetize and thus should decrease as more sellers enter into the market). Instead, what we’ve seen over the past year is the opposite — the S&P 1M volatility risk premium (as measured by the difference between the VIX index vs SPX 1M realized volatility) actually increased quite meaningfully, from 1.5% in 2022 to 3.6% in 2023. Implied volatility may be low, but it’s not trading particularly cheap compared to realized volatility (SPX 1M realized vol went from averaging 24% in 2022 to just 13% in 2023).

Xu also notes that the vol curve has been more skewed to the call wing, i.e., out-of-the-money call vols have been rising relative to ATMs. This could be explained by a demand to hedge against volatility spikes from today’s current levels (a scenario that played out in the “Volmageddon” of 2018). (Pay attention class–by which I mean my real, actual classes–we’ll be discussing that after Spring Break.)

So the short vol crowded trade driving down vols story is certainly logically weak and factually unsupported, and the alternative that the rise in vol-related derivatives notionals is driven by buyers does have support in the data.

Remember children: never argue from a price change. Especially in derivatives markets with arguments based on open interest/volume.

There does appear to be some interesting intermediation going on. There has been a lot of activity in individual stock options (e.g., Nvidia). It appears that some buying pressure has been accommodated by hedge funds selling those options, and buying index options. This is a form of spread trading (in a way not dissimilar from the infamous basis trades) that hedge funds specialize in. It would tend to contribute to higher notionals in index vol positions–both long and short. There is also spreading between short-dated (especially “zero day”) options and longer-dated options.

Regardless of the underlying driver here (index vol bets or individual stock vol bets) it does appear that the surge in volatility trading has been buyer driven, not selling driven, as indicated by the behavior of risk premia.

Sadly, it is the Bank for International Settlements (BIS) that has pushed the “vol shorts have pushed down implied vols (absolutely–but not relative to realized vols). So it’s fair to say that the BIS is riding the volatility short bus. Which is embarrassing.

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.

Alan Blinder (among others) fears the abrogation of Chevron deference. Blinder is less hysterical than Rosenblum in his criticism (a low bar to clear!) but substantively he is no more persuasive.

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.

John Cochrane laments that a new theory of regulation is required, because the Stigler-Peltzman-Becker theories, and public interest theory, are inadequate. I agree that these theories are inadequate, but do not believe that there is a vacuum. Certain strands of public choice that treat bureaucracies as independent agents in their own right have much to teach here. I recommend the works of Gordon Tullock and James Q. Wilson in this regard. (Tullock was an amazing scholar whose work deserves close attention–even his work from nearly 60 years ago.)

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.

The old, old game of Pin the Tail on the Speculator has been updated. According to Bloomberg, the speculators who now “disrupt” the oil markets are not human: they are bots. Specifically, bots operated by Commodity Trading Advisors (CTAs).

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The SEC remedy for this litany of horrors?

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

The definition of what must be disclosed is comprehensive:

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

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

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

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

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

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

But that’s not all!

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

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

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

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

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

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

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

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

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

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

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

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

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