Streetwise Professor

An UNCTAD paper by David Bicchetti and Nicolas Maystre analyzing high frequency data from commodity futures markets has received a tremendous amount of attention in the few days since its release. The paper purports to present evidence that high frequency trading has distorted commodity prices, hence the flurry of attention to what is in fact a rather unexceptional paper.  Indeed, the only thing exceptional about it is the authors’ extreme over-interpretation and sensationalization of the results, and their failure to consider seriously more reasonable interpretations of their findings.  Their characterization of their findings borders on academic malpractice, and raises questions about their sincerity.

The empirics are rather straightforward.  Bicchetti and Maystre calculate rolling correlations between EMini S&P 500 futures returns and the returns on 6 commodity futures contracts-WTI, corn, soybean, wheat, sugar, and live cattle.  These correlations are calculated at various frequencies ranging from 1 second to 1 hour.

They find that correlations were typically around zero before jumping substantially around September, 2008. Based on this, they conclude that “the financialization of commodity markets has an impact on the price determination process.  . . . In fact, the strong correlations between different commodities and the S&P 500 at very big frequency are really unlikely to reflect economic fundamentals.”  They further claim that “HFT strategies, in particular the trend-following ones, are playing a role.”

Their basis for this claim is extremely thin.  They note that HFT trading has become increasingly important in recent years.  They note that correlations jumped in 2008.  They conclude that the former caused the latter.

Really?

Gee, now what happened in September, 2008?  Let me think.  Think. Think. Think. Oh, I remember now-we had a financial crisis!

Could that maybe explain the change in correlations?

Damn right, it could-and did.  First, note that the correlations between the S&P 500 and commodity prices are going to be driven primarily by whether supply or demand shocks are driving commodity prices.  Take oil as an example.  When supply shocks are important, one would expect zero or even negative correlations between oil prices and stock prices.  An adverse oil supply shock should lead to higher oil prices and lower stock prices.

When demand shocks predominate, however, positive correlations are to be expected.  Adverse aggregate shocks depress both oil prices and stock prices.

Thus, correlations depend on the composition of shocks.  When demand shocks (driven by shocks to income) predominate, correlations should be positive; when commodity-specific supply shocks predominate, correlations should be zero or negative.  (With the ags, since supply shocks are unlikely to be correlated with aggregate income or growth, one would expect near-zero correlations.  With oil, supply shocks can have macro effects, so negative correlations can arise.)

Starting in the fall of 2008 there was a dramatic increase in the flow of information about demand-related shocks.  The predominant feature of those months was a dizzying flow of macroeconomic-related news.  Would major economies be thrown into depression? Would the financial sector collapse?  Would economies recover?  How rapid would the recovery be? What were governments doing to trying to stem the collapse and rekindle growth?  The composition of economic shocks shifted decisively towards demand/income-related shocks that dwarfed commodity-specific supply-related shocks.

In this environment, commodity-specific supply-related information was swamped by systematic demand-related information.  You would expect-clearly-this to lead to positive co-movements between stock prices and commodity prices, because both were being driven by demand related information.

Moreover, financial shocks during the crises that  constrained risk-bearing capacity that were quite prevalent during this period would have affected both stocks and commodities, and in the same way.  These shocks to risk bearing capacity would have affected expected returns on commodities and equities in the same way.  This would have also contributed to substantial positive covariation.

The very discontinuity in the correlations around the time of Lehman supports this view.  Algorithmic trading and HFT trading (they are different) were both growing throughout the mid-to-late-2000s.  There was no discontinuous jump in the utilization of these strategies at the time of Lehman.  But there was a discontinuous jump in the correlations.  A much more plausible interpretation of the data is that a discontinuous change in the nature of economic shocks (becoming predominately economy-wide demand-related shocks) and correlated shocks to risk bearing capacity (that led to correlated shocks in expected returns) attributable to the (discontinuous) financial crisis explains the discontinuous change in correlations.  The authors offer no plausible explanation-none-of how a continuous growth in HFT could lead to a discontinuous jump in correlations precisely in September, 2008.

Indeed, their measure of HFT-the ratio of volumes to trades-flattened out precisely during this period, after having fallen since the beginning of 2007.  If this is a measure of HFT, it should have jumped down discontinuously at the time correlations jumped up if in fact HFT was driving correlatons.  But the exact opposite happened.  The authors let this obvious problem with their interpretation pass in silence.  This is inexcusable.

There is other information in the report that strongly supports the view that fundamentals were in fact driving the correlations.  In particular, the WTI-S&P correlation dropped substantially in January-April, 2011.  This is precisely the period in which the Arab Spring and in particular the outbreak of civil war in Libya led to substantial supply shocks in the oil market.  As noted above, supply shocks for oil should lead to opposite movements in oil prices and stock prices.  An increase in the flow of supply-related information should lead to lower correlations between stock and oil prices.  The Arab Spring and Libyan events led precisely to such an upsurge in supply shocks, and correlations fell exactly as would be expected if fundamentals were actually driving prices.  Under the HFT interpretation, there would have had to have been a drop in HFT utilization during this period, which certainly did not occur.

In sum, the evidence presented in the widely hyped Bicchetti-Maystre paper in fact strongly supports the view that fundamentals were driving commodity and stock prices during the sample period.  In particular, the main piece of evidence that B-M emphasize-the jump of correlations in September, 2008-corresponds to an obvious regime change in which economy-wide shocks that would affect both stock prices and the demand for commodities occurred more frequently and with greater severity.  One would predict-and in fact I did so predict contemporaneously-that such a change would lead to a substantial change in the correlations between stock and commodity prices. (I made this prediction publicly at a symposium held at the Bauer College shortly after the beginning of the crisis, and actually made the conditional prediction in the summer of 2008 that the only thing that would bring down oil prices was a serious economic downturn.)  The change in oil-stock price correlations around the time of the Libyan crisis is also consistent with the hypothesis that price movements reflected information about fundamental supply and demand conditions.

In contrast, there were no discontinuous changes in “financialization” or the utilization of HFT either in September, 2008 or during the Arab Spring/Libyan period.

In sum, the actual evidence presented in the paper strongly supports the hypothesis that fundamentals drive prices.  It does not provide any support for the hypothesis that “financialization” or HFT is distorting prices and overriding the impact of fundamentals.  Indeed, there is strongly contrary evidence.

Thus, although the empirical analysis in this paper is unobjectionable, the interpretation is contrary to the actual results and a reasonable reading of the economic and financial history of this period.  Indeed, the interpretation is so at odds with the data and history that the motives of the authors are open to serious question.  They jump on the anti-financialization, anti-HFT bandwagon even though (a) the actual data does not support that interpretation, and (b) other, quite opposed, interpretations are much more reasonable. Whenever there is a yawning gap between the most reasonable interpretation of an empirical analysis, and the interpretation that the authors advance, one may reasonably question the intellectual honesty of those interpretations.

And I do so question.

I therefore recommend examining the various graphs presented in the paper in light of an understanding of how the composition of economic shocks should affect correlations, and an understanding of what was happening during the sample period of the study.  I further recommend completely disregarding the Bicchetti-Maystre interpretation of their results, because it betrays no understanding of either the economics or the history.

The advocates of mandated OTC derivatives clearing insisted-insisted-that mandated clearing would simplify the market, and reduce dangerous interconnections between financial institutions.  The canonical illustration of this point was something like this, with the first diagram being the messy bilateral, pre-clearing mandate market, and the second being the neat and tidy clearing mandate market:

Uhm, not really. Not at all. These diagrams presume that the only interconnections between OTC derivatives users are via the derivatives markets themselves. In fact, derivatives users are connected via credit and liquidity support mechanisms as well, and the adoption of clearing which results in the unbundling of the credit and liquidity arrangements embedded in derivatives trades will lead to the forging of new connections that will make the post-mandate system as complicated and interconnected and fragile, and perhaps more complicated and interconnected and fragile, then it was before.

These interconnections are of different types.  Some are operational.  Consider this from an illuminating article in Wall Street & Technology:

A new swaps ecosystem needs to be established in order to enable central clearing. “You’re talking about a whole reinvention of the entire market,” says Henry Hunter, global head of product development at MarkitServ, a provider of middleware and online confirmation and affirmation services to the buy and sell sides in the derivatives space. “That’s a massive infrastructure change that is happening over a period of years.”

Wholesale reinventions always go well.  Always.  But it gets better:

“It’s a complicated mess,” says MarkitServ’s Hunter, who notes there could be as many as six different players involved in any trade — the client, the executing broker, an execution venue (i.e., the SEF), a CCP, a clearing member acting for the client, and possibly a clearing member acting for the dealer as well. “Managing that choreography can get complicated, so that’s where the middleware comes in.”

And the mess doesn’t stop there. Clearing brokers have the burden of modifying their electronic trading infrastructures and processing systems. According to Morgan Stanley’s Brock Arnason, executive director and global product manager for the Matrix platform, “The infrastructure that is required to support a clearing business is quite significant.” Clearing brokers must capture their clients’ voice and electronic trades and then run them through validation rules to determine clearing eligibility, he explains.

Think of all the operational linkages described in those short paragraphs.  Think of all the possible problems that can arise, particularly in stressed market conditions.  The financial system is a tightly coupled one as it is, and the rigid schedule on which clearing must work, to initiate trades, close them, and margin them, makes it all the more tightly coupled.  The choreography could very well go wrong, and is most likely to go wrong precisely at the most dangerous time.

In addition to the operational connections, there are financial connections, especially related to collateralization: I’ve written about this extensively on SWP, and in places like my recent J. Applied Corp. Fin. paper.  More from the WS&T article:

One of the most disruptive changes on the buy side under the new derivatives rules will be the need to manage margin calls from the clearinghouses on cleared swaps. “Some clients are going from never having to post initial margin to now always posting margin,” comments Morgan Stanley’s Swankoski. When clearing becomes mandatory, “All clients, big or small, are going to have to post initial margin on their cleared transactions.”

. . . .

To help buy-side firms complete this process, the clearing brokers are looking to provide collateral transformation services, according to Forkan. “They’re now building in services to ensure that organizations that post one type of asset can convert it into another type of asset,” he says. “That is a cost of clearing that the asset management community is going to have to bare. Given the huge investment that the banks have made in technology and infrastructure, they are keen to offer services that generate profit — it’s a large opportunity for the global banks to grab market share among the asset managers that need services.”

To reiterate, the advocates of clearing asserted that collateralization would reduce leverage in the system by preventing the bundling of credit in derivatives trades.  But as I’ve said repeatedly, this will just lead to the substitution of unbundled credit for the proscribed bundled leverage.  Collateral transformation is an example of this.  Moreover, this form of credit, when joined with the rigidity of the margining process for cleared transactions (and for non-cleared trades which Frankendodd requires to be marked-to-market on a daily basis), these new credit arrangements are likely to be more fragile than the bundled ones they replace.

In brief, there will continue to be a dense web of interconnections between market participants-the second diagram above is a very misleading of the post-Frankendodd world, which will continue to look like the first diagram.  Moreover, These interconnections are likely to be even more fragile.

And we’re not finished!  Another point that I’ve made for the past several years is also becoming increasingly recognized.  Namely, the breaking of netting sets will arguably lead to greater complexity, greater collateral demands, and potentially greater total risk exposures.

With respect to operational complexity:

Another big challenge for buy-side firms will be managing their existing bilateral OTC derivatives business alongside cleared swaps to gain a holistic picture of counterparty risk. Since not all trades will be required to be cleared, buy-side firms will have both a bilateral book of trades that they are still managing as well as daily collateral calls for the cleared book of swaps, says Omgeo’s Leveroni. “You will end up with a mixed clearing environment and operational complexity that you didn’t have before,” he cautions.

. . . .

“The buy side is going to struggle with having enough collateral to post for the book of business,” Leveroni says. “This is worrying a lot of people. You want to make sure you manage that collateral right, so you only send cash to the cleared call and you send the corporate bond to your bilateral call. You have to be smart in the collateral you send to each call. Those are the real risks to the buy side.”

With respect to increased needs for collateral, consider this from Matt Leising:

Derivatives users will face significant challenges to meet new collateral requirements as the trades are forced into clearinghouses, according to industry executives.

Investors have pledged about $200 billion to back futures trades around the world, Bill de Leon, a managing director at Pacific Investment Management Co., said today on a panel discussion at the Futures Industry Association annual conference in Boca Raton, Florida. That amount could be 10 times as large for the majority of trades in the $708 trillion over-the-counter derivatives market, he said.

“This is going to be one of the biggest challenges going forward,” said Jeffrey Jennings, the global head of listed derivatives at Credit Suisse AG. Exchanges such as CME Group Inc. (CME) are expanding the collateral they accept to allow corporate bonds to be pledged and are offering to reduce margin across assets like futures and interest-rate swaps. “That’s not going to be enough,” he said.

. . . .

Other plans by brokerages to offer to transform for their customers unacceptable margin into cash or U.S. Treasuries that are accepted by clearinghouses won’t solve the problem, and may add to risk during volatile times, said David Olsen, global head of OTC clearing for JPMorgan Chase & Co. (JPM)

“In my opinion, collateral transformation is really just a marketing term for repo,” he said. The collateral obtained from selling securities to garner cash or Treasuries in the repurchase market don’t fit many type of derivative users, such as pensions, that may have 30-year swaps they need to maintain, he said.

With respect to the fact that fragmentation of clearing across jurisdictions and instruments and the elimination of netting economies across cleared and non-cleared positions (a point I’ve made, as have Duffie-Zhu) consider this very readable paper by David Murphy.

It is not an exaggeration to say that every claim made by Frank, Dodd, Geithner, Gensler, and all the other clearing fanboys and fangirls around the world are extreme exaggerations at best, and often flatly wrong.  New vulnerabilities have been substituted for old.  New interconnections have supplanted those that prevailed in the bilateral world-and many of the new interconnections are more problematic.  Financing and liquidity and credit arrangements remain deeply meshed with derivatives transactions.  Mandated clearing eliminates some netting benefits, while creating others, and it is by no means clear that the mandates have reduced exposures.

The whole top down restructuring of the derivatives markets-which represent a complex, emergent order-does not lead to the replacement of a complex and sometimes chaotic system with a simple and ordered one.  It will result it a new complex system that will emerge in response to the new laws and regulations.  The regulations were motivated, in essence, by fears of the instabilities and non-linearities in the old order: but the new system will have its own instabilities and non-linearities. Indeed, I believe that a mandated, top-down attempt to impose a new order is likely to result in a less supple, more rigid, and less stable system than the (imperfect and sometimes unstable) one it is intended to supplant.

An analogy that comes to mind is the Corps of Engineers.  For decades the Corps has intended to impose order on a complex system of rivers.  The results have been less than happy.  The imposed order has too often proved illusory, and attempts to control the system have resulted in an increased likelihood of catastrophic floods and the destruction of valuable natural ecosystems. Attempts to control complex systems are usually futile, and tend to result in the replacement of more frequent small crises with a few mega-crises (this is a point also made by Taleb and Bookstaber).

In this regard it is always useful to remember Hayek’s warning about the illusion of control: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” Chris and Barney and Timmy! and Gary think they know a lot more than they really do.  They see like a state (to use James Scott’s phrase), and as Scott shows, these attempts to re-engineer complex systems from above almost always end in grief.

But as the continued existence and persistence of the Corps of Engineers shows, the illusion of control and the faith that top-down re-engineering of complex systems can work is enduring.  The idea is hard to kill, and ironically, its failures often lead to demands for more and more and more control.  I expect, alas, that this will be the case in the derivatives markets.

The Li(e)for investigation is metastasizing at an incredible place.  Both Bloomberg and FT have run long pieces on the problems with the rate-setting mechanism, and how to fix them.  Investigations (10, according to FT) are proceeding around the world, in the US, UK, Europe, Japan, Canada, and Singapore.  There is a criminal investigation in the US.  Numerous banks are scurrying to cooperate in the hopes of receiving leniency-the prisoner’s dilemma in action.

Some of the reporting is confusing.  There are at least two different motives for the alleged misstatements, one likely being more legally fraught for the banks.  The first motive is that during the throes of the crisis, banks had an incentive to misreport the rates at which they could borrow unsecured in order to avoid the perception that they were on the brink.  The other motive is that traders wanted to influence LIBOR in order to advantage derivatives positions tied to LIBOR-the latter likely presents the banks and individual traders  with far more acute legal problems.

Then there remains the issue of what to do about it.  The most obvious remedy is to base LIBOR on actually borrowing transactions, in the same way as is done with EONIA and SONIA overnight (hence the “ON”) borrowings.  This is a reprise of the data hub idea I advocated for energy trades back in 2003(!).

There is pushback against this idea, however.  One argument is that particularly during times of stress only a few banks are actually able to borrow unsecured for 3, 6, or 12 months, so the rate would be based on transactions from a small set of institutions.

I don’t get this objection, frankly.  So it’s better to base the most important reference rates in the world on what banks that cannot borrow unsecured say they could borrow at, than to base it on the rates that banks that actually do borrow unsecured pay?  Really? The first alternative is an oxymoron.  The second might result in rates from only a few banks being used, but far, far better to base an index that is supposed to reflect the actual cost of unsecured borrowing (by those able to do it) as represented by real transactions then to use the oxymoronic fantasy rates of those who can’t do it.

And if nobody can borrow unsecured in any volume-that’s important information in and of itself.  That raises the question of the advisability of basing so many derivatives contracts on something that has an appreciable probability of not existing from time to time. Better to recognize reality than MSU and pretend it’s real.

Here’s a thought: BBA could continue to report a LIBOR based on the traditional methodology, but just modify its name to LIBORGIGO. Truth in advertising, dontcha know.

This raises a broader point.  Cash settlement is often raised as a panacea for contract design.  Delivery-settled contracts have problems-so go to cash settlement! But as I’ve argued since 1990, in many markets cash settlement is problematic due to the opacity of cash markets, and/or the absence of cash market transactions.  Cash settlement works where there is a liquid and vibrant and transparent cash market (e.g., S&P500 stock index futures) or centralized collection of cash transactions prices (e.g., live hogs).  Everywhere else, problematic indeed.

LIBOR is the most pronounced example of that today.  Natural gas was so in the late-90s and early-00s.  Right now, the Platts’ methods for oil price assessments are under considerable scrutiny.  Market participants have always been skeptical (though they often mute their criticism given Platts’s heft), but IOSCO has issued a very critical and questioning appraisal, and raises the question of whether further regulation is necessary.

It’s deja vu all over again, folks.  Been there, done that.  Went through all these issues with the energy data hub in ’03.  I can show you the scars.  I can tell you some stories (e.g., the trade group guy who asked me what it would take to get me to back off with my proposal.)

The fundamental problems are that cash settlement is hard if there aren’t, well, a lot of cash transactions going on.  Even if there are a decent number of cash trades, that doesn’t help if people don’t report.  Given the public good nature of more informative price indices, there are under-incentives to report.  Indeed, it can be worse than that: reporting can be a private bad.

This raises a justification for mandatory reporting, and that is actually one of the defensible parts of Frankendodd.  That can’t fix the problem of a lack of transactions, but it can make the most of the transactions that are there.

But this also points out the value of delivery-settled derivatives.  The ability to make delivery  gives market participants the opportunity to put their money where their mouths are in a way that is impossible with cash settlement, especially cash settlement based on self-reported prices and assessments. Even if delivery doesn’t occur all that much, the ability to make delivery keeps prices honest (noting, of course, that the delivery mechanism can be abused, but further noting that’s a problem that can be addressed by appropriate anti-corner measures.)

Gazprom is having difficulty making inroads into Asia generally, and into the LNG market particularly.  Its problem?  Apparently so used to dealing with Europeans who have few outside options (yet), the company is incapable of operating in a competitive environment.  It is fixated on maintaining its traditional oil-linked pricing formula, despite the facts that (a) in the US natural gas prices on an energy equivalent basis have fallen to an all time record low vis-a-vis oil, and (b) US firms, notably the Cheniere Energy* mentioned in the Bloomberg piece, are gearing up to export LNG, particularly to Asia, making the US the likely supplier of the marginal mmbtu of gas, and hence making it the world price setter:

OAO Gazprom (GAZP), the world’s largest natural-gas exporter, is struggling to get a foothold in the Asian markets leading global economic growth.

The Russian company’s plan to supply liquefied natural gas to India from 2016, the year the U.S. is set to start gas exports, is faltering after buyers said they’re looking for cheaper fuel from North America. Last year, decade-long talks to supply pipeline gas to China foundered over price disagreements.

“Gazprom has a major problem of having a fixed view on what the price of gas should be, irrespective of market conditions,”Jonathan Stern, chairman and senior research fellow at the Oxford Institute for Energy Studies, said by e- mail. “If this continues, it will create increasing problems for Russian gas exports.”

“Irrespective of market conditions.”  Yup.  That’s the Gazprom way, and that way doesn’t work when it’s not the market.   In contrast, Cheniere is linking LNG prices to US natty gas prices:

GAIL India Ltd. (GAIL), the country’s largest gas supplier, became the first Asian buyer of U.S. natural gas in December when it signed a 20-year deal with Cheniere Energy Partners LP (CQP), which is planning the first U.S. export terminal. The contract, targeting 3.5 million tons a year starting in 2017, is linked to the day- to-day U.S. benchmark gas prices, which fell to a 10-year low of $2.21 a million British thermal units in January. It will also include a fixed component.

Note that this also permits companies like GAIL to lock in a fixed price fairly easily, given its ability to use derivatives to swap floating prices into fixed ones.  (The fixed component in the formula mentioned above covers liquification and transportation costs.)

Gazprom is a hidebound organization, grotesquely inefficient, notoriously corrupt, and unused to and arguably incapable of operating in truly competitive conditions.  It has a guaranteed monopsony at the upstream end (being the only company permitted to export Russian gas) and has traditionally sold in markets downstream where there is little, and often no, competition from other sellers.

Its disconnect from commercial reality grows with every widening of the difference between gas and oil prices.  It can insist on its self-serving formula, but as the US becomes a major exporter of gas-as fundamentals imply that it should be-its insistence will make it an also ran in the LNG market.

Right now, Gazprom’s biggest hope is that political resistance to gas exports in the US lead to bans or limitations on those exports, or the approvals and permitting for export terminals getting bogged down in the American bureaucracy.  Usual Suspect Ed Markey (D-MA) has introduced a bill to ban gas exports.  This will not go anywhere, but it does give edgy Asian buyers pause.  In the aftermath of Keystone XL, moreover, it is clear that failure to secure regulatory approvals can delay or derail altogether extremely beneficial energy initiatives.

Ironic, isn’t it, that Gazprom’s biggest hopes may be in DC: The White House, Capitol Hill, and FERC (which is responsible for permitting LNG export facilities)?

* Full disclosure: #1 daughter works for Cheniere. Any reader of this blog knows, however, that my criticism (ridicule, really) of Gazprom and my commitment to free trade long pre-date her employment there.

In a cri du coeur published in the New York Times, resigning Goldman executive director Greg Smith claims that the firm “sidelines” the interests of its clients “in the way it operates and thinks about making money“:

Integrity? It is eroding. I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact.

Smith also claims that this wasn’t the case when he joined the firm 12 years ago, when apparently Goldman was all about helping little old ladies cross the street and rescuing kittens stuck in trees.  The firm’s dastardly turn is all the doing of Lloyd Blankfein and Gary Cohn.

Please. Goldman is, for the most part, what Goldman was. If you want a look at the firm’s “moral fiber” pre-2000, pre-Blankfein & Cohn, review the history of LTCM’s collapse.  The teetering hedge fund came to Goldman for help.  Goldman said it had to review LTCM’s books first, which LTCM in its desperation  permitted-only to have Goldman trade against every position in that book.

When dealing with any investment bank, and Goldman in particular, caveat emptor is the only rule to follow.  And it always has been.

My surmise is that Smith’s perception that things have changed is a very solipsistic one.  As he’s progressed up the organization-rapidly, to a very high position-he’s privy to things now that he wasn’t as a doe-eyed intern. What he’s seen has changed not because what is to be seen has changed: just that he wasn’t in a position to see it before.

What’s amazing is that an obviously very smart guy wouldn’t consider that possibility.  What’s even more amazing is the credulousness of the financial press in its reaction to Smith’s piece.  It’s obvious they haven’t thought of that possibility either.

Bart Chilton has been fairly quiet recently, but today he made news twice, with two completely contradictory statements.

First, he bemoaned the lawsuits challenging the CFTC’s ability to quantify the costs and benefits of its regulations-as required by Congress:

“Some regulators live in constant fear and are virtually paralyzed by the threat” that they will face “spuriously” filed suits alleging that the costs and benefits of their rules weren’t adequately considered, Chilton said in a speech prepared for the Trade Tech 2012 conference today in New York. “It is a bastardization of the conduct and use of cost-benefit analyses in regulatory rulemaking.”

. . . .

Chilton, a supporter of the speculation limits, said banks and others should be required to provide cost analyses to rebut regulators’ conclusions.

“We put out a proposal, ask for comments and ask what the costs might be,” Chilton said. “Then we either aren’t provided with costs of the regulation, or what we get from the commenters isn’t very helpful.”

Well, if the CFTC could accurately quantify costs and benefits, (a) it wouldn’t need help from the banks to provide cost/benefit analyses, and (b) it wouldn’t have to fear lawsuits claiming it hadn’t performed an adequate analysis.  Eliding over the issue of burden of proof-which Congress has clearly placed on the agency by statute, not on those subject to the rules as Chilton would like it-this is a clear confession that the CFTC is incapable of performing a rigorous analysis that would persuade a court: if it was confident in its ability to do so, why the paralysis.

But on the same day (and I think the same event) Chilton quantified the effects of “excessive speculation” on energy prices to the penny.  Seriously:

Today, Chilton is expected to tell the traders that the “speculative premium” on oil adds 56 cents to every gallon of gas, which he calls “an enormous drain” on businesses. Chilton has previously said oil speculation costs every consumer up to $757 extra a year.

Not 55 cents.  Not 54 cents.  56.  Not $756 dollars/year.  Not $758.  $757.

And Bart can give very precise industry breakdowns of the impact:

Runaway oil speculation is costing the airline and trucking industries $39 billion a year in added expenses, according to new data to be released today.

The airline sector alone could save as much as $9.8 billion annually if Wall Street speculation is curbed, Commissioner Bart Chilton of the Commodity Futures Trading Commission is expected to announce today.

The trucking industry stands to save even more, as much as $29.1 billion a year, according to Chilton, who will reveal the data in a speech before a group of traders at the Javits Center.

I have no clue how Bart calculated these numbers.  (I suspect he has no clue either.  A little more than “suspect”, actually.)  But apparently he believes he can calculate the impacts of speculation with considerable precision, and since there is no way the costs of complying with the regulation could run into the mid-11 figure per year range, it follows immediately that Bart should have no problem convincing any court in the land that the benefits of the regulation exceed the cost.

So why doesn’t he?  So why are he and his fellow commissioners “paralyzed” by the prospect of providing the cost benefit analysis?

The easy answer is that Chilton is almost certainly MSU (making stuff up–trying to keep it clean tonight, folks) regarding the impact of speculation.  I am very familiar with the literature, and the available methods.  Such accurate quantification is impossible, and no reputable method has produced such numbers.

So when is Bart BS-ing? When he says it is impossible to quantify the benefits and costs of the position limit rule?  Or when he says he can–to the penny?

The answer cannot be “neither.” It’s one or the other.  Smart money answer: he can’t really quantify, which is why he doesn’t want the CFTC to be forced to do so.

Which raises another point.  The CFTC position limit rule’s cost benefit analysis, such as it is, repeatedly says that Congress has decided that position limits are necessary, and that as a result the benefits of the rule are presumed to exist.  But Congress has also decided that cost-benefit analysis is required.  The commission doesn’t really have the ability to choose which Congressional directives it must follow, does it? And wouldn’t the cost-benefit analysis requirement be superfluous if Congress had already decided that the benefits exceeded the costs, as the position limit rule repeatedly argues?  So doesn’t that undermine the commission’s argument?

Full disclosure: I filed a declaration on behalf of ISDA  and SIFMA in what Chilton believes to be the “spurious” lawsuit challenging the position limit rule. But as anyone who has read this blog knows, or who has read some of my other writing knows, I have long been critical of claims that speculation distorts prices, and of position limits.

The material from Book IV, Chapter 5 of Wealth of Nations is quite interesting, and applicable to today’s debate over speculation.  In this regard it is useful to distinguish between financial speculation and what is sometimes referred to as “speculative storage.”  Financial speculation is what often gets people’s jockeys in a bunch, but unless these financial speculators are somehow affecting quantities produced or consumed–by distorting prices in ways that induce distortions in storage, for instance–this activity will not affect the prices that consumers pay or producers receive.  Financial speculators deal in price risk, and affect the price of that risk first and foremost. (These statements are a little overbroad: I refine the analysis a bit below.)

What Smith discusses in IV.5 is speculative storage.  People holding inventories of commodities in anticipation of future market conditions.

Such storage decisions are inherently speculative, in the sense that they are based on expectations about future market conditions.  That’s what storage is all about-and what my book on structural models of commodity prices is all about.  Based on noisy signals, market participants try to determine whether the commodity is going to be more scarce in the future than it is at the present.  If so, it is optimal to add to inventories because the commodity is going to be more valuable in the future.  If not, it is optimal to draw down on inventories.

Since these decisions are necessarily based on conjectures about future fundamental conditions, there is a natural role for speculation: taking risky positions in the expectation of earning a profit, based on current information.

If a speculator is correct, he can make large profits.  A speculator who anticipates that the next crop will be small will add to inventory, and if he is right, can sell that inventory at a high price when the crop is harvested and the shortage revealed.  And note that his actions are beneficial: yes, he sells at a high price, but the price would have been higher still had he not added to the speculative inventory in anticipation of the future shortage.  Further note that his actions do raise prices at the time he adds to inventory: if he doesn’t those bushels would be sold and consumed, and the price today (prior to the harvest) would be lower than they are when he holds them off the market (in Smith’s terms, “forestalls” or “engrosses’.)

Of course the speculators are not always right.  They are working on limited information, and things can change over time-think of how decisions made in June of 2008 looked in October of that year.  But this means that speculators have an incentive to collect information to allow them to make better decisions.  Moreover, purely financial speculators that collect information and trade on it (such as by trading calendar spreads) can contribute to price discovery that leads to better inventory decisions.  And as I’ve shown in some of my academic work (some currently in progress) financial speculators can reduce the cost of inventory by absorbing price risk from inventory holders, leading to an efficient unbundling of the functions of making inventory decisions and holding inventory on the one hand, and bearing the price risk of inventory on the other.  (Smith makes a similar point, related to the allocation of capital rather than risk, at IV.5.55-56.)

Smith recognizes the benefits of this intertemporal trade, undertaken by speculators:

Secondly, it supposes that there is a certain price at which corn is likely to be forestalled, that is, bought up in order to be sold again soon after in the same market, so as to hurt the people. But if a merchant ever buys up corn, either going to a particular market or in a particular market, in order to sell it again soon after in the same market, it must be because he judges that the market cannot be so liberally supplied through the whole season as upon that particular occasion, and that the price, therefore, must soon rise. If he judges wrong in this, and if the price does not rise, he not only loses the whole profit of the stock which he employs in this manner, but a part of the stock itself, by the expence and loss which necessarily attend*79 the storing and keeping of corn. He hurts himself, therefore, much more essentially than he can hurt even the particular people whom he may hinder from supplying themselves upon that particular market day, because they may afterwards supply themselves just as cheap upon any other market day. If he judges right, instead of hurting the great body of the people, he renders them a most important service. By making them feel the inconveniencies of a dearth somewhat earlier than they otherwise might do, he prevents their feeling them afterwards so severely as they certainly would do, if the cheapness of price encouraged them to consume faster than suited the real scarcity of the season. When the scarcity is real, the best thing that can be done for the people is to divide the inconveniencies of it as equally as possible through all the different months, and weeks, and days of the year. The interest of the corn merchant makes him study to do this as exactly as he can: and as no other person can have either the same interest, or the same knowledge, or the same abilities to do it so exactly as he, this most important operation of commerce ought to be trusted entirely to him; or, in other words, the corn trade, so far at least as concerns the supply of the home market, ought to be left perfectly free.

Let me emphasize this part:

When the scarcity is real, the best thing that can be done for the people is to divide the inconveniencies of it as equally as possible through all the different months, and weeks, and days of the year. The interest of the corn merchant makes him study to do this as exactly as he can: and as no other person can have either the same interest, or the same knowledge, or the same abilities to do it so exactly as he, this most important operation of commerce ought to be trusted entirely to him; or, in other words, the corn trade, so far at least as concerns the supply of the home market, ought to be left perfectly free.

Exactly. (See also IV.5.42.)

Smith also understood that attempts to control this type of speculation, in particular by limiting price increases during times of dearth, were extremely counterproductive:

When the government, in order to remedy the inconveniences of a dearth, orders all the dealers to sell their corn at what it supposes a reasonable price, it either hinders them from bringing it to market, which may sometimes produce a famine even in the beginning of the season; or if they bring it thither, it enables the people, and thereby encourages them to consume it so fast as must necessarily produce a famine before the end of the season. The unlimited, unrestrained freedom of the corn trade, as it is the only effectual preventative of the miseries of a famine, so it is the best palliative of the inconveniences of a dearth; for the inconveniences of a real scarcity cannot be remedied, they can only be palliated. No trade deserves more the full protection of the law, and no trade requires it so much, because no trade is so much exposed to popular odium.

But Smith also understood the political economy of the situation:

In years of scarcity the inferior ranks of people impute their distress to the avarice of the corn merchant, who becomes the object of their hatred and indignation. Instead of making profit upon such occasions, therefore, he is often in danger of being utterly ruined, and of having his magazines plundered and destroyed by their violence. It is in years of scarcity, however, when prices are high, that the corn merchant expects to make his principal profit. He is generally in contract with some farmers to furnish him for a certain number of years with a certain quantity of corn at a certain price. This contract price is settled according to what is supposed to be the moderate and reasonable, that is, the ordinary or average price, which before the late years of scarcity was commonly about eight-and-twenty shillings for the quarter of wheat, and for that of other grain in proportion. In years of scarcity, therefore, the corn merchant buys a great part of his corn for the ordinary price, and sells it for a much higher. That this extraordinary profit, however, is no more than sufficient to put his trade upon a fair level with other trades, and to compensate the many losses which he sustains upon other occasions, both from the perishable nature of the commodity itself, and from the frequent and unforeseen fluctuations of its price, seems evident enough, from this single circumstance, that great fortunes are as seldom made in this as in any other trade. The popular odium, however, which attends it in years of scarcity, the only years in which it can be very profitable, renders people of character and fortune averse to enter into it. It is abandoned to an inferior set of dealers; and millers, bakers, mealmen, and meal factors, together with a number of wretched hucksters, are almost the only middle people that, in the home market, come between the grower and the consumer.

The ancient policy of Europe, instead of discountenancing this popular odium against a trade so beneficial to the public, seems, on the contrary, to have authorized and encouraged it.

And as we see over and over again, it is not just the ancient policy of Europe, but the modern policy of the US-or at least it would be if many politicians were to get their way.

This discussion is useful in making a valuable distinction.  It is wrong to say that speculators don’t affect prices: competitive, efficient speculation does affect prices by ensuring that information about future and current fundamental conditions is reflected in inventory decisions, and hence consumption and production decisions: this necessarily affects prices.  But as Smith notes, these price effects lead to a more efficient utilization of the commodity over time, in a way that actually alleviates the most acute shortages-shortages that would be even worse if speculative storage were constrained in some way.

That’s different from saying that speculation distorts prices: affecting prices and distorting them are two very different things.

Moreover, these price effects can be different from those of purely financial speculation, e.g., spread trading by hedge funds, although this trading can (as noted above) affect in a beneficial way inventory decisions through both an information channel and a risk allocation channel.

Finally, since speculative storage requires financing of inventory, it is often efficient for banks or other financial institutions to engage in it as they are often incur the lowest cost of financing: witness the large speculative storage of oil by big banks (e.g., Morgan Stanley) at the depths of the financial crisis.  Financial/capital markets and financial institutions are all about the movement of resources over time: storage is just the movement of resources over time too, so there can be a natural complementarity between finance and storage. This last issue is evidently a source of policy controversy involving the Federal Reserve and large banks that it regulates.  More on this soon.  It is fascinating on many levels.

One other policy issue.  Smith’s concern  about the perverse effects of price ceilings during periods of shortage is the most defensible rationale of government storage programs, like the SPR.  If the government cannot precommit to let prices clear the market during periods of shortage, there will be an insufficient incentive for private, speculative storage, especially since as Smith notes it is selling into these spikes that is most remunerative to inventory holders.  Government storage programs can be a second best response to its inability to precommit not to screw things up.  This raises questions about how the government storage program should operate: again, I hope to post on that soon.  Hint: SPR doesn’t appear to be operated in the efficient way.

In a post earlier this evening, I said that anti-speculation frenzies dated from the 19th century.  But they in fact date back much further. In Book IV, Ch. 5 of Wealth of Nations, Adam Smith analyzed the irrational attacks on commodity speculation:

The popular fear of engrossing and forestalling [types of speculative activity outlawed in England] may be compared to the popular terrors and suspicions of witchcraft. The unfortunate wretches accused of this latter crime were not more innocent of the misfortunes imputed to them than those who have been accused of the former. The law which put an end to all prosecutions against witchcraft, which put it out of any man’s power to gratify his own malice by accusing his neighbour of that imaginary crime, seems effectually to have put an end to those fears and suspicions by taking away the great cause which encouraged and supported them. The law which should restore entire freedom to the inland trade of corn would probably prove as effectual to put an end to the popular fears of engrossing and forestalling.

Sadly, I think that Smith’s belief that legalizing speculation would end attacks against it is quaint, but wrong.  Indeed, it appears that the reverse is true: popular terrors and fears-stoked by opportunistic politicians eager to divert blame for high prices to others-lead to attempts to restrict speculation.

But Smith’s analysis of the counterproductive effects of these restrictions does stand the test of time.  It is worth a read.

Reprising his role as Captain Renault, Obama has order Attorney General Holder to “reconstitute” the oil and gas task force in order to round up the usual suspects: oil speculators.  You know, the one he constituted (I guess) last April.  Yeah. That one.  The one that found so much evidence that speculation had distorted prices.  Just like the numerous other FTC investigations that had turned up zero, zip, nada during previous gasoline price spikes.

In other stunning news, 70 nitwit senators and representatives (but I repeat myself) sent off a letter demanding the CFTC “immediately enact strong position limits to eliminate excessive oil speculation.” Apparently they don’t have newspapers, TV, or internet in DC, because these Einsteins and their myriad staffers overlook the fact that the CFTC passed a position limit rule almost 5 months ago–18 October, 2011, to be exact.  But never let the facts get in the way of an opportunity to strike an indignant pose. (I won’t even bother to ask these geniuses to present a coherent explanation of how speculation distorts prices, or how position limits will eliminate these putative distortions. To them, limits are some sort of talisman.)

As I’ve said repeatedly, these anti-speculator frenzies are a hardy perennial, dating well back into the 19th century.  Prices go up, prices go down-blame it on the speculators. They are a convenient whipping boy for poseur politicians (again, apologies for the redundancy).

And as I’ve also said before: no theory, and no evidence. (And no, Bernie, quoting the Saudis doesn’t count as “evidence”.) But I’ve long since given up any expectation of seriousness about energy.  Demonizing speculators is all to easy, and all to successful, and hence appeals to the lazy demagogues who infest DC.

Well, at least Claude Rains was acting.  I sometimes wonder whether Obama, Sanders, Levin, Pelosi, and on and on are. And I honestly don’t know whether it would be worse if they were, or if they weren’t.

The first post I wrote on SWP related to the pricing of message traffic on electronic trading systems. This has become a major issue in the debate over HFT, with (as I noted last week), the SEC musing about impose by regulatory fiat pricing schemes that would penalize cancellations.

But as Jeremy Grant notes in a couple of articles in the FT, exchanges are already implementing pricing schemes to deal with “stupid algos”-and I would argue, “evil algos” too. There is a process of market experimentation going on, with some disagreement among exchanges. Deutsche Borse is considering a pricing scheme similar to that the SEC is considering-imposing a tax on all cancellations above some level. ICE has criticized this idea, arguing that such a scheme does not discriminate between “good” cancellations and “bad” ones: that was my objection to the SEC idea. Instead, ICE assess charges for cancellations based on how far the orders are away from the inside market. Orders close to the inside bid-ask are more likely to be liquidity enhancing, and less likely to be opportunistic efforts to clog the exchange systems. This is far more discriminating approach.

But there is a bigger point here: who should be making these decisions, exchanges or regulators? A strong case can be made for the former.  Exchanges internalize many, and arguably most, of the costs and benefits.  Opportunistic algos reduce the derived demand for exchange services, costing the exchange money.  Good algos that contribute to liquidity increase the derived demand for exchange services, making the exchange money.  Exchanges have an incentive to get the pricing right to encourage the good and discourage the bad, and moreover are likely to have better information, and to be less susceptible to rent seeking influence activities, than government regulators.

Different exchanges engage in different experiments on pricing.  This contributes to a discovery process that is likely to reach an efficient outcome than the process that legislatures and regulators use to set prices and procedures.  Exchanges that develop effective pricing policies gain imitators: those that don’t, lose business.

Yes, it is possible that there are externalities that exchanges don’t take into consideration.  But only fools believe that regulators can understand, quantify, and correct these externalities.  Indeed, the process by which regulators internalize such effects is often highly distorted and inefficient, due to constraints on information and public choice problems.

Exchanges are clearly aware of the relevant issues, are highly motivated to address them in a discriminating and effective way, and are in fact trying to do just that.