Streetwise Professor

Today is the 25th anniversary of the most important event in my professional life. On 11 July, 1989, the Chicago Board of Trade issued an Emergency Order requiring all firms with positions in July 1989 soybean futures in excess of the speculative limit to reduce those positions to the limit over five business days in a pro rata fashion (i.e., 20 percent per day, or faster). Only one firm was impacted by the order, Italian conglomerate Ferruzzi, SA.

Ferruzzi was in the midst of an attempt to corner the market, as it had done in May, 1989. The EO resulted in a sharp drop in soybean futures prices and a jump in the basis: for instance, by the time the contract went off the board on 20 July, the basis at NOLA had gone from zero to about 50 cents, by far the largest jump in that relationship in the historical record.

The EO set off a flurry of legal action. Ferruzzi tried to obtain an injunction against the CBT. Subsequently, farmers (some of whom had dumped truckloads of beans at the door of the CBT) sued the exchange. Moreover, a class action against Ferruzzi was also filed. These cases took years to wend their ways through the legal system. The farmer litigation (in the form of Sanner v. CBT) wasn’t decided (in favor of the CBT) until the fall of 2002. The case against Ferruzzi lasted somewhat less time, but still didn’t settle until 2006.

I was involved as an expert in both cases. Why?

Well, pretty much everything in my professional career post-1990 is connected to the Ferruzzi corner and CBT EO, in a knee-bone-connected-to-the-thigh-bone kind of way.

The CBT took a lot of heat for the EO. My senior colleague, the late Roger Kormendi, convinced the exchange to fund an independent analysis of its grain and oilseed markets to attempt to identify changes that could prevent a recurrence of the episode. Roger came into my office at Michigan, and told me about the funding. Knowing that I had worked in the futures markets before, asked me to participate in the study. I said that I had only worked in financial futures, but I could learn about commodities, so I signed on: it sounded interesting, my current research was at something of a standstill, and I am always up for learning something new. I ended up doing about 90 percent of the work and getting 20 percent of the money 😛 but it was well worth it, because of the dividends it paid in the subsequent quarter century. (Putting it that way makes me feel old. But this all happened when I was a small child. Really!)

The report I (mainly) wrote for the CBT turned into a book, Grain Futures Contracts: An Economic Appraisal. (Available on Amazon! Cheap! Buy two! I see exactly $0.00 of your generous purchases.) Moreover, I saw the connection between manipulation and industrial organization economics (which was my specialization in grad school): market power is a key concept in both. So I wrote several papers on market power manipulation, which turned into a book . (Also available on Amazon! And on Kindle: for some strange reason, it was one of the first books published on Kindle.)

The issue of manipulation led me to try to understand how it could best be prevented or deterred. This led me to research self-regulation, because self-regulation was often advanced as the best way to tackle manipulation. This research (and the anthropological field work I did working on the CBT study) made me aware that exchange governance played a crucial role, and that exchange  governance was intimately related to the fact that exchanges are non-profit firms. So of course I had to understand why exchanges were non-profits (which seemed weird given that those who trade on them are about as profit-driven as you can get), and why they were governed in the byzantine, committee-dominated way they were. Moreover, many advocates of self-regulation argued that competition forced exchanges to adopt efficient rules. Observing that exchanges in fact tended to be monopolies, I decided I needed to understand the economics of competition between execution venues in exchange markets. This caused me to write my papers on market macrostructure, which is still an active area of investigation: I am writing a book on that subject. This in turn produced many of the conclusions that I have drawn about HFT, RegNMS, etc.

Moreover, given that I concluded that self-regulation was in fact a poor way to address manipulation (because I found exchanges had poor incentives to do so), I examined whether government regulation or private legal action could do better. This resulted in my work on the efficiency of ex post deterrence of manipulation. My conclusions about the efficiency of ex post deterrence rested on my findings that manipulated prices could be distinguished reliably from competitive prices. This required me to understand the determinants of competitive prices, which led to my research on the dynamics of storable commodity prices that culminated in my 2011 book. (Now available in paperback on Amazon! Kindle too.)

In other words, pretty much everything in my CV traces back to Ferruzzi. Even the clearing-related research, which also has roots in the 1987 Crash, is due to Ferruzzi: I wouldn’t have been researching any derivatives-related topics otherwise.

My consulting work, and in particular my expert witness work, stems from Ferruzzi. The lead counsel in the class action against Ferruzzi came across Grain Futures Contracts in the CBT bookstore (yes, they had such a thing back in the day), and thought that I could help him as an expert. After some hesitation (attorneys being very risk averse, and hence reluctant to hire someone without testimonial experience) he hired me. The testimony went well, and that was the launching pad for my expert work.

I also did work helping to redesign the corn and soybean contracts at the CBT, and the canola contract in Winnipeg: these redesigned contracts (based on shipping receipts) are the ones traded today. Again, this work traces its lineage to Ferruzzi.

Hell, this was even my introduction to the conspiratorial craziness that often swirls around commodity markets. Check out this wild piece, which links Ferruzzi (“the Pope’s soybean company”) to Marc Rich, the Bushes, Hillary Clinton, Vince Foster, and several federal judges. You cannot make up this stuff. Well, you can, I guess, as a quick read will soon convince you.

I have other, even stranger connections to Hillary and Vince Foster which in a more indirect way also traces its way back to Ferruzzi. But that’s a story for another day.

There’s even a Russian connection. One of Ferruzzi’s BS cover stories for amassing a huge position was that it needed the beans to supply big export sales to the USSR. These sales were in fact fictitious.

Ferruzzi was a rather outlandish company that eventually collapsed in 1994. Like many Italian companies, it was leveraged out the wazoo. Moreover, it had become enmeshed in the Italian corruption/mob investigations of the early 1990s, and its chairman Raul Gardini, committed suicide in the midst of the scandal.

The traders who carried out the corners were located in stylish Paris, but they were real commodity cowboys of the old school. Learning about that was educational too.

To put things in a nutshell. Some crazy Italians, and English and American traders who worked for them, get the credit-or the blame-for creating the Streetwise Professor. Without them, God only knows what the hell I would have done for the last 25 years. But because of them, I raced down the rabbit hole of commodity markets. And man, have I seen some strange and interesting things on that trip. Hopefully I will see some more, and if I do, I’ll share them with you right here.

There was another hearing on HFT on Capitol Hill today, in the Senate. The best way to summarize it was that it reminded me of an evening at the local bookstore, with authors reading selections from their books.

Two examples suffice. Citadel’s Ken Griffin (whom I called out for talking his book on Frankendodd years ago) heavily criticized dark pools, and called for much heavier regulation of them. But he sang the praises of purchased order flow, and warned against any regulation of it.

So, go out on a limb and bet that (a) Citadel does not operate a dark pool, and (b) Citadel is one of the biggest purchasers of order flow, and you’ll be a winner!

The intellectually respectable case against dark pools and payment for order flow is the same. Both “cream skim” uninformed orders from the exchanges, leaving the exchange order flow more informed (i.e., more toxic), thereby reducing exchange liquidity by increasing adverse selection costs. I’m not saying that I agree with this case, but I do recognize that it is at least grounded in economics, and that an intellectually consistent critic of dark pools would also criticize purchased order flow.

But some people have books to sell.

The other example is Jeffrey Sprecher of ICE, which owns and operates the NYSE. Sprecher lamented the fragmentation of the equity markets, and praised the lack of fragmentation of futures markets. But he went further. He said that futures markets were competitive and not fragmented.

Tell me another one.

Yes, there is limited head-to-head competition in some futures contracts, such as WTI and Brent. But these are the exceptions, not the rule. Futures exchanges do not compete head to head in any other major contract. Execution in the equity market is far more competitive than in the futures market. Multiple equities exchanges compete vigorously, and the socialization of order flow due to RegNMS makes that competition possible. This is why the equities exchange business is low margin, and not very profitable. Futures exchanges own their order flow, and since liquidity attracts liquidity, one exchange tends to dominate trading in a particular instrument. So yes, futures markets are not fragmented, but no, they are not competitive. These things go together, regardless of what Sprecher says.  He wants to go back to the day when the NYSE was the dominant exchange and its members earned huge rents. That requires undoing a lot of what is in RegNMS.

Those were some of the gems from the witness side of the table. From the questioner side, we were treated to another display of Elizabeth Warren’s arrogant ignorance and idiocy. The scary thought is that the left views her as the next Obama who will deny Hillary and vault to the presidency. God save us.

Overall the hearing demonstrated what I’ve been saying for years. Market structure, and the regulations that drive market structure, have huge distributive effects. Everybody says that they are in favor of efficient markets, but I’m sure you’ll be shocked to learn that their definition of what is efficient happens to correspond with what benefits their firms. The nature of securities/derivatives trading creates rents. The battle over market structure is a classic rent seeking struggle. In rent seeking struggles, everybody reads out of their books. Everybody.

I’ve spent quite a bit of time in Europe lately, and this gives a rather interesting perspective on US derivatives regulatory policy. (I’m in London now for Camp Alphaville.)

Specifically, on the efforts of Frankdodd’s Igor, Gary Gensler, to make US regulation extraterritorial (read: imperialist).

Things came to a head when the head of the CFTC’s Clearing and Risk  division, Ananda K. Radhakrishnan, said that ICE and LCH, both of which clear US-traded futures contracts out of the UK, could avoid cross-border issues arising from inconsistencies between EU and US regulation (relating mainly to collateral segregation rules) by moving to the US:

Striking a marked contrast with European regulators calling for a collaborative cross-border approach to regulation, a senior CFTC official said he was “tired” of providing exemptions, referring in particular to discrepancies between the US Dodd-Frank framework and the European Market Infrastructure Regulation on clearing futures and the protection of related client collateral.

“To me, the first response cannot be: ‘CFTC, you’ve got to provide an exemption’,” said Ananda Radhakrishnan, the director of the clearing and risk division at the CFTC.

Radhakrishnan singled out LCH.Clearnet and the InterContinental Exchange as two firms affected by the inconsistent regulatory frameworks on listed derivatives as a result of clearing US business through European-based derivatives clearing organisations (DCOs).

“ICE and LCH have a choice. They both have clearing organisations in the United States. If they move the clearing of these futures contracts… back to a US only DCO I believe this conflict doesn’t exist,” said Radhakrishnan.

“These two entities can engage in some self-help. If they do that, neither [regulator] will have to provide an exemption.”

It was not just what he said, but how he said it. The “I’m tired” rhetoric, and his general mien, was quite grating to Europeans.

The issue is whether the US will accept EU clearing rules as equivalent, and whether the EU will reciprocate. Things are pressing, because there is a December deadline for the EU to recognize US CCPs as equivalent. If this doesn’t happen, European banks that use a US CCP (e.g., Barclays holding a Eurodollar futures position cleared through the CME) will face a substantially increased capital charge on the cleared positions.

Right now there is a huge game of chicken going on between the EU and the US. In response to what Europe views as US obduracy, the Europeans approved five Asian/Australasian CCPs as operating under rules equivalent to Europe’s, allowing European banks to clear though them without incurring the punitive capital charges. To emphasize the point, the EU’s head of financial services, Michael Barnier, said the US could get the same treatment if it deferred to EU rules (something which Radhakrishnan basically said he was tired of talking about):

“If the CFTC also gives effective equivalence to third country CCPs, deferring to strong and rigorous rules in jurisdictions such as the EU, we will be able to adopt equivalence decisions very soon,” Barnier said.

Read this as a giant one finger salute from the EU to the CFTC.

So we have a Mexican standoff, and the clock is ticking. If the EU and the US don’t resolve matters, the world derivatives markets will become even more fragmented. This will make them less competitive, which is cruelly ironic given that one of Gensler’s claims was that his regulatory agenda would make the markets more competitive. This was predictably wrong-and some predicted this unintended perverse outcome.

Another part of Gensler’s agenda was to extend US regulatory reach to entities operating overseas whose failure could threaten US financial institutions. One of his major criteria for identifying such entities was whether they are guaranteed by a US institution. Those who are so guaranteed are considered “US persons,” and hence subject to the entire panoply of Frankendodd requirements, including notably the SEF mandate. The SEF mandate is loathed by European corporates, so this would further fragment the swaps market. (And as I have said often before, since end users are the alleged beneficiaries of the SEF mandate-Gary oft’ told us so!-it is passing strange that they are hell-bent on escaping it.)

European US bank affiliates with guarantees from US parents have responded by terminating the guarantees. Problem solved, right? The dreaded guarantees that could spread contagion from Europe to the US are gone, after all.

But US regulators and legislators view this as a means of evading Frankendodd. Which illustrates the insanity of it all. The SEF mandate has nothing to do with systemic risk or contagion. Since the ostensible purpose of the DFA was to reduce systemic risk, it was totally unnecessary to include the SEF mandate. But in its wisdom, the US Congress did, and Igor pursued this mandate with relish.

The attempts to dictate the mode of trade execution even by entities that cannot directly spread contagion to the US via guarantees epitomizes the overreach of the US. Any coherent systemic risk rationale is totally absent. The mode of execution is of no systemic importance. The elimination of guarantees eliminates the ability of failing foreign affiliates to impact directly US financial institutions. If anything, the US should be happy, because some of the dread interconnections that Igor Gensler inveighed against have been severed.

But the only logic that matters her is that of control. And the US and the Europeans are fighting over control. The ultimate outcome will be a more fragmented, less competitive, and likely less robust financial system.

This is just one of the things that Gensler hath wrought. I could go on. And in the future I will.

While I’m doing the SWP Itoldyasopalooza, three more items.

First, the CFTC has reopened comments on the position limits proposed rule. The CFTC has taken intense incoming fire on the issue of hedge exemptions in particular, and with good reason. There are many problems, but the most egregious is the restriction on “cross hedges” (e.g., using gas futures as a hedge against electricity price risk).

I discussed this issue in my comment letter to the CFTC. Here’s the gist of the problem. The CFTC calculates the hedging effectiveness (measured by the R2 in a regression) of nearby NG futures for spot electricity prices. It finds the effectiveness is low (i.e., the R2 in the relevant regression is small). Looking past the issue of how some risk reduction is better than nothing, this analysis betrays a complete misunderstanding of electricity pricing and how NG futures are used as hedges.

Spot electricity prices are driven by fuel prices, but the main drivers are short term factors such as load shocks (which are driven by weather) and outages. However, these spot-price drivers mean revert rapidly. A weather or outage shock damps out very quickly.

This means that forward power prices are primarily driven by forward fuel prices, because fuel price shocks are persistent while weather and outage shocks are not. So it makes perfect sense to hedge forward power price exposure with gas futures/forwards. The CFTC analysis totally misses the point. Firms don’t use gas forwards/futures to hedge spot power prices. They are using the more liquid gas futures to hedge forward power prices. This is a classic example of hedgers choosing their hedging instrument to balance liquidity and hedging effectiveness. Gas forwards provide a pretty good hedge of power forward prices, and are are more liquid than power forwards. Yes, power forwards may provide a more effective hedge, but that’s little comfort if they turn out to be roach motels that a hedger can check into, but can’t leave if/when it doesn’t need the hedge any more.

The CFTC  ignores liquidity, by the way. How is that possible?

Market participants have strong incentives to make the liquidity-hedging effectiveness trade off efficiently. They do it all the time. Hedgers live with basis risk (e.g., hedging heavy crude with WTI futures) because of the liquidity benefits of more heavily traded contracts. The CFTC position limit rule substitutes the agency’s judgment for that of market participants who actually bear/internalize the costs and benefits of the trade-off. This is a recipe for inefficiency, made all the more severe by the CFTC’s utter failure to understand the economics of the hedge it uses to justify its rule.

As proposed, the rule suggests that the CFTC is so paranoid about market participants using the hedge exemption to circumvent the limit that it has chosen to sharply limit permissible hedges. This is beyond perverse, because it strikes at the most important function of the derivatives markets: risk transfer.

(This issue is discussed in detail in chapter 8 of my 2011 book. I show that the “load delta” for short term power prices is high, but it is low for forward prices. Conversely, the “fuel price delta” is high for power forward prices, precisely because load/weather/outage shocks damp out quickly. The immediate implication of this is that fuel forwards can provide an effective hedge of forward power prices.)

Second, Simon Johnson opines that “Clearing houses could be the next source of chaos.” Who knew? It would have been nice had Simon stepped out on this 5 years ago.

Third, the one arguably beneficial aspect of Frankendodd and Emir-the creation of swaps data repositories-has been totally-and I mean totally-f*cked up in its implementation. Not content with the creation of a single Tower of Babel, American and European regulators have presided over the creation of several! Well played!

Reportedly, less than 30 percent of OTC deals can be matched by the repositories.

This too was predictable-and predicted (modesty prevents me from mentioning by whom). Repositories are natural monopolies and should be set up as utilities. A single repository minimizes fixed costs, and facilitates coordination and the creation of a standard. I went through this in detail in 2003 when I advocated the creation of an Energy Data Hub. But our betters decided to encourage the creation of multiple repositories (suppositories?) with a hodge-podge of reporting obligations and inconsistent reporting formats.

This brings to mind three quotes. One by Ronald Reagan: “‘I’m from the government and here to help you’ are the 8 scariest words in the English language.” The other two by Casey  Stengel. “Can’t anybody play this game?” and “He has third base so screwed up, nobody can play it right.”

One of the reddest of herrings is that the movement to for-profit exchanges is the source of our current woes in securities and derivatives markets. The herring were running today in DC, at a hearing on HFT held by  the Permanent Subcommittee on Investigations. One of the witnesses, Andrew Brooks of T. Rowe Price testified thus:

We question whether the functional roles of an exchange and a broker-dealer have become blurred over the years creating inherent conflicts of interest that may warrant regulatory action. It seems clear that since the exchanges have migrated to “for-profit” models, a conflict has arisen between the pursuit of volume (and the resulting revenue) and the obligation to assure an orderly marketplace for all investors. The fact that 11 exchanges and over 50 dark pools operate on a given day seems to create a model that is susceptible to manipulative behaviors. If a market participant’s sole function is to interposition themselves between buyers and sellers we question the value of such a role and believe that it puts an unneeded strain on the system. It begs the question as to whether investors were better served when exchanges functioned more akin to a public utility. Should exchanges with de minimus market share enjoy the regulatory protection that is offered by their status as exchanges, or should they be ignored?

Back in Houston after a long trip to Turkey, France, Switzerland, and the Netherlands speaking about various commodity and clearing related issues, plus some R&R. Last stop on the tour was Chicago, where the Chicago Fed put on a great event on Law and Finance. Clearing was at the center of the discussion. Trying to be objective as possible, I think I can say that my critiques of clearing have had an influence on how scholars and practitioners (both groups being well-represented in Chicago) view clearing, and clearing mandates in particular. There is a deep  skepticism, and a growing awareness that CCPs are not the systemic risk safeguard that most had believed in the period surrounding the adoption of Frankendodd. Ruben Lee’s lunch talk summarized the skeptical view well, and recognized my role in making the skeptic’s case. His remarks were echoed by others at the workshop. If only this had penetrated the skulls of legislators and regulators when it could have made a major difference.

And the hits keep on coming. Since about April 2010 in particular, the focus of my criticism of clearing mandates has been on the destabilizing effects of rigid marking-to-market and variation margin by CCPs. I emphasized this in several SWP posts, and also my forthcoming article (in the Journal of Financial Market Infrastructure, a Risk publication) titled “A Bill of Goods.” So it was gratifying to read today that two scholars at the LSE, Ron Anderson and Karin Joeveer, used my analysis as the springboard for a more formal analysis of the issue.

The Anderson-Joeveer paper investigates collateral generally. It concludes that the liquidity implications of increased need for initial margin resulting from clearing mandates are not as concerning as the liquidity implications of greater variation margin flows that will result from a dramatic expansion of clearing.

Some of their conclusions are worth quoting in detail:

In addition, our analysis shows that moving toward central clearing with product specialized CCPs can greatly increase the numbers of margin movements which will place greater demands on a participant’s operational capacity and liquidity. This can be interpreted as tipping the balance of benefits and costs in favor of retaining bilateral OTC markets for a wider range of products and participants. Alternatively, assuming a full commitment to centralized clearing, it points out the importance of achieving consolidation and effective integration across infrastructures for a wider range of financial products. [Emphasis added.]

I have been working since last year on a whitepaper (sponsored by Trafigura) on The Economics of Commodity Trading Firms. After about a month of limited theatrical release, the paper is now publicly available at the link.

Even if I do say so myself, the paper provides a pretty thorough overview of commodity trading firms, ranging from their economic function as “agents of transformation” (of commodities in space, time, and form), to risks and risk management, to corporate structure (private vs. public), to capital structure, to asset ownership, to the systemic risks (or lack thereof) of commodity trading.

One of the main takeaways for me was the diversity of commodity trading firms. Making generalizations is difficult. Another takeaway (related, in a way) is that some of the conventional wisdom about these firms (e.g., there is a general trend to asset ownership and vertical integration) is not correct.

But rather than discuss the report extensively here, I leave it to you all to read it. Comments welcome.

An exchange chairman believes that all trading should take place on exchanges. In commenting on securities market structure, CME Group Chairman Terry Duffy criticizes fragmentation-especially the existence of dark pools-and touts the lack of fragmentation in futures trading.

The concentration of trading activity on futures exchanges, as opposed to the fragmentation across different exchanges (as well as off-exchange venues) in equities is due to a major difference in the treatment of orders. In futures markets, exchanges own their order flow: hypothetically, if there was another exchange posting a better price in a particular product, CME would not be obligated to direct an order to that better-priced market. When exchanges own their order flow in this way, traders direct orders to the exchange where they expect to get the best price. This is typically the market where most traders are. This creates a centripetal force that causes all activity to tip to a single dominant exchange. That is why CME, Eurex, ICE, etc., have monopolies or near monopolies in the products they trade. (And yes, Terry, even though no one is stopping anyone from competing with you, this order flow effect means that no one can do so effectively, leaving you a de facto monopoly. Only LIFFE’s idiocy in its battle with Eurex in 1998 allowed the Germans to get trading in the Bund futures to tip their way.)

This is the way it used to be in equities too. Prior to the late-2000s, the NYSE effectively owned its order flow, and 80-85 percent of trading volume in NYSE listings took place on the NYSE. The remainder occurred on “third markets” that catered to the verifiably uninformed (more on this below).  But in 2005 the SEC changed the rules in a fundamental way. It passed RegNMS, which socialized order flow by requiring exchanges to route orders to others displaying better prices. Within a very short period, a handful of exchanges executing between 8-20 percent of volume competed fiercely with one another. The NYSE’s effective monopoly had been broken.  This is why Goldman paid $6.5 billion for a specialist unit in 2000, and sold it for $30 million this year. The 2000 price capitalized monopoly rents: there are none to capitalize in 2014.

Duffy says he’s fine with this kind of fragmentation  of trading across exchanges with the associated intense competition (though that’s very easy for him to say because he doesn’t have to worry about that outcome given the lack of a RegNMS-type rule in futures markets), but he thinks dark pools should be shut down.

To evaluate this position, you need to understand what role dark pools play. Just like third markets and block markets of the pre-RegNMS era, dark pools (and internalization of retail order flow) are a ways of screening out informed traders. This reduces the costs of the uninformed who can trade on dark pools be reducing their vulnerability to adverse selection. This is good for them, but the overall effects are much harder to understand. Order flow on exchanges becomes more toxic (i.e., a higher proportion of the order flow is informed) which raises adverse selection costs on exchanges, and thereby raises trading costs there.

The net effect of this is very difficult to determine. This is another application of the second best. Since exchanges may have market power, the additional competition from off-exchange venues can improve efficiency even if it raises adverse selection costs for some traders. Moreover, as I’ve argued in my HFT posts recently, since some informed trading is of the rent seeking variety, by reducing the returns to informed trading dark pools can reduce wasteful investments in information.

This means that Duffy’s criticism of dark pools might be right. But it might be wrong.

One thing is definitely true. Market structure has huge distributive effects. Although the rules on dark pools have very uncertain efficiency effects, there is no doubt that these rules affect the distribution of costs and benefits across different types of traders. It is precisely these distributive effects which make the battles over market structure so divisive and protracted.

I’d also note that Duffy ignoring some features of futures markets, and derivatives markets generally, that perform functions similar to dark pools. For instance, CME allows block trading. Indeed, it is engaged in a tussle with the CFTC, which wants to reduce the amount of block trading in order to force more volume into the order book.

But block trades are a way that less-informed large traders can reduce adverse selection costs. They have long performed this function in equity markets, and are now doing so in futures. And by stripping out that order flow from the order book, block trades have the same effects as dark pools.  Blocks are a form of fragmentation.

Block markets are non-anonymous: that’s how they screen out the informed. Block traders won’t deal with those they believe likely to be informed, and by trading face-to-face traders can develop reputations for not being informed and profiting systematically at the expense of their counterparties.

Well, wouldn’t you know it, but this is how OTC derivatives markets work too. The lack of price transparency in OTC markets is often bewailed, but OTC markets are transparent in another important way that exchanges are not: they offer counterparty transparency, whereas exchanges are counterparty opaque. This benefits, say, firms that are trading to hedge in large volume (who are likely to be uninformed). It’s not a surprise that trading activity migrated from OTC to blocks on CME and ICE after Frankendodd made swaps trading more expensive. Both futures blocks and swaps are ways of reducing the execution costs of large, likely uninformed traders.

Put differently: blocks (and swaps) are a form of fragmentation, in the sense that they divert trading activity away from the limit order book. So Duffy shouldn’t be quite so sure about the superiority of the futures market model. It is fragmented in its own way, and has a lot more market power. But of course Duffy likes the last part, though he would never admit it.

The battle over bank participation in physical commodities is reaching a climax. The deadline for commenting on potential Federal Reserve regulation of this activity is approaching, and many letters from groups representing banks (‘natch) but also from energy and commodity industry groups plead with the Fed to permit continued bank involvement in the markets. However, on Capitol Hill the sentiment largely runs the other way, and Senators Sherrod Brown and Elizabeth Warren submitted a letter demanding that the Fed defenestrate banks’ commodities businesses.

Most of the Brown-Warren letter is stuff I’ve written about before, so I won’t comment more on it now. But this part stood out to me, and deserves a rebuttal:

Commodities activities present risks that are different from financial-market risks, are idiosyncratic, and have the potential to disrupt more than just the financial system. Global supply chain disruptions can affect industries in the broader economy that rely upon raw materials.

First, from a systemic risk perspective, the fact that commodities risks are idiosyncratic, and different (i.e., less correlated) with other risks in the banking system is a good thing. Diversification is beneficial in this regard.

I have looked at some evidence that speaks directly to this issue. Over the period of the crisis, the profits of the biggest physical commodity trading firms (the Glencores, Cargills, Vitols, etc.) did not suffer the same extreme drop as bank profits. Indeed, with a few exceptions (Bunge) profits of the major commodity trading firms rose from 2008 to 2009, when bank profits were in freefall.

This lack of cyclicality in trading firm profits, which is in stark contrast to the extreme cyclicality in prices (especially for energy and metals) is readily understood. Physical trading is a margin and volume business: these factors, not flat prices, drive profits. Due to the inelasticity of supply and demand for commodities, margins and volumes tend to be much more stable than flat prices. Prices, rather than quantities, tend to bear the bulk of the burden of responding to demand shocks. Moreover, some commodity trading activities-notably storage-tend to be countercyclical, providing a source of profit to physical commodity traders during recessions.

Commodity trading firms actually had more issues when prices spiked in 2008, because it was difficult for them to finance inventories at very high prices, and the low prices of 2009 eased these financing constraints.

The lack of cyclicality, which contrasts starkly to the pronounced cyclicality of earnings in traditional banking and capital market activities, means that physical commodity trading could reduce the systemic risk posed by banks. The effect will not be large, because even for the biggest banks  commodity trading revenues are small relative to those generated by the more traditional activities. But directionally, this lack of cyclicality in physical trading profitability makes it an attractive part of a bank’s portfolio, especially from a systemic risk perspective.

Second, the Brown-Warren warning about disruptions beyond the financial system are vastly overblown. Presumably what they mean is that if a large bank or several large banks with commodity trading operations were to run into financial trouble, this could disrupt global supply chains. But especially for the commodities that banks tend to focus on (particularly energy), they represent a small fraction of total physical market trading activity. If they disappeared overnight, others could step in and handle most of the business at a slightly higher cost. (Not to mention that it is kind of strange to justify driving banks out of the business by saying that if they leave the business it could disrupt global supply chains.)

But even more importantly, we know that even major disruptions in global supply chains are likely to have only trivial impacts on the global economy. Look at the Japanese earthquake and tsunami of 2011. It devastated supply chains throughout Asia, far more than the loss of even several major commodity trading firms could have. Yet the effects on global growth were minimal. Several central banks examined the issue, and found that the catastrophe reduced global growth by around .1 percent for a couple of quarters. Even in Asia, the effect was minor.

As another example, the implosion of the merchant energy sector in the US in 2002 had no marked effect on US economic activity.

Another concern raised about bank participation in physical markets is environmental risk. This is potentially a serious concern, but even there legal protections (notably dealing through subsidiaries that protect a bank or bank holding company from liability) and insurance can sharply reduce the risk that legal exposure arising from an oil spill or the like could threaten the viability of a large financial institution. Also, since different commodity trading activities pose different environmental risks, a blanket restriction on commodity trading activities, some of which are not particularly environmentally risky, is not warranted.

In sum, the Brown-Warren arguments are not persuasive. Financially, the nature of physical commodity trading tends to reduce the cyclicality of of bank profits, which tends to reduce systemic risk. The fears about threats to global supply chains from the failure of any major commodity trader leading to adverse macroeconomic consequences are vastly overblown. Finally, the environmental/legal risk issues can be allocated away from banks through organizational structure and insurance. Since there also complementarities between traditional banking activities and commodity trading (which I discussed in posts from last summer) some commodity producers and consumers would pay higher costs if they could not enter into physical trading deals with banks: this is one reason why some of these producers and consumers object to limitations on bank participation in these markets. It’s hard to see the benefits of a ban (or restriction), but some costs are evident.

I doubt that will matter much in the end though. Commodities are a politically sensitive issue. Banks are a politically sensitive issue. Put them together, and the sensitivities are acute. Meaning that politics will largely drive the outcome.

Update. One other amusing part of the Brown-Warren letter. They say:

Some have argued it is preferable to allow commodities activities and physical asset ownership within the regulated banking system, rather than at the more lightly regulated commodity trading houses. As a general matter, the CFTC maintains authority to police fraud and manipulation in the commodities markets, regardless of the party engaging in such behavior.

So are banks somehow less subject to deterrence by the threat of CFTC action? If the objective  is to reduce the amount of manipulation and fraud, to justify forcing banks to eschew commodity trading it is necessary to argue that banks are  somehow less responsive to CFTC action than commodity trading houses. Maybe, but it’s not obviously true and I’ve seen no evidence that would support my view.

This relates to a point I made in earlier posts, namely, that if the economics are such that banks find it tempting to manipulate, non-banks will also find it tempting. Meaning that moving a business (e.g., metal warehousing) from a bank to a non-bank is unlikely to reduce the amount of manipulation.

One other thing needs to be said in this context. The Brown-Warren point is correct to the extent that it demonstrates that the term “lightly regulated” is used far too sloppily. Yes, trading houses are less subject to less of some kinds of regulation than banks, but they are subject to anti-fraud and anti-manipulation rules just as banks are. Similarly,  environmental laws and anti-trust laws and many other laws apply to these firms. “Lightly regulated” does not apply uniformly to all forms of bad conduct. The fact that commodity traders are not subject to some regulations that banks are (e.g., capital requirements) makes sense, given the differences between them.

Whenever anyone says “unregulated” or “lightly regulated”, I get suspicious and skeptical. Often those using these phrases are playing a shell game.

Joe Stiglitz presented a paper on HFT at the Atlanta Fed conference earlier this week that has received a lot of attention. The paper is worth reading, but I actually recommend Felix Salmon’s synopsis, which breaks out the issues nicely.

I agree with Stiglitz in part, and disagree in part. The agreement is that Stiglitz hits many of the themes of my recent posts on HFT, notably that when there is private information, financial markets are unlikely to reach first best outcomes, and that making welfare comparisons is very difficult: I would say nigh-on to impossible, actually. Stiglitz also recognizes that HFT affects the incentives to collect information, which is another theme that I’ve emphasized.

Where I disagree is that Stiglitz (like DeLong) concludes from these insights that HFT is wasteful and should be restricted. This conclusion does not follow at all, and can be traced to some implicit assumptions about the nature of informed trading by non-HFT traders.

Stiglitz says “HFT discourages the acquisition of information which would make the market more informative in a relevant sense.” And by “relevant sense” he means fundamental information about the real economy. He laments that HFT “can be thought of as stealing the information rents that otherwise would have gone to those who had invested in information.” Further, he criticizes that much of what HFT does is merely accelerate the revelation of this information, and this acceleration is so small that it cannot improve any decision on any margin, and hence the resources used by HFT are wasted.

But this implicitly assumes that the information produced by non-HFT traders, the collection of which is reduced by the “stealing of information rents”, is in fact fundamental information that would improve decisions. But as I’ve noted repeatedly, many of the informed traders who HFT firms sniff out are producing information that does not improve any economic decision on any margin. Getting better information about an impending earnings report can be very profitable, but revelation of this information doesn’t improve decision making.

By assuming that non-HFT informed traders are producing information that invariably improves decisions, Stiglitz misunderstands what a great deal of informed trading is about, and thereby ignores a benefit of HFT order anticipation-based trading, and crucially, of HFT quote adjustments that cause markets to run away from big traders and thereby limits their ability to profit on their information.

One way to think about it is that there is cash flow relevant information, and decision relevant information. Pretty much all decision relevant information is cash flow relevant, but not all cash flow information is decision relevant. One major example is what Stiglitz emphasizes: the slight acceleration of revelation of information. But I claim that a lot of the information produced by institutional traders is of exactly this type. Stiglitz (and DeLong) ignore this, which leads them to biased appraisals of the efficiency of HFT.

That is, once one recognizes that some informed trading is rent seeking, and socially wasteful, “stealing of information rents” by HFT can be a feature, not a bug.

Stiglitz also ignores that even if HFT reduces the amount of decision relevant information produced and incorporated into prices, reducing this source of private information still reduces the adverse selection costs incurred by uninformed investors trading for portfolio rebalancing or hedging reasons. This reduction in adverse selection costs tends to improve the allocation of risk. This benefit must be weighed against any cost arising from the reduction in the production of decision relevant information.

In brief, Stiglitz and I agree that HFT reduces the incentive to collect information. Where we differ is that Stiglitz believes this is an unmitigated bad, whereas I strongly believe that this is totally wrong, because Stiglitz’s characterization of informed trading is very unrealistic. My point is that non-HFT informed trading can be parasitic, but Stiglitz does not recognize this or account for it in his analysis.

Stiglitz also complains that HFT liquidity is junk liquidity. In particular, prices move before large orders can be executed.

This is a variant on the criticism that HFT reduces information rents. Moreover, Stiglitz fails to make comparisons between realistic alternatives. The ability to adjust quotes faster reduces adverse selection costs, and allows HFT to quote tighter markets. Restricting HFT in some way will lead to wider spreads and lower quoted depth. Either way, big orders will have a price impact.

Stiglitz also claims that HFT reduces other, better forms of liquidity. Salmon actually explains this point more clearly:

HFT does not improve the important type of liquidity.

If you’re a small retail investor, you have access to more stock market liquidity than ever. Whatever stock you want to buy or sell, you can do so immediately, at the best market price. But that’s not the kind of liquidity which is most valuable, societally speaking. That kind of liquidity is what you see when market makers step in with relatively patient balance sheets, willing to take a position off somebody else’s book and wait until they can find a counterparty to whom they can willingly offset it. Those market makers may or may not have been important in the past, but they’re certainly few and far between today.

HFT also reduces natural liquidity.

Let’s say I do a lot of homework on a stock, and I determine that it’s a good buy at $35 per share. So I put in a large order at $35 per share. If the stock ever drops to that price, I’ll be willing to buy there. I’m providing natural liquidity to the market at the $35 level. In the age of HFT, however, it’s silly to just post a big order and keep it there, since it’s likely that your entire order will be filled — within a blink of an eye, much faster than you can react — if and only if some information comes out which would be likely to change your fair-value calculation. As a result, you only place your order for a tiny fraction of a second yourself. And in turn, the market becomes less liquid.

These points are pretty dubious. The kinds of market makers that HFT displaces (locals on futures exchanges, specialists, day traders) were hardly characterized by “relatively patient balance sheets.” Their holding periods were also quite short. Indeed, one of the filters academics use to identify HFT traders is firms that end the day flat: this exactly what most locals and specialists strove to do. And most traders that “do a lot of homework on a stock” were not doing so to supply liquidity through limit orders that they did not adjust frequently. Those who do a lot of homework are usually liquidity takers, not liquidity suppliers.

In sum, although Stiglitz’s analytical framework and broad conclusions are correct, his specific conclusions about HFT are not. They are not correct primarily because he has a very unrealistic view of the nature of informed trading. Once one recognizes that much informed trading is a form of rent seeking-the point that Hirshleifer made over 40 years ago-most of Stiglitz’s objections to HFT dissolve. Put differently, Stiglitz is right to believe that the financial sector may be too big, in part because there can be excessively strong incentives to collect information and trade on it, but he fails to take this point to its logical conclusion when evaluating HFT.

I do find it rather odd that strongly left-leaning economists like Stiglitz and DeLong who are broadly skeptical of financial markets focus their criticism on one new feature of those markets-HFT-without considering the implications of their broader critiques of the financial sector. At root, their criticism is that much financial market activity is rent seeking. If you believe that, you have to consider how HFT affects these rent seeking activities. Once you do that, it is impossible to sustain the critiques of HFT, because even if there are rent seeking aspects to HFT, it also can reduce other forms of rent seeking.