Streetwise Professor

A board member of the ECB, Benoît Cœuré, gave a speech that discussed “the new risks associated with central clearing.” It is evident that Cœuré is a proponent of central clearing, though it is annoying to see him identify multilateral netting as the main benefit (<holds head in hands>).  But it is good to see yet again that central bankers are aware that central clearing does create new risks, and that regulators must be proactive in addressing them.

The problem is that he overlooks the most important risks.  Reading between the lines, like most regulators, Cœuré focuses on the solvency risks of CCPs, and about policy tools that can limit the probability of CCP insolvency and mitigate the adverse impacts of such an insolvency.

But as I’ve written repeatedly in the past, it’s not the insolvency risk per se that should keep people up at night.  Indeed, the measures taken to address the solvency risk can actually exacerbate the real risk a dramatic expansion of central clearing creates for the financial system: liquidity risk.

Liquidity crises are what threaten to bring down financial systems.  For most financial institutions, there is a connection between liquidity risk and solvency: banks become illiquid because (in a world of imperfect information) people believe they might become insolvent.  Maturity mismatches plus imperfect information plus possibility of insolvency combine to create liquidity crises.

CCPs don’t have the maturity mismatches, and they aren’t leveraged.  They cannot experience liquidity crises in the same way banks can.  The direct liquidity risk of CCPs is related to their ability to turn collateral into cash in the event of a member default.

But as I’ve said over and over, clearing affects the needs for liquidity by market participants.  Central clearing can be a source of, or accelerant of, liquidity crises.  Big price moves lead to big margin calls lead to spikes in liquidity demand. These are most likely to occur during periods of financial stress, and can greatly exacerbate that stress.  Moreover, failure of a CCP is most likely to occur due to the inability of traders to fund margin calls due to the shortage of liquidity.   This old article by Andrew Brimmer discusses two episodes I’ve analyzed on several occasions-the Hunts in silver and Black Monday-and shows how it is liquidity/credit/funding of margin calls for CCPs that can create stresses in the financial system.

This is where the systemic risk of clearing arises.  But the subject is totally absent from Cœuré’s speech.  Which is worrisome.

There is also the fallacy of composition problem.  The measures that Cœuré advocates to make CCPs stronger do NOT necessarily make the system stronger.  Strengthening CCPs can actually exacerbate the liquidity problems that clearing causes during a crisis.  The CCP may survive, due to these measures, but the stresses communicated to the rest of the system (and the stress has to go somewhere) can cause other institutions to fail.

This is what scares the bejeezus out of me.  Regulators don’t seem to get the fallacy of composition, and aren’t focused on the liquidity implications of greatly expanded central clearing.

These fears are heightened by reading this DTCC report about collateral and collateral management.

It contains this heading that should make every central banker and financial regulator soil his armor:

Margin Call activity to increase By up to 1000%

Then there’s this:

Operational Capabilities and Settlement Exceptions Management: The potential ten-fold increase in margin call volumes, and the resulting complexity due to market changes, could overwhelm the current operational processes and system infra-structures within banks, buy-side firms and their administrators. As a result, firms will need to invest in technology and also reengineer the settlement, exceptions management and dispute resolution processes in place today. According to a 2011 De- loitte paper, investments in operations required to build and sustain advanced collateral capabilities is estimated at upwards of $50 million annually for top-tier banks.

Be afraid.  Be very, very, very afraid.

The dramatic increase in the scope of clearing substantially increases the operational complexity of the system.  More importantly, it increases the system’s operational rigidity, because cash has to flow quickly, and according to a very precise schedule.  From client to FCM to CCP to FCM to client.  Any failures in that chain can bring down the entire system.

I say again.  Systemic risk in financial systems is largely due to the fact that these systems are tightly coupled.  Clearing increases tight coupling.  This almost certainly increases systemic risk.

More players have to move more money in more jurisdictions as a result of clearing mandates.  As the DTCC report makes plain, this is a new responsibility for many of these players, and they do not have the capability or experience or systems.  Greater operational complexity involving more parties, many of whom are relatively inexperienced, creates grave risks in a tightly coupled financial system.

The irony of all this is that the evangelists of clearing, including notably Timmy! and GiGi in the US, argued that central clearing would reduce the interconnectedness of the financial markets.  Wrong. Wrong. Wrong. Wrong.

It reconfigures the interconnections.  The entire collateral management system the DTCC document describes is a dense web of interconnections.  And to reiterate: under central clearing (and the mandate to margin and mark-to-market uncleared derivatives) these connections (couplings) are tighter than in the old system.  Both old and new systems are highly interconnected.  The connections in the new system are tighter, and are more vulnerable to failure as a result.

I’ll tell you what makes me have to go change my armor: the regulators seem oblivious to this.  To the extent they are focused on collateral, they are focused on initial margin. No! It is variation margin calls during periods of large market movements that will threaten the stability of the system. Now there will be more such calls–1000 pct more, according to DTCC–and more participants are involved, meaning that there are more links and nodes.  The tightly coupled nature of the system means that the breakdown of a few links can bring down the entire thing.

In other words, there seems to be a disconnect on interconnections, most specifically on how clearing has not reduced interconnections but reshaped them, and how the new system’s interconnections are much more rigid, tightly coupled, and time-sensitive.

Not to pick on Cœuré: his speech is just one example of that disconnect.  The thing is that most speeches by regulators and central bankers exhibit the same disconnect.  Target fixation on making CCPs invulnerable does not address the main systemic risk that an expansion of clearing creates.  That systemic risk involves the financial/funding and operational risks of meeting large margin calls in a stressed environment on a precise time schedule.

It’s about liquidity, liquidity, liquidity.  Clearing transforms credit/solvency risk into liquidity risk.  The operational aspects of clearing-the need to move cash and collateral around in large amounts on a tight time schedule-affects the demand for liquidity, and also create points of failure that can cause the liquidity mechanism to seize up, threatening the entire system.

This is what should be the focus, but I’m seeing precious little evidence that it is.  Someday we’ll pay the price.

After years of wending through to what is to an American an incomprehensible legislative process that involves a three body problem (the trialogue of the Commission, the EU Parliament, and member states), Europe has agreed on its version of the trade execution portion of Frankendodd: Mifid II.  (The clearing and OTC collateralization equivalents are covered under a different law, EMIR.)  A good summary is here.

It contains many of the objectionable features of Frankendodd, namely, a mandate that swaps be executed on SEF-like entities (Organized Trading Facilities, or OTFs, in Euro parlance), and commodity position limits.  The former were pretty much a done deal after the Pittsburgh G20 meeting, the latter a reflection of the global suspicions of “speculation” in commodities, but intensified by European NGO convictions that speculation in food is evil.  (The shade of Adam Smith is shaking his head, noting that his observation about the equivalence between the popular terrors and suspicions against speculation and  the popular terrors and suspicions involving witchcraft is as apt today as it was in 1776.  Except that witchcraft is probably much more socially acceptable these days.)

But the EU has added its own idiosyncratic idiocies to its law.  Two things stand out.

First, the EU has mandated open access to derivatives exchange CCPs, in an attempt to demolish the vertical silo model.  Yes, the mandate is delayed-by as much as 5 years-but “I will wait 5 years to be stupid” hardly seems to be much of  a defense.  As I’ve written for years-a year or two before SWP began, in point of fact-the vertical silo makes economic sense (from a transactions cost economics perspective), and the pro-competition justification for it (namely, to encourage competition in execution) is inconsistent with what economists have known since the 1960s (the “one monopoly rent” theorem).

Second, and even more inanely, Mifid II caps the dark pool share in the trading of any individual equity at 8 percent.  Overlooking the operational difficulties of enforcing a collective constraint on volume across multiple venues, this reflects a suspicion of dark pools (a pejorative name in itself) that is again not grounded in good economics.  In a second best world, where competition between exchanges is imperfect, off-exchange venues (block markets in the old days, internalization, dark pools) can be welfare enhancing.  The fact that many market participants find them the lowest-cost venue to transact in should at least give pause to regulators, and ask them to inquire why this is true, and do the appropriate cost-benefit analysis of the trade-offs involved.  But no, fools rush in.

It strikes me that the  Euros have created a new Pixar character.  Buzz Darkpool: “To stupidity and beyond!” Derivatives trading mandates and position limits are stupid, but they’ve decided to go beyond that.

Meaning that the US can perhaps adopt what I’ve often said is the Russophile motto: “Not the worst!”

One of the annoying things about the debate over HFT, particularly related to the quality of liquidity supplied by HFT traders, is the lack of any historical context.  HFT firms are criticized for pulling liquidity suddenly, particularly when volatility ticks up, thereby exacerbating price moves and the impact of order flow on prices.

The thing is, that market makers/liquidity suppliers have been doing this since time immemorial. Liquidity suppliers have always chosen flight over fight.

I’ve written about that in the past (focusing, for instance, on Black Monday).  This recent blog post provides some excellent historical color that illustrates the point quite well.

Having traded the markets since 1985, I would like to explain what market liquidity actually meant in the pre-electronic days and what it means in the world of electronic trading.

During the 1987 October crash, Black Monday, I was a junior trader in government bonds and futures. Black Monday was not a crash which was over in seconds or minutes; no, the world stopped turning actually for days. The mini crash of 1989 had a similar pattern. Chernobyl 1986, Gorbachev crisis in 1991 and UK election day in 1992, were all similar liquidity gap events seen by market traders.

The beauty of those days (the late 80s) for a trader, was that markets were very often in a ‘fast market’ condition. This meant that one was able to trade at any price and all rules were thrown overboard until the board officials were able to control the pit again. Without computers, we simply could not deal with the enormous amount of activity in the markets at those times and simply stopped (or delayed) sending price information out, not just for seconds, but minutes and even (during the week of Black Monday) days. Clearers had backlogs to clients for days.

What investors, customers, institutions looked at in those days were screen prices on systems like Reuters or Bloomberg: feeds fed by the voice of the official. If the official did not yell a price in the mic, the data group would not enter a price, and the world would never see this price. Under fast markets no prices were entered and the screen would just read ‘fast’ (if you were lucky). Future and option prices on screen were seen as tradeable prices and in slow markets they may have been pretty close to the truth. In fast markets they were inaccurate and it was not possible to trade the price indicated on the Reuters screen. Yet the world still thought this was the correct price.

Being in the pit, one cannot keep buying or selling an instrument, so traders would hedge their positions. Hundreds of times I have been in situations where there was simply no bid or offer in the instrument to hedge in. The signal from a broker out of the futures pit simply stated, ‘no bid, no bid’, yet all the screens where showing a bid or an offer. Was this liquidity? The world clearly thought it was, but we all knew there was panic on the floor and you were lucky to trade one lot.

Yes, I know Mr. Spanbroek is talking his book.  (The EPTA represents HFT firms.)  But what he writes about the good old days on the floor are accurate.  They were good days mainly for the guys on the floor, who would supply liquidity when it was profitable, but would head for the exits when the order flow was toxic.  Ditto traders upstairs in the OTC markets.  This is a characteristic of liquidity supply and liquidity suppliers pretty much everywhere and always.

This subject always brings to mind a legendary-and I mean legendary-trader, who told me in the early-00s he was all in favor of the markets going electronic because he was “sick of getting raped by the floor.”  About 2 years ago he told me that he couldn’t compete with HFT.  I guess there was a Goldilocks “just right” era in between, say 2002-2007 or so, but the criticisms of liquidity suppliers is a hardy perennial.  And there is some justice to the charges.  The point is that it is not new, and it is not unique to HFT.  It is inherent in the economics of liquidity supply.

And there is no easy policy solution.  A policy intended to fix one problem will just create others.  Again, the problems inhere in the economics of liquidity supply.

Emails from two readers raise some interesting points about the alleged front-running of Fannie and Freddie by swap dealers.

And that’s one of the points.  Swap dealers. These were principal-to-principal transactions: the dealers were the principals to the trades.  Front running  traditionally involves violation of an agency relationship.  A broker that has a fiduciary relationship with a customer who trades ahead of that customer’s order is front running.  The dealers have no fiduciary duty to their counterparties, as far as I know.

Also, F&F were repeat players, and could refuse to trade with dealers they thought were taking advantage of information about their order flows.  Back in the block trading days, firms that “bagged the street” by selling blocks when they were in possession of private information had a difficult time of finding counterparties.  As a face-to-face market, something similar should have worked in the swap market.

This correspondent also suggests that F&F might have benefitted from this, and may have let dealers know what was coming so the dealers could hedge, meaning if anybody was hurt here, it was the futures traders who were picked off by the dealers placing their hedges. (But then again, given that this would have happened over a long period of time, the futures quotes should have compensated the traders for the risk of being picked off in this way.)

So, there is some doubt that this is even front running, let alone manipulation.

The other correspondent wonders whether the new Dodd-Frank language banning “any act, practice, or course of business that is fraudulent, deceptive or manipulative.”  That could be.  The same language is in SEC Rule 10b-5, and this has been used to prosecute front running.  So it wouldn’t be surprising to see this used to in the Fannie and Freddie case.

I have studied manipulation for going on 25 years now, and one of my pet peeves is the promiscuous and imprecise use of the term.  I often quote a cotton broker, William Clayton, who in Congressional testimony said “The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

Case in point: a story from a couple days ago about the FBI investigating the trading of interest rate swaps:

Wall Street traders may be manipulating a key derivatives market and front running Fannie Mae and Freddie Mac, hurting the US-owned mortgage giants in the process, according to an FBI intelligence bulletin reviewed by Reuters.

. . . .

Disclosure of the suspected manipulation and front running came in an FBI intelligence bulletin that was distributed last week by the bureau’s field office in Charlotte, North Carolina, to security officers at financial services firms.

Front running  is not manipulation.  Manipulation distorts prices, and causes them to move away from where they should be (at least temporarily, although the effects can be highly persistent).  If anything, front running causes prices to move where they were going to go anyways, but faster.   Front-running is a source of information leakage.

Front running raises the trading costs of the entity that is front run–allegedly Fannie and Freddie in this case.  It results in a redistribution of wealth away from those who are front run to the front runner.  But these effects are notably different from real manipulations, like corners and squeezes, or banging the close/settle, or the release of false information.

In the stock and futures markets, front running by a broker or specialist is a violation of the agency relationship with the client.  In securities markets in the US it is a violation of Section 10(b) of the 1934 Securities Exchange Act.  I don’t know, and don’t have time to research at the moment, whether front running of interest rate swaps falls afoul of any law or regulation.

But it ain’t manipulation, as the term should be construed as conduct that distorts prices.  Although everything that is manipulative is bad, not everything that is bad is manipulative.  But as William Clayton noted 80 odd years ago, that distinction is almost universally overlooked.  Especially now, in media coverage of financial markets.

Scott Irwin has provided his responses to David Kocieniewski.  Read the whole thing.

It’s My Turn

The responses to the recent NYT article by David Kocieniewksi certainly make interesting reading.   I don’t want to belabor points already made so well by others in response to the numerous problems with the article (especially Craig).  Instead, I want to offer some additional points that I think merit further consideration or elaboration:

1. To start, it is important to clarify that the heart of the controversy is the trading activities of a new type of participant in commodity futures markets—financial index investors—during the 2007-2008 commodity price spikes.  The concern was that unprecedented buying pressure from index investors created massive bubbles in commodity futures prices, and these bubbles were transmitted to spot prices through arbitrage linkages between futures and spot prices.  The end result was that commodity prices far exceeded fundamental values during the spikes.  Dwight Sanders and I labeled this the “Masters Hypothesis” in honor (dishonor?) of the central role that hedge fund manager Michael W. Masters played in pushing this line of thinking.   It is crucial to understand the key features of the Masters Hypothesis.  First, it implies that index buying in commodity futures markets created massive price bubbles—20, 30, 50% overvaluations (take your pick).  Second, it implies the price bubbles were long-lived, measured in months if not years.  These features have driven the acrimonious debate about “speculation” in commodity markets that first erupted in 2008.  Without the charge of massive and long-lasting bubbles the intense public policy debate about speculation limits would not have taken place.
2. My position on the validity of the Masters Hypothesis has been consistent from the earliest days of the controversy.   In fact, in an ironic twist, one of my earliest publications on the controversy was an op-ed that Dwight Sanders and I jointly authored—drum roll please—yes, in the NYT in July 2008.   A few quotes:  “Over all, there is limited evidence that anything other than economic fundamentals is driving the recent run-up in commodity prices…The complex interplay of these factors and how they affect commodity prices is often difficult to grasp immediately, and speculators are a convenient scapegoat for the public’s frustration with rising prices. That’s unfortunate because curbing speculation — and hobbling the ability of businesses that rely on futures markets to reduce their risk — is counterproductive.{
3. If my work was somehow tainted by associations with “Wall Street,” then why the editorial endorsement by the Paper of Record in 2008?   It also seems convenient that this little fact was omitted in Mr. Kocieniewksi’s recent article.   I made sure he was aware of my previous NYT op-ed article when he interviewed me. I suspect he was already aware of it given his exhaustive background research on the two of us.
4. The academic research pertaining to the Masters Hypothesis since 2008 has been overwhelmingly negative.  I submit that there is very little credible academic research that is consistent with the basic tenets of the Masters Hypothesis.  That is, index buying is not associated with massive and long-lasting price bubbles in commodity futures markets.  There are no “accidental Hunt Brothers.”   Some unnamed persons (one has the initials GG) like to characterize academic research on the subject as being roughly equally divided between studies that find a positive impact of index positions on prices and studies that fail to find an impact.  This characterization is misleading.  Yes, some studies find evidence of a positive impact but the impacts are invariably small and fleeting or do not line up with the spikes of 2007-2008.  This type of evidence does not support the Masters Hypothesis.  So, when properly interpreted the evidence to date is not divided equally, but instead overwhelmingly rejects the Masters Hypothesis.  And this is what is important from a public policy perspective—small impacts do not provide much justification for costly new regulation of commodity futures markets.
5. My approach to research on the market impact of index investment has always been to go where the data lead.  My co-authors and I have sliced and diced the available data many different ways and we cannot find a smoking gun (a full list can be found here).  As I like to put it, if the Masters Hypothesis is true then the relationship between index positions and commodity futures prices should literally jump off the page.  It does not.  Importantly, there is also limited evidence of bubbles in commodity futures markets independent of whether or not they are associated with index investment.   My co-authors and I could not find evidence that bubbles have become larger or longer-lasting since index investment came on the scene.  If anything they have become smaller and less frequent.
6. If my research on speculation is slanted/biased/tainted then it sure has fooled a whole bunch of academics who serve as journal editors and reviewers.  I have published 13 papers since 2009 dealing directly with the speculation controversy in 9 different academic journals.  And several more are currently under review.  Yes, under review.  This means the articles don’t get published unless they first pass muster with reviewers and then a journal editor.  I don’t know exactly how many editors and reviewers I have dealt with on these papers (several were invited submissions but still subject to peer-review), but it is safe to say that it must be at least 20-30 people.  So, we are to believe that my biased research ran this gauntlet of editors and reviewers and the bias managed to go undetected the entire time?  Give me a break.
7. Just for the record, I want to state in public that I did not even know about the Chicago Mercantile Exchange (CME) donations to the business school here at the University of Illinois when the donations were made.  I only became aware of them in the last year or so through conversations with our development staff.   (OK, I should actually be a little embarrassed by that last statement given my work on commodity futures markets.)   In any event, to draw an inference between the gifts to the business school from the CME and my research really is ridiculous.  I made this clear in my interviews with Mr. Kocieniewksi.
8. I do have a long working relationship with the CME, and before that, with the Chicago Board of Trade (CBOT).  This after all is my research area.   The CME has not funded any of my research since 2007.  However, I did work on a commissioned white paper for the CME in 2005 when the grain contract convergence problems first erupted.  My co-authors (Phil Garcia and Darrel Good) and I were paid a total of $15,000 for the work, which we split equally.   I did accept a position on a new Agricultural Advisory Council that the CME started in late 2013.  The council will meet three times a year at various locations around the country and serve as a sounding board for various issues that come up with regard to agricultural futures markets.  I will receive the same $10,000 annual stipend for this position as the other members of the council.   That is the sum total of my financial ties to the CME.
9. I have had numerous interactions with CME staff in recent years on a host of issues related to commodity futures markets, including, of course speculation.  Sometimes I have reached out to them and sometimes they reach out to me.  Most of the time it is the former and involves pretty obscure questions about things like how the grain delivery process works or help in getting some data.  My research would be far less interesting and useful without this help.  I have the utmost respect for the professionalism of the CME staff and I have never been asked for any type of quid pro quo.  Never.  When I have agreed to participate in presentations, write blogs, etc. I have done so because I believed my research and analysis contributed to better understanding of the issues.
10. My other research on commodity market speculation has been funded from three main sources.  First, the Laurence J. Norton Chair that I hold here at the University of Illinois provides earnings each year that go to support my research program (thank you U of I!).  Second, I have had two grants from the Economic Research Service of the USDA on commodity speculation related topics since 2008.  The first one included work directly on speculation while the second focused on convergence in grain futures contracts. Both have been completed.  Third, Dwight Sanders and I did a commissioned study for the OECD in 2010.  I lost track of the emails with the exact amount we were paid but I know it was only a few thousand dollars.
11. Yieldcast is a product of T-Storm Weather that I helped develop with a former graduate student, Mike Tannura, and Darrel Good.  Yieldcast provides “real-time” U.S. corn and soybean yield forecasts for subscribers.  My main role is to build the statistical models that form the basis of the forecasts and to prepare the weekly forecasts during the growing season.  As indicated in the NYT article I do not have direct contact with Yieldcast subscribers.  I am fortunate that side of the business is ably handled by Mike Tannura through T-Storm.  It is really laughable to think that I have somehow been rewarded through this channel by Wall Street as a payoff for my speculation research.  I know how hard Mike has worked to build the base of subscribers for this product, and if it only were that easy!  I have never seen one email, one voice mail, or absolutely anything that connects my research on speculation to taking out a subscription for Yieldcast.
12. As the NYT article indicated, Dwight Sanders and I did conduct a study in 2012 for Gresham Investment LLC on the market impact of index investment.   Given the political sensitivities surrounding the speculation issue, I gave considerable thought as to whether I ought to pursue the consulting project.  I knew some would see taking any funding from a commodity firm as being a conflict of interest.  But, the project provided access to detailed firm level position data that has previously been unavailable to researchers and this made it worthwhile in my mind.  Sure, I didn’t mind getting paid as well.  The NYT article got it wrong when it said I was paid the full $50,000.  Dwight and I split that equally so I was actually only paid $25,000.  We are working on several interesting papers based on this new dataset.
13. If the charges (really, innuendoes) in the NYT article are baseless, then readers might reasonably ask what does motivate my “defense of Wall Street”?  Good question.   I am indeed a “freshwater” economist that became convinced early in my career that commodity futures markets were an invaluable market institution that improved the discovery of prices and the ability of market participants to shift risks.  While these markets are by no means perfect (as Craig’s work on manipulation highlights), on balance, the good vastly outweighs the bad.  So, when the current speculation controversy erupted in 2008 I was struck by the similarity of the present controversy and those that have buffeted the industry in the past.  Change only the names and dates and not all that much is different.  This has been a reoccurring theme in my own writings since 2008 (including the July 2008 NYT article…could not resist).  And I admit that I made an intentional decision early on to play a more public role in the present controversy.  Three of my professional heroes are Holbrook Working, Tom Hieronymus, and Roger Gray, who spent much of their illustrious academic careers defending futures markets.  All the motivation I needed.

Scott Irwin

University of Illinois

Risk Magazine’s annual review issue includes a set of short contributions on the progress that has been made on the G-20 OTC derivative reforms.  (If you run into paywall problems: there are ways.  There are ways.)  The contribution by yours truly is under the category Academics (plural) even though I am the only academic in the piece.  I guess I count for double, or something.
But that’s not the best part.  The best part is the headline:

Progress and peril: Davie, Dodd, Maijoor, Pirrong and more on the G-20 reforms.

Sharing top billing with Chris Dodd!  What is the world coming to?  I guess it could be better (or worse): it could have been Barney.  Or Gary.  Or Bart.

To spare you having to scroll through all of the contributions by politicians, lawyers and people who actually work in these markets, here’s my two cents:

When the Dodd-Frank Act was passed, I thought the Sef mandate was its worst part. It has nothing to do with the act’s ostensible purpose – reducing systemic risk – and imposes a one-size-fits-all model for trading swaps that will likely decrease the efficiency of the market. The made-available-for-trade provision of the Sef rule merits the title ‘worst of the worst’. This says if a Sef applies to the CFTC to trade a particular type of swap, and it approves the application, all trading of that type of swap must occur on a Sef. This turns the ordinary competitive process on its head. In most markets, a firm introduces new products, and if it is desirable to consumers, it sells. If the product is flawed, it doesn’t. Under this rule, a firm that introduces a flawed execution method imposes this bad choice on all consumers.

The CFTC could prevent such a perverse outcome by not approving an application. However, the agency’s animus to the traditional dealer-centric trading model and its fetish for transparency means the CFTC sets very low standards for approval. It also demonstrates the CFTC’s bizarre interpretation of cost-benefit analysis: it considers only the trivial cost of filing an application, and totally ignores the massive costs that would result if traders are forced to execute in an inefficient way.

Swap market participants and transactions are diverse. There is no execution model to fit all – counterparties themselves are best placed to determine how to execute their trades. Sef mandates already constrain choice, and made-available-for-trade puts the execution decision in the hands of third parties whose interests are not aligned with those actually trading. Given the size of these markets, if the untried Sefs don’t work as hoped – even for a modest subset of traders – the dislocations and inefficiencies will be immense.

The Risk editors chopped my last line, which was: “I fear that the epitaph of the OTC swap market will be: ‘Died of a Theory.'”  (A line lifted from Jefferson Davis’s epitaph on the Confederacy.)  The Theory, of course, is that traditional means of executing OTC derivatives trades are flawed, if not evil, and that Gary Knows Best in imposing a simulacrum of a centralized, order driven market that has worked well for futures on swaps, which are different in many ways.

Felix Salmon posed several questions for David Kocieniewski about his scurrilous article about Scott Irwin and me.  And-shockingly!-David Koscieniewski refused to answer a single one.  Not. A. Single. One. So if you don’t win that Pulitzer, Dave (and we know that’s what you want, isn’t it?), there’s always the Royal Order of the Weasel ready to be claimed.  You should be a runaway. Emphasis on the Runaway!

Instead of actually answering direct questions posed to him, our dear David doubled down on insinuation, innuendo, and ad hominem.  That’s our boy: go with what you got, eh?

I will respond more fully later, through multiple channels, but a few comments are in order now.

1. Kocieniewski insinuates that I have violated the American Economic Association disclosure guidelines.  Fail, Dave. Pure fail.  The AEA guidelines require disclosure of any support (financial, in the form of data, etc.) on submissions to peer reviewed publications.  I have not submitted any work to a peer reviewed publication that has been supported by any party with an interest in the speculation debate.  I told you this during our interview.  So what is it?  Is David ignorant, stupid, or dishonest?  I can’t answer that.  Those are all observationally equivalent.
2. I responded to all FOIA requests, forwarded to me via the University of Houston’s general counsel’s office, in a timely fashion.  Any suggestion to the contrary is false.
3. My work for “one of the largest commodity exchanges” had nothing to do with speculation, and occurred after my positions on speculation were public.  Years afterwards.  Years.  As in plural.
4. My work for “one of the largest commodity trading houses, Trafigura” occurred years after my positions on speculation were public.  Again, years plural.  I had no contractual relationship with Trafigura until September, 2013.  Um, I testified before Congress on speculation-testimony which gives dear David the faints-in July 2008.  You know, five freaking years before. And that’s not even the best part! Trafigura is not a speculator.  It is a hedger.  It routinely sells massive quantities of futures to hedge its massive quantities of oil transactions.  But-correct me if I’m wrong (but I’m not)-Kocieniewski’s article focuses on how speculators drive prices up by buying futures.  Hedgers. Speculators. Buy. Sell.  Up. Down. Whatever, eh? It’s all the same to our Dave. So again: David Kocieniewski: ignoramus, idiot, or liar? I say again: Observationally equivalent.
5. Kocieniewski explicity refers to  the fact that “this debate [over speculation] began more than five years ago.”  Excuse me, but I wrote my first blog post on this in August, 2006.  I know you are math challenged, David (I read your piece on Goldman’s warehouse operations), but using the fingers on your left and right hands, you should be able to cipher that that works out to about 7 years (and about four months, but hey, let’s round down!).  So I weighed in on this before “the debate began.”  Just call me prescient.  But here’s the point: how did my (non-existent) consulting work on speculation years later affect my opinions?  Do you have issues with the concept that the cause must precede the effect?

More later.  I’m just getting warmed up (spits into palms, old school style).

Thanks again, Felix.  The cat caught the weasel.

David Kocieniewski of the NYT is answering questions this week about his deep thoughts on “issues ranging from the role of Goldman Sachs in the global aluminum market to academics who have reaped financial benefits while defending some of the largest players in the commodities business.”  (Bonus opportunity! Gretchen Morgenson is teaming with DK to answer!)

Have at it, folks. I am sure you have inquiring minds that want to know the answer to some questions about Kocieniewski’s journalism.

Update: Please leave a comment to this post if you ask a question and it is not answered.  Also let me know what your (unanswered) question was.

To get back to the substance of the speculation debate, let me reprise something I’ve discussed for years to illustrate the vapidity of many of the arguments about speculation.  I’ve been making this point for more than 6 years: it was a focus of a presentation I made at a conference in Champuloc, Italy in January 2008.

It relates to the use of position data to attempt to identify the price impact of speculation.  You know the drill.  Speculators are huge net long, so they must be driving up prices, right?  We’ve seen that argument repeated over and over and over again.

But here’s the thing.  For every long, there’s a short.  So how do you know the net long speculators are driving prices up?  Why aren’t the net short hedgers driving down prices?

Here’s the example I keep coming back to that illustrates the stupidity of using net speculative positions to claim that prices are too high or too low.

Back in the 1990s and early 00s, gold prices were low.  Very low.  $300 and below.  Back then, the hue and cry was that prices were artificially low because . . . wait for it . . . producers were massively short because of hedging programs.

Well, if producers were massively short that means that speculators were massively long.  So if speculators drive prices, why weren’t gold prices stratospherically high in the late-90s early-00s?  After all, supposedly in 2008, and the last couple of years, the massive long speculative positions were inflating prices.  Why didn’t the massive long speculative gold positions a decade ago inflate gold prices?  Flipping things: If short commercial positions were depressing gold prices a decade ago, why didn’t they depress oil prices in 2007-2008, and over the last couple of years?

Hence the danger of superficially examining net positions and claiming that one side of the market is inflating (or depressing) prices: an equally legitimate argument is that the other side of the argument is depressing (or inflating) prices.

But the point is that neither argument is legitimate: both are equally illegitimate.  Derivatives positions net out to zero.  Derivatives are in zero net supply.  Looking at one side of the market, and ignoring the other, makes no sense.

Basic finance theory says that if anything, net positions should predict risk premia, and price trends.  In a simple Keynes-Kaldor model, if speculators are net long, prices should drift up.  Or not: if the price of the commodity in question is uncorrelated with the pricing kernel and markets are well-integrated, prices won’t drift at all even if speculators have a net position.

But the basic point is that in standard finance speculation and hedging affect risk premia, not price levels.  The relationship between positions and risk premia depends the integration between the commodity market of interest and the broader financial markets, and the covariation between the commodity price and the pricing kernel.  If the “financialization” of commodities means anything, it means that commodity markets have become more closely integrated with the broader financial markets, and that this has impacted risk premia.  The evidence of Hamilton and Wu (and UH PhD student Bingxin Li) points exactly in this direction: risk premia in oil plunged to near zero in the mid-2000s, when index trading increased dramatically.  Any impact on the level of prices overall is due to indirect effects of risk premia: risk premia affect the costs of hedging which affect output and storage and consumption, which affect prices.  But whatever those knock-on effects are, whether prices rise or fall, they are likely efficiency enhancing: they reflect the consequences of a more efficient allocation of risk.  (By the way, I explained this to Chilton years ago.  Talk about pearls before swine.)  (I say “likely” because of the usual caveats about the difficulty of making welfare comparisons in incomplete markets.)

So word to the wise.  If you want to make a persuasive argument about the impact of speculation (or hedging) on the level of spot prices (rather than on the difference between spot and futures prices), don’t say anything about net derivatives positions.  Because the market as a whole has no net position.

Comparing the gold and oil cases has reminded me of this Escher drawing.  Who is drawing whom?  Which hand is the long?  Which hand is the short?