Streetwise Professor

It’s New Years Eve, and perhaps a little game is in order to get ready for the turn of the calendar in about 3 hours.  Let’s play connect the dots.

• In July, David Kocieniewski writes a big-totally incoherent, but big-article in the New York Times on the aluminum warehouse controversy involving Goldman Sachs, JP Morgan and others. The article focuses on Goldman’s Metro Warehouse in Detroit.
• On 1 August, 2013, the law firm Lovell, Stewart, Halebian and Jacobson LLC files suit against Goldman Sachs for violating Sections 1 and 2 of the Sherman Antitrust Act in its operation of the Metro Warehouse in Detroit.
• The Lovell, Stewart complaint cites the Kocieniewski article.  Numerous news articles state that Lovell, Stewart is the firm that filed the complaint.
• Lovell, Stewart is one of the leading plaintiffs’ law firms in the country.  It is indisputably the leader in manipulation class action lawsuits filed under the Commodity Exchange Act.  LSHJLLP has been the lead counsel or co-lead counsel in virtually every major manipulation lawsuit in the US, and has won hundreds of millions of dollars in settlements in such cases.  Its web page lists numerous past and current commodity manipulation cases, as well as other cases filed against financial institutions.
• I have worked as an expert in numerous cases for Lovell, Stewart (and its predecessor law firms) going back to 1994.  Many of these are manipulation cases.
• David Kocieniewski knew, before writing his hatchet job, that I had worked for Lovell, Stewart.
• Kocieniewski did not ask me about my work for Lovell, Stewart.  He did ask me about my work for trading firms and banks.  I did mention, on my own initiative, that I had been adverse to such firms in some of my work.
• Kocieniewski mentioned my work for trading firms and banks, but did not mention my work for Lovell, Stewart.

So there are the dots.  Help me connect them.

Seriously.  I would like you to tell me in the comments what you see when you connect those 8 dots: what inferences do you draw?  I know what I see, but I’d like to crowd-source this.  Maybe you all see something different.  Thanks in advance for your help, and have fun playing!

And to all my readers: have a Happy and Healthy New Year.  Your interest and continued support is what makes this a rewarding endeavor.  Cheers!

I have always admired Thomas Sowell greatly.  I read his Knowledge and Decisions during my first year of graduate school, and it had a profound effect on my thinking and way of looking at the world.  I also read most of his work on discrimination, and found his book on Marxism to be a classic in intellectual history: a truly fair and penetrating appraisal of Marx, and Marxists (the two things aren’t the same, which is one of the points of the book).  Conflict of Visions is a classic: there is no better book for understanding the intellectual roots behind the political divisions in the West.  Yes, Sowell has strong views, but he is like John Stuart Mill in his ability to characterize his opponent’s views fairly and objectively.

Sowell has also been the subject of some the the ugliest personal attacks directed against any scholar over the last 40 years.  For the progressive left, to be black and on the right is to be an anathema who must be destroyed.  Yet he has handled the vicious attacks on him with equanimity and humor, and has never been cowed.

It is therefore beyond humbling to have Dr. Sowell come to my defense, and take on the New York Times “hit piece.”

All I can say is that I am honored beyond words.  Thank you, Dr. Sowell.

The NYT hatchet job has elicited quite a bit of discussion on the web, and on Twitter.  Several major bloggers have saddled up and ridden to the defense of Scott Irwin and I.  Pride of place goes to Felix Salmon, who wrote a long and thoughtful post at Reuters. This is particularly gratifying, because Felix and I have had our differences in the past (e.g., over the empty creditor problem) but I have always found him to be extraordinarily fair and open minded.  Felix wrote his piece before I posted mine, meaning that his was based on publicly available information (including his past interactions with me) which confers a considerable degree of objectivity: most importantly, it shows that information that the NYT ignored or distorted was there in plain sight.  Felix is like a judge entering a summary judgment motion against the NYT, with prejudice, making it unnecessary for the defense even to present its case.  I think it’s correct to say Felix’s verdict is pretty brutal, but eminently fair.

Other members of the cavalry include Jeff Carter’s Points and Figures blog (who was the first to arrive on the scene), Peter Klein at Organizations and Markets, Sonic Charm (or is it Crimsonic?) at Rhymes With Cars and Girls (who always cracks me up, whatever he’s calling himself these days), and John Hinderaker at Powerline. Peter and John point out the double standard under which academics who work with private business are often accused of being corrupt, whereas the motives of those who accept money from the government are almost never questioned.   Peter focuses on the Fed, John on climate research.  The common conclusion of all is that the NYT piece was a deeply biased smear written in bad faith with ulterior motives.  Crimsonic calls for a retraction.  Interesting idea.

Felix’s post and mine also unleashed a torrent of tweets.

Thanks to all.  I’m sure this isn’t over yet.  So keep your horses watered and your powder dry.

A few days ago the WSJ reported that US securities exchanges are close to upgrading one of the Securities Information Processors, the part of the RegNMS market structure that links the various exchanges.  The SIP consolidates and disseminates quote data from the various exchanges.  It provides the linkages that are necessary for the links-and-information structure created by RegNMS.

The SIPs have been a source of chronic complaints in the industry.  The current fix was compelled by a breakdown in the SIP over the summer that caused a shutdown in trading of some stocks.  But even when the SIPs work, they disseminate information more slowly than the private connections between exchanges and HFT firms.  This gives an advantage to HFT traders.

The WSJ story indicates that the operating system of the SIP is obsolete.

This issue illustrates an inherent problem with a utility-type model in securities markets. I discussed this problem in my research in the late-90s and early-00s, including in a JLEO article that was published in 2002.  That research was focused on a CLOB model, but the same issue is relevant for a the current SLOB (Simulacrum of a Limit Order Book) model. Specifically, a utility CLOB (or SLOB) has strong public good aspects.  All market participants benefit from better technology and improved performance, but would prefer that others pay for it.  Collective action and public goods problems tend to lead to under provision of quality and technological improvement.

SIPs are industry public goods, and face the same problems.  No wonder they are obsolescent.

There are other problems with the linkages approach that undermine incentives to  invest in SIP quality and technology.  The whole idea behind the linkages approach is to facilitate competition between exchanges.  But exchanges have no incentive to facilitate competition between themselves.  Competition is likely to be weaker with a kludgy linkage system, so why should exchanges push to improve it?  Not to mention that some interests, notably HFT, which would face a diminished competitive position with  more advanced SIP, also have an incentive to impede updates.

This is an inherent challenge to the linkages approach.  Its effectiveness depends on, well, the technology that links markets.  But the incentives to invest in those linkages are suboptimal due to the public good problems, exacerbated by the fact that competing exchanges don’t have an incentive to intensify competition between them.

But as I’ve often written, the alternatives have their own problems.  Most notably, if you don’t mandate linkages between markets, order flow network effects tend to cause the dominance of a single exchange.   So you need linkages and socialization of order flow if you want competition, but there will be underinvestment in the linkages.

US securities markets are committed to the linkages approach.  Public goods problems that provide inefficiently weak incentives to invest in the links necessary to make the approach work mean that it will be beset by chronic difficulties.

According to one of my industry contacts, this article in the Fiscal Times has “created a lot of unwanted buzz” in DC.  Because our betters find it so very inconvenient when reality intrudes on their fantasies.

The article focuses on the clearing mandate.  It points out that the main effect of the mandate is to shift risk around, and concentrate it in CCPs.  The risk doesn’t go away.  It moves.

Let me think.  Who was pointing this out five years ago?  Modesty prevents me from naming names.

Clearing was sold-most notably by my bêtes noire Geithner and Gensler*-as a magic box that made counterparty risk disappear.  This was a false claim, and arguably a dishonest one.  I find it hard to believe that Gensler, for instance, really believed what he said.  And the alternatives are ugly.  He (and other advocates of the clearing mandate) either made arguments he (they) knew to be untrue, or was (were) utterly ignorant of the implications of the policies that he (they) was (were) implementing and supporting.  Choices: (A) Idiot. (B) Liar. (C) There is no choice (C).

In reality, clearing mainly shifts around counterparty risk, and creates new risks, most notably liquidity risks.

All of these things were foreseeable, and foreseen-by some. Who were ignored, and at times reviled.

Why did this happen? It seems to me that in the heated days of the crisis, there was a desperation to find a solution.  For a variety of reasons, most notably the fact that the major cleared markets dealt with the Lehman situation without much problem, policymakers seized on clearing as the panacea.  And once they had done that, getting the clearing mandate passed became an end in itself.  The decision had been made, all doubts had to be suppressed.

But where does that leave us? With the growing recognition that the alleged panacea was nothing of the sort.  With the creeping recognition that the mandate has created a new set of risks.  A new set of potential sources of systemic instability.  So now policymakers are scrambling to address and to mitigate these problems.

It would have been so much better had these problems been anticipated, in advance, and the law drafted accordingly.

This is not Monday morning quarterbacking. I and others anticipated these problems at noon on Sunday.  But we were left on the sidelines, while the geniuses called and ran the plays. We are going to be dealing with the consequences of that for years to come.

*One blessedly departed from government “service”, and the other blessedly about to do so.

The Brent-WTI spread reached a record level last week, defying predictions that the gap would continue to close.  But this isn’t the retro spread of the last couple of years.

When Brent-WTI was at its earlier record wides, the spread between Brent and Gulf Coast crude prices (e.g., LLS) was not that anomalous.  Instead, WTI was at a huge discount to LLS. This reflected a bottleneck in getting crude from the Midcontinent to the Gulf.

Now that bottleneck is largely eliminated: LLS is only at a $4 premium to WTI, which is pretty close to marginal transportation costs.  The current price structure is that the LLS-WTI spread has normalized, but the LLS-Brent spread has cratered.

So where’s the bottleneck now?  Part of it is legal: it is impossible to export crude from the US, except in a limited way to Canada.  It is possible to export products, and US refined product exports are at all time highs, nearly 3 times larger than the level of only 8 years ago.  (Interestingly, US product exports started their upward trend in 2005, well before the splurge in US oil production.)  However, refinery capacity is insufficient to close the gap, and there are logistical constraints that limit the amount of products that can be shipped out.   Some simple distillation units are being built to refine crude into products (including fuel oil) that can be exported.

Meanwhile, production issues in Libya and Nigeria are supporting Brent prices.

If the differential persists, it will be interesting to see whether there is pressure to eliminate, or at least relax, the constraints on exports of US crude.  I would presume that even if pressure begins to build, there will be a political battle in the US that will likely long delay any such relaxation or elimination.  So in the meantime this will be a boon for domestic refiners, and a roller coaster ride for traders.  The political, infrastructure, and refining bottlenecks that separate Brent and WTI will not close anytime soon, and the supply shocks on either side of the divide will cause prices to move with considerable independence.  A continued spike in US production will weigh on US prices, but can’t be communicated efficiently to Brent prices because of the bottlenecks; similarly, another shock to Nigerian or Libyan production will primarily move Brent.

In some ways, the world oil market, which is conventionally considered a “world” market due to the relative ease of shipping the stuff around the world, is becoming more like the natural gas market, with regional markets separated due to various bottlenecks, and the prices in these markets driven by idiosyncratic supply and demand shocks in those regional markets.  The adjustments necessary to ease the bottlenecks in crude are likely cheaper than those in gas, but they won’t take place overnight.  And until they do, Brent-WTI will remain a major speculative play.

I’ve been hammering on the theme of the systemic risks of central clearing-especially mandated central clearing-for around five years.  And now those concerns are being expressed with greater frequency.  Fed Governor Jerome Powell gave a speech focusing on the most straightforward source of systemic risk in mandated clearing: the concentration of risk in the clearinghouse, which becomes a single point of failure whose collapse could jeopardize the broader financial system.   Bernanke made a similar argument a couple of years back.

Some articles from the last several days highlight more subtle, but in my view more important, concerns.  This Reuters piece mentions several things I’ve focused on over the years: the strains that clearing can put on the liquidity of individual firms, and the system at large; margin pro-cyclicality;  and crucially, the fact that self-preserving actions taken by CCPs may have destabilizing effects elsewhere in the financial system.

This last point demonstrates a danger in the Powell approach which focuses on making CCPs invulnerable, which I’ve referred to as the levee effect.  Just as making the levee higher at one point does not reduce flooding risk throughout a river system, but redistributes it, strengthening a CCP can redistribute shocks elsewhere in the system in a highly destabilizing way.  CCP managers focus on CCP survival, not on the survival of the entire system, and this is quite dangerous when as is almost certainly the case, their decisions have external effects.  Indeed, greater reliance on CCPs increases the tightness of the coupling of the financial system, which can be highly problematic under stressed conditions.  Liquidity and funding are the primary channels by which CCP decisions will have external effects on the broader financial markets.

These considerations are related to a broader point, which is that CCPs are merely parts, albeit important ones, of a broader financial system, and they must be evaluated in the context of the entire system.  An article in the International Financing Review by Christopher Whittall provides another illustration of this, again related to liquidity.  He notes that Basel III’s leverage ratio clashes with the tremendous thirst of CCPs for liquidity:

“The move towards central clearing creates a focus on how to fund margin requirements, which should dictate an increase in repo activity from banks. The problem is repo becomes very unappealing for banks under the leverage ratio.”

So sayeth the head of fixed income at a major bank.  CCPs create tremendous funding needs, and particularly contingent funding needs that are especially large in stressed conditions when liquidity is hard to come by.  These needs are hard enough to address in the absence of a leverage ratio, but as the fixed income guy notes, this is an even bigger problem when it is present.  As he says: “Viewed as a whole, we can start to start to see how these different regulations don’t quite hang together from a macro-prudential perspective.”

Exactly.  Illustrating another theme: Regulatory responses to the crisis have tended to focus on the individual pieces with too little attention paid to how regulations of one piece affect the other pieces.  The interaction between the leverage ratio and clearing mandates is a particularly worrisome example.  In any complex system, it is the interaction between interconnected pieces of the system that can lead to abrupt collapses.  Making each piece of the system more robust doesn’t necessarily make the system more robust.  Indeed, the opposite can be true.

Yes, I’ve been a Cassandra on these issues.  So in some sense, it’s good to see that the concerns that prompted my prophesies are now getting more widespread attention.  But methinks that the post-crisis regulatory juggernaut is impossible to reverse, and that although some of the problems in clearing and the interactions between clearing and other aspects of financial regulation can be ameliorated, the basic sources of systemic risk inherent in the new financial and regulatory structure will persist.

Matt Leising had a nice article a few days back about the CFTC’s rule that does not treat US Treasury securities as “qualifying” liquid resources for CCPs.  Instead, under new regulation 33-33 they must obtain “prearranged and highly reliable funding.” Based on Fed rules, this means that a CCP must get  committed line of credit from banks.   This imposes a substantial cost on CCPs, because under new Basel III rules, committed lines impose a large capital charge on the issuing banks.  For purposes of calculating capital, the banks have to assume that the lines are fully drawn.  This capital cost will be passed onto CCPs.

It is ironic that outgoing (resisting the great urge to snark) Chairman Gary Gensler repeatedly argued that one of the main benefits of the Frankendodd clearing mandate is that it would reduce the interconnectedness of the financial markets, especially interconnectedness through derivatives contracts.  Now he has pushed through a regulation that mandates an interconnection among major financial institutions via a derivatives channel: the lines connect derivatives CCPs to major banks.   I have long pointed out that Gensler’s claim that clearing would reduce interconnectedness was grossly exaggerated, and arguably deceptive.  Instead, I pointed out that the mandate would reconfigure-and is reconfiguring-the topology of the network of connections between financial firms.  What the CFTC has done is dictate what that form of interconnection will be.  This particular dictate is extremely problematic.

A CCP needs access to liquidity in the event of a default of a clearing member.  The CCP needs to pay obligations to the winning side of the market, in cash, in a very tight time window.  Failing to make these variation margin payments could impose financial distress on those expecting the cash inflow, and more disturbingly, call into question the solvency of the clearinghouse.  This could spark a run in which parties try to close positions in order to reduce exposure to the CCP.  Given that this is likely to occur in highly unsettled market conditions, such fire sales (and purchases) will inevitably inject substantial additional volatility into price that can exacerbate pressures on the clearing mechanism.

A CCP holding Treasuries posted as IM by the defaulting CM can sell them to raise the cash.  Alternatively, it could repo them out.  During most periods of financial turbulence-and financial crisis-which is likely to be either the cause or effect of the default of one or more large CMs, there is a “flight to quality” and Treasury security prices rise and there is a rush to buy them by investors seeking a safe haven.  Moreover, under such circumstances the Fed will perform its lender of last resort function, and readily accept Treasuries as collateral: even if CCPs could not access the Fed directly*, they could access it indirectly.   Thus, in “normal” crises, Treasuries should be highly liquid, and a ready source of cash that can be used to meet variation margin obligations.

Put differently, from a liquidity perspective, Treasuries are a negative beta asset: they become more liquid when overall market liquidity declines-or verges on collapse.  This is a highly desirable attribute.  Another way to characterize it is that from a liquidity perspective, Treasuries have right way risk.

Bank lines are very different.  Banks become stressed during crisis situations, and face a higher risk of being unable to perform on credit lines under these circumstances.  (Indeed, what if the defaulter is one of the suppliers of a committed line?) Banks fighting for survival but which can perform might try to evade this performance during stressed market conditions, which in a tightly coupled system (and clearing is a source of tight coupling) can be extremely disruptive: a few minutes delay in performing could cause a huge problem.  And if the banks do perform, doing so poses the substantial risk of increasing their risk of financial distress.  That is, committed lines are positive beta from a liquidity perspective: that is, they pose wrong way risks.   If drawn upon, these lines can be an interconnection that is a source of contagion from a derivatives default to systemically important banks, precisely at the time that they are least able to withstand the shock.

In the event, a CCP that does collect Treasuries as IM can likely use these right way assets to raise the cash need to meet its obligations, and can avoid drawing down on its committed line.  But that would mean that the committed line is superfluous, and imposes unnecessary costs on the CCP, and hence on the users of the clearing system.

I also conjecture that having met its liquidity requirements with a committed line, pursuant to the CFTC reg, CCPs would  have a weaker incentive to take Treasuries as collateral, and a stronger incentive to permit the posting of lower quality assets (or incentivizing such posting by reducing haircuts assessed to such collateral) for IM. This would mitigate the cost impact to users that results from the CCP having to secure the committed line, and pay for it (the cost being passed onto the users), thereby reducing the loss of trading/clearing volume and the associated revenues.  This would increase the odds that the line will be drawn on (because the lower quality assets pose a substantial risk of becoming illiquid during a crisis situation-they embed wrong way risk too).  I’ll have to think this through more, because the situation is somewhat complex: it depends on the pricing of the line, which will depend on the likelihood it will be drawn against, and the market conditions at the time it is.  This will depend in part on the quality of collateral that the CCP collects.  I’m not sure of what the equilibrium outcome will be, but I suspect that mandating the obtaining of lines will undermine incentives to demand the posting of high quality collateral.  If it does, this is a bad outcome that increases wrong way and systemic risks.  If it doesn’t, then the cost of the lines is superfluous and a burden on clearing and derivatives trading.

There is one scenario in which Treasuries would not be good collateral: if the financial crisis (and default of a CM or CMs) was the result of a fiscal crisis in the US, or a default (real or technical)  of the kind feared during the last (but the last, most likely) debt ceiling standoff.  But that’s an Armageddon scenario in which banks are likely to be highly stressed and unable to perform, or in which they would incur exceptional and arguably existential costs if they did.  Put differently, there’s likely no good source of liquidity in this scenario, and the CFTC rule will hardly make a difference.

In sum, it is highly unlikely that bank lines are a better source of liquidity, especially under crisis situations, than Treasuries.  Indeed, they are plausibly worse, and actually create an interconnection that can transmit a shock to the derivatives market (and the CCP that clears it) to systemically important banks: this is the exact opposite of what clearing was supposed to achieve. The cost of the lines, which is likely to be substantial, particularly given their necessary size, is a deadweight burden on the markets: all pain, no gain.

Other than that, the rule is great.  And a fitting parting shot from Gensler.

* Frankendodd makes it difficult for US CCPs to obtain Fed liquidity support.  This is a serious mistake that could come back to haunt us in some future crisis.  To work effectively, the LOLR must be able to direct liquidity to where it’s needed,  quickly and efficiently.  CCPs could be a major source of liquidity demand in future crises, which makes isolating them from the Fed highly dangerous, and the invitation to an ad hoc response in some future crisis.

The CFTC has released its new position limits proposed rule.  It is an improvement on the earlier version, but still lacks a serious logical and empirical basis, try as the agency might to muster up a justification.

It is an improvement primarily for two reasons.  First, it has more sensible aggregation standards.  Whereas in the 2011 proposed rule, an entity would have to aggregate positions in every entity of which it had a 10 percent or greater stake in order to determine its overall position for the purpose of determining compliance with the limit, now that threshold has been increased to a more reasonable 50 percent.

Second, the new proposal does not include “class limits”.  Under the 2011 rule, swaps and futures were treated as different classes, and long positions in one class were not offset against economically equivalent short positions in the other.  Thus, a firm could have a zero economic exposure because a swap position was offset by an equivalent futures position, but it could be in violation of the position limit.  This made no economic sense, and was likely a surreptitious way of hamstringing swap dealers’ ability to enter into transactions with the massive passives who bother Chilton (and Gensler) so much.  Along with many others, I submitted comments criticizing this approach, and lo and behold, it has disappeared.  Now position limits are based on net exposures, meaning that a swap dealer can hedge a swap entered into with a customer using futures, in any quantity, without falling afoul of the position limit rule.

Unfortunately, not all nonsensical features of the 2011 proposal have vanished along with the class limits.  Most notably, the 2013 proposal not only includes, but extends the scope of, the “conditional limit” on positions held during the last 5 days of the a contract month.  Under this provision, the limit on delivery-settled contracts during the last 5 days is 25 percent of the deliverable supply, but the limit on otherwise identical cash-settled contracts is 5 times larger (i.e., 125 percent of deliverable supply).

As I commented in 2011-based on a paper I published in the Journal of Business in 2000-this makes no economic sense.  A trader that is long a delivery settled contract can manipulate by standing on excessive deliveries, thereby effectively buying up too much of the deliverable supply.  But a trader that is long a cash-settled contract can have the same price impact by buying the same quantity in the cash market.  Under the conditional limit rule, the holder of the cash-settled contract can get 5 times the benefit from this price impact as the holder of a delivery-settled one. The logic of the 25 percent of deliverable supply limit implies that the CFTC believes that taking delivery of something less than 25 percent of deliverable supply permits the long with a futures position of 25 percent of deliverable supply to manipulate profitably.  This means that the holder of a cash-settled position equal to 125 percent of deliverable supply can manipulate far more profitably.

This rule is passing strange especially considering that the CFTC has filed a manipulation claim against a trading firm-Parnon-that allegedly used cash market purchases to distort futures prices.  The strategy that the CFTC finds illegal in Parnon would benefit both cash-settled or delivery-settled contracts.  Under the conditional limit rule, the agency provides an incentive for the holders of cash-settled contracts to engage in such strategies.

What’s more, whereas the 2011 rule would have potentially constrained such strategies by limiting ownership of physical supplies by the holder of a cash-settled derivatives position to 25 percent of deliverable stocks, the new rule imposes no such constraint.  Instead, it imposes a requirement to report cash market holdings, and hopes that market oversight officials at exchanges will intervene if it looks like a manipulation is in progress.

None of this makes economic sense, and is in fact logically contradictory.  What makes it worse is that whereas in the 2011 proposal the conditional limit applied only to natural gas futures, it now applies to all contracts subject to position limits.

A big chunk of the proposal is a long-winded justification of the rule, in an effort to overcome the legal challenges that saw a federal court reject the 2011 proposal.  It seems to me that the commission is merely restating the arguments that failed in court, so I don’t really see how this helps.

A couple of things struck me as quite interesting.  In both the 2011 and 2013 proposals, the CFTC utilized the Hunt silver case and the Amaranth case as examples of the kind of destabilizing conduct that the rule would prevent. But whereas the 2011 rule argued that large leveraged positions (like those held by the Hunts) posed a threat to market stability, the word “levered” does not appear in the 2013 proposal’s discussion of the kinds of positions that are particularly worrisome.

This is interesting to me, in part, because my criticism of the 2011 rule as over-inclusive focused on the leverage issue.  If leverage is the problem, I argued, why impose the rule on unlevered positions, like those held by ETFs (which are fully collateralized) or real money investors? If leveraged positions were the real problem, the rule was over inclusive because it would apply to unlevered positions too.  Arguably, this argument had some impact, as all reference to the unique dangers posed by leveraged positions disappeared between 2011 and 2013.

But dropping the argument doesn’t eliminate the problem.  The CFTC has not shown how large, unlevered positions with trading decisions made by many individuals (as is the case with ETFs like USO or USNG) pose a threat to market stability in the way the Hunts did, or can cause unwarranted fluctuations in commodity prices.

Relatedly, the 2011 rule argued that position limits would reduce systemic risk.  I commented that it is wildly implausible that even a disorderly liquidation of a large position in a small market could destabilize the financial system.  Would a disorderly liquidation in the milk futures market really pose a threat to world financial stability?  Seriously?

And wouldn’t you know, the 2013 justification does not mention systemic risk.

More generally, the two-two, mind you-cases that the CFTC puts forth to justify its imposition of limits is highly unpersuasive.  I regularly use the Hunt case as an example of how speculation can distort prices.  Or, should I say, the example.  It is pretty much the exception that proves the rule. It occurred over 33 years ago.

Talk about ancient history.  When do we get to the part about the Trojan War?

The commission’s analysis, such as it is, of the Amaranth episode relies heavily on a report from the Senate Subcommittee on Investigations.  This report in no way demonstrates that Amaranth distorted prices, or that the liquidation of its position when it ran into financial trouble caused unwarranted price fluctuations.

A more plausible story is that Amaranth took a huge bet on natural gas spreads based in large part on a view that 2006 would be another big hurricane season.  When September came with no hurricanes, and none in prospect, spreads collapsed and Amaranth lost a lot of money.  The loss does not demonstrate that Amaranth distorted spreads, just that it took a big bet on these spreads, and bet wrong.

It’s not the job of the regulators to prevent market participants from losing big, if those big bets do not distort prices, either when they are initiated, or when they are liquidated.  (In the event, Amaranth’s positions were assumed-quite profitably-by JP Morgan and Citadel, with no notable dislocation in market prices.)

Moreover, even taking the commission’s view, the two episodes do not support the level of limits it proposes to impose.  The 2013 limits (like those proposed in 2013) would limit an individual firm to between 2.5 percent and 10 percent of open interest: the bigger the contract, the smaller the limit as a fraction of open interest.

But the Hunts and Amaranth had around 40-50 percent of the open interest in big contracts-at least 4 times, and arguably close to 20 times the limits the commission has proposed.  So even if you could argue that a 40 percent position could distort prices, or result in unwarranted price fluctuations when the position is liquidated, that doesn’t imply that a 10 percent or 5 percent or 2.5 percent of open interest position would.  There is thus a huge gap between the sizes of the positions that the CFTC claims, based on historical experience, distort markets, and the sizes of the limits it is proposing.

This is related, in a way, to cost-benefit analysis.  The agency is required to compare the costs and benefits of the regulation, but its analysis is perfunctory, at best. In particular, it does not provide a persuasive cost-benefit analysis of any major attribute of the rule, most notably of the size of the limits.  It basically adopts a precautionary principle approach: big positions could cause big problems, so they should be constrained as a precaution.  It asserts-but does not show-that liquidity will not be unduly restricted as a result.  This is insufficient.

Chilton-who has announced his departure-has claimed that the new proposal is immune to legal challenge.  I wouldn’t be so sure.  Even if the court accepts the verbose arguments relating to the commission’s obligation-or not-to make a finding that the limits are necessary, the agency is still vulnerable on the adequacy of its cost-benefit analysis.  Judge Wilkins never ruled on this issue in his 2012 decision, and in my opinion the CFTC is still vulnerable here.

It is not just the cost-benefit trade-off of the rule overall, but the specific choices made.  Most notably, the size of the limits needs to be justified better on a cost-benefit basis.  Similarly, the conditional limit needs to be so justified: and I’ll say that it is impossible-impossible-to do so, if one is constrained to using, you know, rigorous economics.

The rule is unbelievably long.  Five-hundred thirty three double spaced pages.  533.  (395 pages excluding appendices and attachments.) I have read most of it, but have to spend more time digesting the bona fide hedging portion of the rule.  More on that later.

Oh.  There are 846 footnotes: this is where the land mines lurk.  And there was much rejoicing.  By the lawyers, anyways.