Streetwise Professor

My daughter Renee’s article, “Commodity Regulation After the Financial Crisis”, was just published in Economic Affairs.  Quite appropriately, the article immediately preceding hers is John Cochrane’s “How Did Paul Krugman Get It So Wrong?”  How much time do you have, John?  Actually, the Cochrane article is a very good read, and resonates with a lot that I wrote during the crisis and the debate over the stimulus.  But Renee’s article is a better read, of course!

Congratulations, R.  First of many!

I’m in London for a conference at the LSE. Here with the family, and we’ve seen most of the typical sites (it’s my family’s first time in the city).

The highlight for me, however, was watching the ring trading at the London Metal Exchange. (Yes.  You don’t need to tell me.  I know I’m weird.)  Very interesting.  Each metal trades for five minutes–in theory.  In reality, there is desultory bidding and offering until the last 30-45 seconds of the 5 minute period, at which time trading really picks up.  A visual illustration of volume clustering.  Although it is face-to-face open outcry trading, it is very different than Chicago.  It is more like a sequence of call auctions, rather than a true continuous auction.  Moreover, the trading crowd is small–there were 15 people in the ring, and about twice that many clustering around it.  I’m glad I could see it, after having worked with LME data and studied metals rather extensively for about 18 years (yikes!)

Thanks to Allan Schoenberg for helping to set things up, and special thanks to Miriam Heywood at the LME for giving us the tour.

I cannot recall a situation where a US Secretary of the Treasury, or any cabinet member, for that matter, has been the subject of such scathing rebuttals as Timothy Geithner.  The disdain that his lectures on derivatives regulation unleashed is pretty amazing.  It was not respectful disagreement.  It was disrespectful disagreement.  And not from anonymous sources, but from named representatives of government and industry bodies.  Nor is this a new thing.  The Chinese and German Finance Minister Wolfgang Schaeuble, to name but two, have been brutal in their criticisms of Geithner.

This makes it all the more curious to read in the WaPo piece that I linked to yesterday that Geithner has a very close relationship with Obama, arguably the closest relationship of all the cabinet members.  But perhaps that’s not so curious after all: for all his rhetoric about rebuilding relationships with other nations, Obama apparently has a very poor relationship with the leaders of most other countries–worse relationships than Bush.  This suggests that Obama, a notoriously aloof individual, doesn’t really care about what them furriners think.  And as the foreign criticism of Geithner demonstrates, I think those feelings are reciprocated.

Timmy!, the addressee in a WaPo love letter (h/t R) isn’t feeling the love from outside the 202.  Timmy! lectured—or should I say hectored—the world on derivatives, saying, for all intents and purposes, our way or the highway.

To say this went over like the proverbial, uhm, lead balloon would be the understatement of the year.  The Singapore Monetary Authority and the Hong Kong Monetary authority took umbrage at Geithner’s implication that they were lax regulators.  The CEO of the Futures and Options Association, Anthony Belchambers, was quite biting in his reply:

US Secretary Geithner’s comments do not appear to take any account of the fact that the SEC, arguably, was an equally tragic failure – and by a regulatory authority that was notably “heavy touch” but also in some areas “no touch”!

Ouch!  Can you say “Bernie Madoff”?  I knew you could.

Martin Wheatley, who is leaving his position as the head regulator in Hong Kong to take up the leadership of the UK’s Consumer Protection and Markets Authority (eat your heart out, Elizabeth Warren!) was equally scathing.  More so, actually:

US Treasury secretary Tim Geithner was talking “nonsense” when he warned that the world must follow America’s lead on financial regulation, according to a senior European regulator and outgoing head of Hong Kong’s market watchdog.

“To suggest that the US sets a gold standard that other markets should follow is nonsense,” said Mr Wheatley, speaking on the last day of his six-year stint as head of Hong Kong’s Securities and Futures Commission.

That’s gonna leave a mark.

I guess this is what they call smart financial diplomacy.  It’s having about the same effect as the administration’s “smart diplomacy” more generally.  Which is not a good thing.  International coordination on derivatives and other aspects of financial regulation, but US browbeating will not facilitate this coordination.  The opposite effect is more likely, and all of the WaPo puff pieces in the world won’t make any difference.

Reading the BIS paper I just posted about brought to mind an issue that I think is of paramount importance, but which has been almost completely overlooked.  Like many other analyses of the effects of clearing mandates and rules relating to derivatives, the focus has been on providing mechanisms to reduce the likelihood of default on derivatives positions.  The idea is that losses on derivatives positions can be a channel of contagion between important financial institutions.  So to address this problem, legislators and regulators want to raise collateral requirements and other requirements to ensure that non-defaulting derivatives counterparties receive all that they are owed when a firm defaults.

But focusing on derivatives alone is dangerous.  All of the measures intended to increase the safety of derivatives markets–increasing collateralization, multi-lateral netting, etc.–privileges derivatives and derivatives counterparties.  But that privileging comes at the expense of other claimants of a bankrupt firm.  Let’s say that without greater collateralization and netting, derivatives counterparties would have lost X, but with the greater collateralization and netting, they lose 0.  Sounds great: there is no possibility of derivatives losses cascading from firm to firm.  But not so fast: what means, to a first approximation* is that now somebody else loses X more than they did under the previous rules.  In other words, the loss of X has been shifted from the derivatives counterparties to somebody else. There can still be contagion—just via a different channel.

There is something of a debate about the priority of derivatives in bankruptcy.  Mark Roe has questioned this priority privileging.  I’m in London for a conference at the LSE, and one of the conference papers, by Patrick Bolton and Martin Oehmke, also questions privileging derivatives.  I’m not sold on the specific Roe-Boton-Oehmke arguments because I think they don’t see the whole picture, but I do think it is a very important issue.

It is a particularly important issue in the context of the ongoing regulatory debate because all of the rules intended to reduce the likelihood of derivatives defaults effectively increase the priority of derivatives.  Which means that they reduce the priority of other claimants.  That’s not obviously a good thing.  But since the regulators and legislators have failed to look at the problem holistically, instead focusing on derivatives in isolation without seriously questioning how the changes in derivatives rules will primarily shift risk rather than reduce it, whether it is a good thing or not has escaped attention completely.

A couple of analogies come to mind.  One is target fixation.  Many fighter pilots become so focused on the target they are chasing that they fail to see the guy that just jumped their six and is about to shoot them down.  Being fixated on the derivatives target, regulators and legislators are unaware that they are shifting risks elsewhere—risks that may very well jump them of the future while they are still fixated on derivatives.

Another is levees.  Building up a levee around a particular city protects that city, yes, but the rising water has to go somewhere.  So raising the levees in one place makes the flooding problem worse somewhere else.  Legislators and regulators seem obsessed with raising the levees around Derivatives City, without regard as to how this will affect where the water goes and who gets flooded–Commercial Paper Town and Moneymarketville, for instance.  It could well be the case that keeping Derivatives City high and dry results in even more devastating flooding in other, less privileged precincts.

The Corps of Engineers has created many problems in the past with its attempts to control the Mississippi and Missouri Rivers through its efforts to control floods: there is a very real risk that a (metaphorical) Corps of Financial Engineers will also create havoc despite its intention to do good.

There are of course differences.  A river system is more mechanical than a financial system.  But that actually makes the situation more fraught in financial markets.  Market participants will respond to the privileging of one class of claim—such as derivatives—by adjusting their behavior, by adjusting what they trade, their capital structures, etc.

But maybe it’s not that different.  The design of the levee system will affect where people build and how they build.  Designing the levee system properly requires just that—a systemic approach, not an approach focused on just one part of the system, but its entirety; and an approach that takes into account how people will respond to the design of the levee system.  Unfortunately, that’s not the way that it’s being done in the derivatives markets.  The history of the Mississippi River valley suggests that’s not an encouraging thing.

* As I discuss below, this privileging will affect decisions people make, and thus the amount of risk.  That means the problem is even more complex than what I consider here.  But that only makes the derivatives-centric focus of regulators and legislators even more dangerous.

Bart Chilton, apparently all knowing, has decided that the priority rules that exchanges have chosen are all wrong, and need to be changed.  In his continuing war on high frequency trading (not to be confused with his war on commodity speculation), he has condemned size priority rules.  He claims that these give “cheetah” (stop it Bart!  You’re killing me with your clever repartee) traders that can move faster than others an unfair advantage that they use to game the markets.

Any centralized trading mechanism has to have priority rules—rules that determine the sequence in which orders are filled.  Price priority—the highest bid and higher offer get executed first—is universal, but secondary priority rules are needed to break ties between bids and offers at the same price.  Different secondary priority rules are possible.  A common one is first-come-first-served.  This is called time priority, giving the earlier orders at a given price priority in execution over ones entered later.  Another secondary rule may give some priority to designated market makers.  Still another is size priority, which gives bigger orders preference over smaller ones.  There can also be hybrid rules which use time, market maker status, and size to allocate trades between quotes entered at a given price.

Each priority rule provides different incentives.  There is no obvious “best” rule: every alternative involves trade-offs.  Chilton apparently believes that time priority is best, and that size priority is unfair.  But he provides zero, zip, nada in terms of an analysis of the trade-offs involved.

Size priority, no surprise, gives an incentive to quote in size.  This can be very beneficial, as it means that big market orders can be accommodated more readily without large price movements.  This can be important in markets in which liquditiy demanders desire to trade in size—which is the case, and increasingly so.  For somebody worried about flash crashes, you’d think this would be a virtue.

Exchanges internalize many—perhaps not necessarily all, but many—of the costs and benefits of alternative secondary priority rules.  Whether they are competing, or monopolists, exchanges that choose priority rules that result in the creation of the amount and type of liquidity that is preferred by most traders in the marketplace generate more volume and can charge higher fees and can make more money.

A coherent objection to exchange choices would require some sort of demonstration that there is an externality resulting from these choices.  Chilton, to belabor the obvious, does no such thing.

Chilton says that high frequency traders program their algorithms to optimize results given the secondary priority rule.  Really?  Wow.  Who knew?  But that would be true regardless of the rule.  If exchanges went with strict time priority, the HFTs would adjust their algos accordingly—and those with the fastest connections and best programmers would win.  The algorithms would be different, but odds are that the winners and losers would be the same.

It is particularly strange that Chilton simultaneously objects to size priority rules and HFT in which the fastest algos win.  Under time priority, speed (and hence things like collocation, computing power, etc.) would be even more important.  If he has a problem with the race going to the swiftest, protesting against size priority rules is a strange way to go about it.

Unless and until there is a convincing demonstration of that exchanges face systematically distorted incentives in their choice of priority rules, regulators should butt out.  Objections to priority rule choices should be based on a clear and concise identification of some sort of externality.  For absent such an externality, exchanges have every incentive to make the trade-off that maximizes value.  Not everybody will be happy with the choice because traders are diverse.  But that’s the nature of the real world in which trade-offs are pervasive, as opposed to the Never Never land where too many regulators and legislators seem to dwell.

Yes, there definitely is an echo.  The BIS has released a paper that, er, echoes several SWP themes.  Most notably, the paper by Daniel Heller and Nicholas Vause notes that variation margin calls can lead to substantial demands on market liquidity.  In high volatility environments, the liquidity needed to fund variation margins would represent over 28 percent of G14 dealer cash and cash equivalents on one day out of 200 for interest rate swaps alone.  CDS margin calls could also result in a substantial cash drain on dealers.

It should also be remembered that these kinds of events are likely to be associated with (either caused by, or causing) tightness in funding markets.   It should also be noted that the BIS just looks at dealer variation margin payments.  In stressed market conditions, however, other market participants—including hedge funds, broker-dealers, and depending on the kinds of regulations that are adopted, certain derivatives end users—will also be subject to big margin calls.  This places further demands on liquidity.   These hedge funds and others would be looking to banks—including notably the big dealers—for funding.  This could lead to major liquidity shortages, and as the BIS notes, central banks are likely to need to inject liquidity either to banks or CCPs in order to mitigate these shortages.  [The zero sum nature of these margin calls raises some interesting issues.  I am currently noodling through some models based on the Holmstrom-Tirole setup to work through these issues.]

It would not be correct to suggest or imply that this is a problem associated with clearing alone.  Many OTC derivatives trades—including trades between dealers—are marked to market daily, and require variation margin payments.  Thus, big price moves would create funding demands to meet margin calls even in the absence of central clearing.  However, note that the increase in initial margins that clearing mandates, and margining mandates for non-cleared derivatives, will increase funding and liquidity needs beyond the level that would be required without these mandates.  Add to this Basel III liquidity requirements, and the heightened potential for liquidity crunches in the new environment are clearly manifest.

The BIS paper also quantifies the potential burden that variation margin payments could place on CCP default funds in the event of a default by one or more clearing members.  It concludes:

With a probability of one in 10,000, non-margin resources at risk from the failure of one particular dealer, two particular dealers or any dealer with sufficiently adversely affected portfolios would respectively be 20%, 37% and  42% of total initial margins for IRS, and 36%, 46% and 65% of total initial  margins for CDS. If prevailing levels of volatility were high, these figures would  equate to $21 billion, $39 billion and $44 billion for IRS, and $13 billion,  $16 billion and $23 billion for CDS.

These are big numbers, and indicate the kinds of resources that CCPs must have on tap to deal with defaults.

Note especially that these resources are likely to be contributed by major banks—which means that major defaults will impact non-defaulting bank balance sheets, contrary to the facile claims that clearing would put a firewall between derivatives defaults and major banks.  It also has implications for the appropriate capital charges for default fund exposures.

The BIS report quantifies roughly the economies of scope that result from clearing (another common theme here), and argues that these economies will permit more economical use of capital.  Left unstated is an important point that I’ve emphasized—but which is too often ignored.  Specifically, if clearing improves capital efficiency, it will reduce the marginal cost of trading derivatives, which will lead to an increasing scale of derivatives trading—and hence greater total counterparty risk.  Even if one assumes that CCPs allocate a given amount of counterparty risk more efficiently than is the case in the bilateral markets (an arguable assumption), it is not evident that this improvement in the allocation of risk would more than offset the effect of an increase in the total amount of risk to be allocated.  This issue deserves far more attention than it has received—which is not a hard statement to make, given that it has received almost no attention whatsoever.

The BIS report also discusses procyclicality of margins—another echo.  This is an extremely important—and extremely vexing—matter.  It is one about which CCPs are quite sensitive.  I don’t have any easy answers, except to say that (a) it is a real issue that deserves attention, (b) it is by no means obvious that CCPs have the appropriate information or incentive to take into account the knock-on effect of margin changes, and that (c) mechanical, value-at-risk driven approaches like those proposed by CFTC, SEC, and the Fed are the worst way to set margins.

Today’s WSJ carries an article related to procylicality in which I am quoted.  The issue is getting attention, and is not going away.  It is not going away in part because it is a very knotty problem.  So I am certain that the echoes will continue for some time to come.

The deputy governor, financial services of the Bank of England, Paul Taylor, gave a speech warning of the dangers inherent in clearinghouses. All of his major points were raised in my ISDA discussion paper (and which I’ve been flogging in my research and here on SWP for going on 3 years now).  Most notably, he highlighted the dangers of procyclical margins, and the very real possibility of a CCP failure and the devastating consequences such a failure would have. Been there, said that.

Such realism is good to hear, but as I said when Bernanke echoed similar concerns, it would have been a damn sight better had people like Mr. Tucker piped up before the clearing mandate train left the station with Congressional and Parliamentary Casey Joneses at the throttle.

But here’s the truly ironic part.  As I did in my ISDA piece, Tucker grapples with how to resolve a failed CCP:

Two strategies come to mind, which I am airing for debate. The first would be ‘recapitalising’ the CCP so that it can carry on.  The second would be to aim to bring off a more or less smooth unwinding of the CCP’s book of transactions.

On the former route, in the banking sphere the basic strategy is to develop regimes for bondholders to share in the losses after the equity is wiped out; a distressed bank gets ‘recapitalised’ in some way through a reconstruction of its liabilities.  But CCPs do not issue debt, so there is not obviously an economic equivalent of recapitalisation by way of haircutting the debt claims of bondholders.  Recapitalisation would seem to entail an injection of new outside capital.   That should not come from the public sector.  So the only options are the surviving clearing members themselves or a new ‘owner’.  On the face of it, the clearing members would have to be involved, as surely the stricken CCP’s default fund would also need replenishing in order for it to continue.

If the default fund were to be replenished by its surviving clearing members, that could in principle be sorted outat the time or it could be pre programmed.  In practice, making it up at the time must be dangerous.  A pre-programmed allocation of losses would be akin to the old “Down To The Last Drop” rule that used to be employed by a Chicago clearing house [the CME], under which surviving clearing members ultimately had collectively to absorb all losses: mutualisation.  (It was dropped because, as banks became futures-exchange clearing members, bank supervisors didn’t like the unlimited exposure of CMs who were banks.  An example of unjoined-up thinking.) [That’s not the way I heard it explained by those involved in the decisions.] [Emphasis added.]

Breathe deep the irony.  Remember that the primary justification advanced for mandating CCPs was to create a firewall that would limit the exposure of major financial institutions to counterparty losses arising from derivative defaults.  That is, the concern was that the failure of one large financial institution would cause it to default on derivatives trades, imposing losses on other large financial institutions, potentially resulting in their failure.  CCPs were supposed to contain default risks and prevent the from spreading, contagion-like, through the financial system.  But Mr. Tucker argues that for clearing mandates to work, it is necessary to breach the firewall and make big financial institutions the residual claimants of counterparty risk.

Mr. Tucker has just revealed the dirty little secret.  Well not a secret exactly; I’ve been pointing this out for years, notably in my posts on AIG.  Specifically, clearing does not make risks go away.  (No, Gary, there is no magic box.)  It just shifts risk around.  It has to go somewhere.*  Collateralization, by moving derivatives counterparties to the front of the creditor line, shifts risks to other creditors (who may well be large financial institutions, in part).  If collateralization is insufficient, the risks go to the other members of the clearinghouse–which means, it goes to other financial institutions.  Put differently, it vectors the risk right back to the same financial institutions that clearing was intended to protect.

Following the inexorable logic of the situation, namely, that the risk has to go somewhere, Tucker looks for where the risk can go.  Can’t go to bondholders, because a CCP doesn’t have any.  So it must go to clearing members–large financial institutions.**  Which means we’re right back where we started.

Which is another echo.  Several times I’ve predicted that clearing mandates would likely spur a process similar to that in the apocryphal story of the Indian village infested by mice, that brought in cats to eliminate the mice, that brought in dogs to deal with the proliferation of cats, that brought in elephants to drive out the hordes of dogs . . . and then brought back the mice to rid themselves of the rampaging elephants.  Clearing mandates were predicated on the chimerical belief that it was possible to make risk go away, when in fact, its primary effect is to shift risk around.  Which raises the question of where it has to go.  The BOE’s Mr. Tucker has apparently concluded, quite logically, that ultimately it has to rest with large financial institutions where it was in the first place.

In other words, bring back the mice.

* As I’ve noted repeatedly, clearing also affects incentives and therefore can affect the level of risk in the system.  There are a variety of reasons why CCPs may lead to an increase in total risk exposure, mainly by creating moral hazard, and increasing capital efficiency through netting.

** An important caveat here.  The nature of clearing members is not exogenous, and independent of the sharing rule.  Imposing good to the last drop is likely to make big banks reluctant to be clearing members with effectively unlimited exposure to other members.  Instead, GTTLD would likely lead to the creation of affiliates with limited capitalization.  By not recognizing this likelihood, Mr. Tucker is guilty of some “unjoined-up thinking” of his own.

Update.  Whoops.  In my hurry, wrote “Taylor” instead of Tucker.  Thanks MDC.

FT Alphaville has an interesting post on metals warehousing that resonates with my earlier post on the subject.   They call attention to a BBC report on commodities.

Recall that I dismissed the concerns about leveraging market power, and said that the crucial issue was information.  Given the availability of statistics on metals inventories, I downplayed the information advantage that warehouse owners have, but the Alphaville post suggests I was hasty in that judgment:

MR [BBC reporter Michael Robinson]: Steinweg is the last independent warehouse. Does it give them [the banks which own warehouses] an unfair advantage?

MR: John van der Lek told me he’s relieved that the Steinweg group is still independent, he says he’d like to avoid any suspicion of conflict of interest.

MR: “But what’s wrong with a bank owning a warehouse?”

ST [Warehouse operator Steinweg’s head of metals John van der Lek]: “I don’t know why they want to own warehouses. There must be a reason for that. But I don’t know why they do.”

MR: “Is it good business for a bank?”

ST: “Could be, but I don’t know, I don’t think so. I don’t have an idea what their feeling for taking over a warehouse.”

MR: “The danger is pretty obvious. That the bank has more information than other traders because it owns a warehouse?”

ST: “Yeah. That is to a danger for the traders. Maybe so we’re in a situation where people get more information out of the warehouses, but we are here independent and we would like to keep it that way. And we hope our customers appreciate that.”

All that said, trading is about information flows, and integration of traders into physical assets is ubiquitous–and has been for a long time–for exactly that reason.  Again, recall that major grain merchants did–and still do–operate the main delivery warehouses for CBOT/CME Group contracts.  Banks have been going into physical asset ownership in energy in recent years.  BP always viewed its asset ownership as a key to its trading operations.  That’s the way the game is played.

Anybody who owns the physical assets like storage facilities will have an information advantage when it comes to trading.  The relatively recent move of financial institutions into this area reflects a complementarity between access to this information flow and the ability to operate and finance trading operations.

In other words, it’s not about leveraging market power.  It’s about putting information and capital together.  That’s the essence of trading.  It’s the financial equivalent of a Reese’s Peanut Butter Cup.

The CFTC made all the front pages by filing manipulation charges against Parnon Energy, Arcadia Petroleum LTD and Arcadia Energy (Suisse), all affiliates of the trading firm Arcadia.

Let me say at the outset that I am in favor of addressing manipulation by ex post actions like those filed by the CFTC, and have long made that argument.  Let me also say that in 2002, Arcadia was accused of manipulation of Brent crude, and price patterns at the time were symptomatic of a corner, and per public reports, Arcadia’s trading was consistent with an attempt to corner.  Thus, I have no objection to the type of action the CFTC has brought, and don’t put it beyond Arcadia or a company like Arcadia to engage in manipulative conduct.  Indeed, I wish that the CFTC would rely more on ex post actions and less on things like position limits or ex ante jawboning to reduce the frequency and severity of market manipulation.

That said, based on the complaint, I conclude that the CFTC case is a tenuous one.  It is tenuous because of the novel nature of the claim, and the weak support for that claim provided by the price and trading data cited in the complaint.

The CFTC does not allege a corner.  Instead, it claims that Arcadia engaged in deceptive conduct.  It bought cash WTI forward contracts it did not need, then sold those contracts in the last three trading days of the WTI “cash window.”  The CFTC alleges that the buying deceived the market by suggesting buying interest that was not there, creating a false perception of market tightness.  This perception of increased tightness caused backwardation to increase.

Arcadia’s subsequent sales allegedly disabused the market of its (allegedly false) belief, causing backwardation to fall.  Arcadia allegedly lost money on these cash WTI purchases and sales, but made up for it through first buying and selling nearby spreads, and once the front month contract stopped trading on NYMEX, shorting the (new) nearby spread.  The creation of the perception and subsequent destruction of the perception of tightness, the CFTC alleges, generated profits for those spread positions.

Thus, the CFTC alleges a trade impact manipulation, rather than a corner.  These are always a greater challenge to prove, and the proof the CFTC adduces is hardly convincing.

In particular, the price data do not provide strong support for the allegation.  Consider the first alleged episode, in January, 2008.  Per the complaint, Arcadia bought 4.1 million barrels of February WTI cash crude.  During this period, it was also buying the February-March spread.  But in the 3 January-8 January period, when this trading–notably the cash trading, per the complaint–was allegedly creating an artificial perception of tightness in the market, (a) front month cash WTI fell by about $3.30/bbl, (b) the February-March (GH8) backwardation actually fell by 4 cents, and (c) front month WTI fell relative to front month WTS and LLS.  The spread did jump up 25 cents between the 8th and the 10th, and the WTI-LLS front month spread jumped by over a dollar, but this is after Arcadia’s purchase of the cash WTI contracts, and the purchase of the bulk of the GH8 spreads.  So to believe the CFTC, one has to believe that the market only became aware of the impending tightness with a lag–which is hard to reconcile with its assertion that it became aware that the demand was chimerical immediately on the sale of Arcadia’s cash position.

Moreover, by 15 January the GH8 spread had fallen to a level below its value prior to the commencement of Arcadia’s buying.  Then, when Arcadia began to sell the GH8 spread, the spread actually began to widen, going from 17 cents to 64 cents during the period that Arcadia was selling it. February WTI actually rose relative to February WTS during these days of selling February WTI as well.

This is all very hard to square with any assertion that the market was responding to Arcadia’s trading activity.  After all, NYMEX February futures and WTI cash forwards are effectively perfect substitutes, both allowing the buyer to take delivery of 1000 barrels of WTI in Cushing during February, 2008.  The market was showing greater signs of tightness at the very time Arcadia was reducing its demand for February WTI.  It will be devilish hard for CFTC to argue that purchases of near perfect substitutes have different price impacts, and for it to argue that the market was very sensitive to Arcadia’s trading of February WTI when its sales are associated with rising backwardation and its purchases are associated with falling backwardation.

The GH8 cash WTI spread did indeed go from backwardation to contango during the cash window of 25-28 January, when Arcadia was doing its selling of Feb cash WTI.  But February WTI actually rose during this period, and indeed rose on 28 January when Arcadia did most of its selling.  Again, this is not symptomatic of a market that was suddenly convinced that demand tightness had declined.

It must also be noted that the collapse in the February-March cash spread was equally large for LLS ($.985), and more than twice as large for WTS ($2.335).  Thus, the spread collapse was not limited to the product that Arcadia was trading.

Perhaps CFTC will argue that Arcadia’s deceptive buying had lifted and then crushed LLS and WTS spreads as well, but any manipulative buying should have a larger impact on the commodity actually bought, and the 25 January-28 January spread moves are not consistent with that.

What’s more, making this argument would present the CFTC with an acute problem.  It defines “market dominance” based on the size of Arcadia’s position relative to the WTI market.  If LLS and WTS are such close substitutes for WTI that buying one impacts the prices of the others because they are effectively one market, then for the purpose of determining market dominance Arcadia’s position must be measured relative to that market–WTI, WTS, and LLS, plus any other close substitutes.  It would be much harder to prove market dominance under such an expanded market definition.

In brief, the price and trading patterns for the January episode are not consistent with the CFTC allegations.  Prices fell throughout, even after Arcadia allegedly fooled the market into believing that conditions were tight.  Prices and backwardation did not rise when Arcadia was buying.  Backwardation was rising when Arcadia was actually selling the spread.  The spread collapse during the cash window that the CFTC apparently believes is its “Gotcha” piece of evidence was mirrored by collapses as large or larger in other types of oil.

I also note that the CFTC has provide no evidence that any of the price and spread moves were statistically significant.

The spread and trading co-movements are more equivocal during the March, 2008 episode.  The April-May (JK8) spread did rise when Arcadia bought it, and during the period it commenced buying April cash WTI.  But the biggest move in the spread, from $1.16 to $1.94 occurred when Arcadia sold its JK8 NYMEX spreads.  It was buying 3.5 mm bbl of April cash during this 14-19 March period,  but it was selling 14.4 mm bbl of JK8 spreads–meaning that it sold 10.9 million more barrels of April WTI than it bought during this period–so how could this contribute to an explosion in the perceived tightness of WTI–as indicated by the 78 cent increase in the backwardation? Note too that the WTI April cash flat price was falling $5.73 during the period it was buying the 3.5 mm bbl of April cash crude–another thing that is hard to square with a perception of increased tightness.

Furthermore, the April-May LLS spread fell by more during the cash window ($2.29) than did the WTI spread ($2.015).  This is very hard to square with any coherent manipulative theory, and as noted before, any story in which sales of WTI cause declines in the price of LLS would require a market definition under which it would likely be very hard for CFTC to prove market dominance.

I should also mention that even ignoring this problem, the CFTC’s market definition is suspect.  It compares Arcadia’s position to the company’s estimate of flows of WTI in Cushing during the delivery month.  But this ignores stocks of oil in Cushing, which were about 17 mm bbl during this period.  Now some of these barrels were not WTI, but some if not most of these barrels should be included in any calculation of the size of Arcadia’s purchases relative to the size of the market.

Corner manipulation cases are hard: the CFTC has never won one.  Trade impact manipulation cases in which it is alleged that buying or selling created false perceptions of demand are even harder to analyze and prove.  Thus, just based on the nature of the allegation alone, the CFTC has filed a very challenging case.  When one looks at the evidence the CFTC presents in its complaint, the odds become even higher.  For the January episode in particular, the most straightforward interpretation of the evidence cuts squarely against the allegations.  This will be a very difficult case for the agency to win.

There’s another lesson here that has been lost in all of the hue and cry over the filing of the complaint.  CFTC has been examining the oil market with a fine tooth comb going back to 2005 if memory serves.  If this is the best case they can find after all that, the oil market must be pretty damn clean.