Streetwise Professor

The Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues has issued its findings regarding the Flash Crash and potential regulatory remedies to such events.  Overall it is a solid effort that makes a serious attempt to grapple with the thorny issues arising out of the May 6 events, and changes in financial market structure more generally.

My primary criticism is that the report assigns far too much importance to the speed of modern, electronic markets dominated by high frequency traders that are the primary liquidity suppliers.  This over-emphasis is pronounced in section I, titled “Volatility.”

The report confirms what has been pretty evident from the start, namely, that liquidity was eroding before May 6, and then virtually disappeared for a short period of time on that date.  But it does not provide any reason to believe that this was something that was driven particularly by high speed electronic trading.  The economics of market making have been the same for a long time under a variety of trading technologies.  These economics are dominated by considerations related to information–and especially information asymmetry–and risk.  These considerations are present in every trading and technology environment.  There are, moreover, informational and risk conditions in which liquidity suppliers leave the market in droves.  This happened in old-fashioned face-to-face markets: witness the fact that on 19 October, 1987 most futures market locals left the floor–or were pulled off by their clearing firms.  The Flash Crash just demonstrates that these factors are relevant in electronic markets too.

By focusing on high speed computer trading, and suggesting that it is fundamentally different from liquidity supply in the old days, the report distracts attention from the more fundamental causes of crashes.  Yes, HFT is new, but HFT market makers are responding to the same economic factors in similar ways to their old school floor trader counterparts.  The main novelty of HFT is that high frequency traders trade across markets, rather than in one or two.  The report would have done better to focus how to best mitigate the age old plagues of market making in an electronic environment.

The report discusses the advisability of imposing obligations on market makers, but wisely demurs from recommending this.  It recognizes the difficulties, though it does not acknowledge the most important problem, namely, that obligations are costly and will affect adversely liquidity supply in non-crisis periods.

The report also correctly lauds the CME’s stop functionality, and recommends it be adopted in other markets as well.  It makes constructive and reasonable recommendations about how this functionality can be tweaked to make it more robust.  In brief, it recommends what could be described a “reload” feature that would kick in if the initial application of the stop functionality failed to stem a crash.

One particularly interesting part of the report relates to “Preferencing, Internalization, and Routing Protocols.”  It is particularly interesting because it highlights an issue that I analyzed in my 2005 article “The Thirty Years War.”  In that article, I noted that the SEC had deliberately chosen an “information and linkages” approach rather than a central limit order book  (CLOB) approach to securities market structure.  I further noted that the rules adopted by the SEC did not preserve time priority across trading venues, and did not protect all limit orders in all books against execution on another venue at an inferior price to those not at best of book.  These were problematic features of the SEC RegNMS, and I was critical of both (especially the fact that only limit orders at the top of the book are protected).

The report argues that the lack of time priority inherent in the “no trade through” rule has encouraged internalization of orders, and that the lack of integration across books at prices away from the inside market can exacerbate price movements.  It therefore recommends that the SEC study the costs and benefits of changing these aspects of RegNMS.  Specifically, it recommends study of the imposition of a “trade at” rule which would effectively restore time priority.

I agree with the recommendation, but think that these issues are somewhat of a red herring with respect to the Flash Crash.  This is especially true of the “trade through” rule.  The report authors argue that the current rules favor internalization; internalizers supply liquidity; but internalizers stopped providing liquidity during the Flash Crash, leading to an additional flow of orders to public markets that stressed an already liquidity constrained situation.  Imposing a “trade at” rule that would make it impossible for internalizers to match quotes standing in the public market would encourage additional liquidity supply in the public markets.

This is no doubt true, but the report doesn’t analyze the counterfactual, i.e., how things would have worked under the trade at rule.  Yes, there likely would have been less internalization.  Thus, in normal circumstances, more liquidity would be supplied via public quotes and less via internalization.  But we saw during the Flash Crash that public market makers fled and as a result quotes disappeared.  Internalizers provided less liquidity at the same time.  But isn’t it highly likely that the liquidity suppliers that entered the public markets during “normal” times to replace internalizers would have also fled the market in conditions like those that provoked the Crash? I think so.  The report doesn’t consider this counterfactual, so it cannot support a different conclusion.

That is, I think that it is accurate to say that a “trade at” rule would shift liquidity from internalizers to public quotes during normal times, but that this does not imply that liquidity would be higher overall (across all sources of liquidity supply) during stressed periods.  The quotes that appear in public markets because quote matching becomes harder would be highly likely to disappear in Flash Crash-like conditions because it is particularly costly to provide firm quotes under those conditions–that’s why the quotes disappear.  Thus, it is worthwhile to have a debate/study about the wisdom of the trade at rule, but that debate study should recognize that just because internalizers fled when the market went crazy doesn’t mean that the new public quoters attracted to the markets when internalizers are hobbled will stick around.

A look at the futures market bolsters this skepticism that internalization was a major contributor to the Crash itself.  The index futures markets are not fragmented, and are not subject to internalization.  The quote matching problem doesn’t exist there.  At all.  But it suffered serious liquidity withdrawals on 6 May.  Thus, in my view, internalization is a red herring with respect to Flash Crashes.  It is an important issue, but its relevance is primarily during “normal” times and that should be the focus of any study.

I was also intrigued by the report’s discussion of peak load pricing and the problems of system capacity constraints driven in part by high cancellation rates for HFTs.  This subject was, in fact, the subject of the first substantive post on SWP.*  There I puzzled as to why exchanges didn’t set traffic-sensitive price schedules for access to exchange matching computers.  I noted that the lack of pricing of capacity could lead to overconsumption of computer resources, lags in getting orders executed, and even shutdowns of the trading system.  Interesting to see that 5 years after I wrote that piece the issue is getting some attention.  I’m still puzzling, and look forward to seeing how the exchanges and regulators deal with this issue.  (The report mentions the difficulty of pricing cancellations in a fragmented market structure.  This is another manifestation of the US equity market-centric mindset of the report’s authors.  That isn’t an issue in futures markets, or foreign markets that are less fragmented.  The puzzle is not explained by market fragmentation.)

In sum, the report moves the ball forward some.  I think it gets sidetracked on some issues, but its focus on the need to encourage liquidity supply during stressed times is salutary.  A lot of work remains to be done to see just how that can be accomplished in an efficient way, however.

And speaking selfishly, that’s a good thing.  For the report confirms something I wrote in the conclusion of “The Thirty Years War”:

Therefore, the proposed rules [Reg NMS] are not the final battle in a ThirtyYears War. I fully expect that in 2075, some professor will write an article about the latest clash in an ongoing Hundred Years War over securities market structure regulation.

These market structure issues are thorny indeed, and will not be resolved any time soon.  I am sure they will not be resolved by early-2013, when my next book, Financial Market Macrostructure: The Organization of Securities and Derivatives Markets should appear.  Which should be good for sales 🙂

*The post was titled “VOLT”, a neoacronym (which might be a neologism) for “Value of Lost Trade.”  The idea was that in figuring out how much generating capacity is needed in an electricity market, it is conventional to assign a “value of lost load” (VOLL) to the consumption of power lost when system capacity is reached.  Similarly, when deciding how much trading capacity to build, it would be advisable to determine the value of a trade lost or delayed due to a shortage of system capacity.

. . . of SWP discussing clearing, here’s a video (approx. 90 minutes) of my talk on the subject at the Law and Economics Workshop at Columbia Law School from December of last year.  You need to supply your own NoDoz.

There are a lot of jokes about economists that go something like: “An economist and a physicist are on the top floor of a skyscraper.  Someone runs in screaming: ‘The building is on fire. The stairways are all blocked.’  The physicist immediately panics, then looks at the economist, who is amazingly calm.  The physicist says: ‘How can you be so calm?  We’re all gonna die.’  The economist smiles wanly and says: ‘No we’re not.  First, assume a 100-story ladder.'”

That genre of joke came to mind when reading this:

Clearing houses for derivatives can help reduce risk to the financial system, Federal Reserve Governor Daniel Tarullo said in written remarks prepared for House Financial Services Committee testimony tomorrow.

“If properly designed, managed, and overseen, central counterparties offer an important tool for managing counterparty credit risk, and thus they can reduce risk to market participants and to the financial system,” Tarullo said.

Translation: “First, assume a properly designed, managed and overseen central counterparty.”

Yes, if we assume all those things are true, our assumed world is wonderful indeed.

But as I’ve written for the past two-and-a-half years (and I think I can honestly say “you read it here first!”), all that is easier assumed than done.

Reading an article by Samuel G. Hanson, Anil K. Kashyap and Jeremy C. Stein in the most recent issue of the Journal of Economic Perspectives helped crystalize a thought that is implicit in what I’ve written, but which I have not made as explicit as I should.

Specifically: Historically clearinghouses have been microprudential institutions, with the responsibility of ensuring that a particular set of claimants get paid what they are owed due to the default of a single trader or firm, just as bank regulation has been microprudential in its focus on ensuring that depositors get paid in the aftermath of the failure of an individual bank.  But Dodd-Frank and all of the other initiatives around the world give CCPs huge macroprudential responsibilities.

As Hanson et al show, there can be substantial tensions between microprudential and macroprudential regulation: some things that are prudent microprudentially are very dangerous from a macro/market-wide/systemic perspective.   I do not believe that Frank-n-Dodd, Geithner, Gensler, the EC, you name it were or are fully cognizant of the difference.  And therein lies the danger.

Here’s the most obvious example.  CCPs utilize margins–collateral–to control counterparty exposure.   That’s sensible microprudentially.   But as I argued beginning in 2008, and as Brunnermeir and Pedersen formalized in 2009, collateralization and rigid mark to market can be systemically destabilizing.  I referred to this as the “collateral death spiral.”  Prices change a lot, imposing big MTM losses on some parties, who liquidate their positions, exacerbating the price moves, which leads to more liquidations.  This positive feedback mechanism is what creates serious systemic risks.

Brunnermeir and Pedersen emphasize that a purely mark-to-market system that bases margin calls only on price moves, and makes no effort to distinguish between fundamentals-based price moves and those that result from mispricings or liquidity effects are the most systemically dangerous.  And that’s exactly how CCPs work.  They are ruthlessly mechanical. If you talk to people in the futures business, that is a feature, not a bug.  I can’t count the number of times I’ve heard about the virtues of the “discipline of a rigorous daily mark-to-market system.”  Microprudentially–agreed.  Macroprudentially–not true, and more than that, dangerously misleading.

So, there is a fundamental disconnect between Timmy!’s and GG”s paeans to rigid collateralization and mark-to-market and their assertion that mandatory clearing will eliminate the prospect that derivatives will be a source of systemic risk.  Indeed, evaluated properly, the reverse is more likely to be true.  In times of market stress, rigid collateralization can be a doomsday machine.

That is a reality that can’t be assumed away–but has been.   And don’t count on that ladder saving our collective rear ends when–when, not if–the next financial firestorm occurs.

The big news in Exchangeworld is the likely merger of NYSE-Euronext and Deutsche Borse.

This reflects in some sense a return to financial normalcy in the aftermath of the crisis.  The years leading up to the crisis saw a plethora of exchange mergers and combinations, but the pace of consolidation slowed noticeably in 2008-2010.  Now it is picking up again.

Both NYSE-Euronext and DB operate cash equity and derivatives exchanges.  The former operates NYSE, of course, and also European equity markets in the Netherlands, Portugal, France, and elsewhere, and the LIFFE derivatives exchange in London.  The latter operates the German stock market, a US-based options market ISE (a purchase in the pre-crisis boom which turned out to be a rather bad deal for DB) and the Eurex derivatives exchange which trades equity options and a wide range of financial futures.  DB is highly vertically integrated; most importantly, it operates its own execution and clearing platforms in both equities and derivatives.  LIFFE historically outsourced its derivatives clearing to LCH.Clearnet, but is also vertically integrating into clearing (although it still contracts with LCH for some clearing services).

Cost savings are the major driver of this merger.  There are substantial scale and scope economies in execution systems.  In derivatives, moreover, there are substantial scale and scope economies in clearing.  In particular, margining and netting efficiencies reduce customer capital costs.

The competitive effects are likely to be relatively small, even though that has been a focus of a lot of the commentary.  Cash equities are already ruthlessly competitive, especially in the United States: RegNMS socialized order flow, eliminating any tipping effects, as demonstrated by the precipitous decline in NYSE market share from the mid-80s to the mid-20s in the years following RegNMS.

With respect to derivatives, the LIFFE and Eurex do not compete head to head in any major product.  Cross-product competition is relatively tame in futures.  And just as with the CME-CBT merger, putting LIFFE short term interest rate futures and UK government bond futures and Eurex European bond products on the same platform would facilitate spreading trades and enhance liquidity and reduce trading costs and execution risks for customers.

Nor do LIFFE and Eurex compete head-to-head with any CME product.  Thus, the direct competitive effect of the merger on CME is also likely to be relatively mild.  By reducing trading and clearing costs, a LIFFE-Eurex combination may attract some business from CME product groups to its product groups, but again, these inter-product class cross elasticities do not appear to be large.  Order flow has not been socialized by regulatory fiat in derivatives on either side of the Atlantic, meaning that the order flow network effect is still in place.  This means that LIFFE and Eurex could not credibly compete against CME on its home turf (each had conspicuous failures trying): it also means that a combined LIFFE-Eurex will face daunting obstacles in trying to do so.  Indeed, I doubt they will seriously try; twice burned, thrice shy would be a reasonable motto.

Consistent with this, CME Group’s stock price has been up close to 2 percent since the news of the potential tie up became public.

The biggest uncertainty surrounding the deal involves European antitrust approval.  As noted above, the merging exchanges are not direct competitors in any major product.  In the US, in the mergers of CME and CBT and CME and NYMEX, that fact was decisive in avoiding  Justice Department challenges.  It should be in Europe too, but I’m not as familiar with European antitrust thinking or precedents so I’m not sure they’ll see it the same way.

The most interesting question involves clearing.  European policymakers have been critical of vertical integration in clearing.  (The USDOJ is too, but only disclosed its (economically nonsensical) objections after the CME-NYMEX merger closed.)  They deem vertical integration as anticompetitive, and have failed to consider seriously the efficiencies that integration can generate (a subject I’ve written a lot about on SWP and my academic research).

Given this skepticism, the Euro antitrust folks may view this merger as an opportunity to open up access to clearing at Deutsche Borse and LIFFE.  That is, I could see them conditioning approval of the merger on the parties’ agreement to open up access to their clearing services.  It will be interesting to see whether they attempt to do so: I estimate that there is a non-trivial probability of this happening.  If they try, it would likely be a deal killer.  DB in particular has been adamant that integration is an essential part of its model and strategy, and LIFFE has adopted that view as well.  A deal becomes much less attractive–and, in my opinion, unattractive–if it requires a fundamental transformation of the exchanges’ business models.

The news of the potential deal has sparked considerable speculation about other tie-ups.  One commonly heard belief is that CBOE is the odd-man out, and that it should tie up with CME.  Other than the fact that both have “Chicago” in their names, these entities don’t have a lot in common, or a lot to gain by combining. In particular, there are no benefits on the clearing side. There are no economies on the regulatory/compliance side.  There are not really big advantages on the system side either.  So, other than savings on letterhead and some management salaries, there is nothing to be gained by merging.

It is likely that many more possible combinations will be mooted and discussed in the coming days.  I’ll be among those discussing them, but that will have to wait.  For teaching calls.  It’s rough work, but somebody has to do it.

Writing in Commodities Now, Reuters reporter John Kemp takes issue with my criticism of the CFTC proposal on position limits. I appreciate the attention, but I’m underwhelmed by his arguments.

There are a lot of details, but the gravamen of his complaint is that my view on the purpose of position limits is far too narrow:

Pirrong defines the rationale for intervention too narrowly. Large leveraged positions run by the Hunt Brothers did indeed threaten to bring down their own brokers and several other financial institutions. But systemic risk is not the only reason for regulators to intervene to prevent market manipulation.

Kemp directs his beef at the wrong guy.  His real problem is with the CFTC because these were the only–I repeat only–reasons the CFTC set out it its NOPR.  My critique of the proposal is that it was a vastly overinclusive way to achieve the objectives the CFTC set out.  Again, the objectives the CFTC set out.  I was responding to what was in the proposal, but I did mention quite pointedly that the CFTC was utterly silent on whether speculation was culpable in the mid-2000s price spikes, or those going on now.  How is it possible to respond to arguments and assertions that are not made?

Since it was the CFTC that was setting out the rationale for its proposed intervention, if that rationale is too narrow, Kemp should direct his ire where it belongs–the CFTC–not where it doesn’t–yours truly.

Kemp also critiques my views on manipulation and the proper way to deter it.  Oh no!  Please don’t throw me in the manipulation briar patch, Brer Fox!

Actually, born and bred in the briar patch, John.  We are agreed that past efforts to deter manipulation through ex post enforcement have been troubled, at best.  In this, Kemp is no doubt late to the game, because I’ve been making that argument since the mid-1990s.

That said, I’ve noted that manipulation is not inherently “unprosecutable” (a word Kemp lifts from Jerry Markham).   The problems with detecting, deterring, and punishing manipulation can be corrected by a proper understanding of the economics, and a judicious use of, yes, econometrics–something that apparently sends Kemp into apoplexy.

Moreover, I have made very concrete recommendations as to how manipulation law can be reformed to address the problems it has experienced.  (Not that you would know that from reading Kemp’s description of my views and arguments.)  The problem is that instead of taking a new, economics-based approach to the problem, Congress keeps returning to the vapory SEC 10(b)-5 “manipulative contrivance or device” standard, like a dog returning to its own vomit.  Doing the same thing over and over again and expecting different results is insane.  I’ve recommended specific and practical ways to stop the insanity.

As an aside, Kemp laments that manipulators have only been subject to civil, rather than criminal, sanctions.  There are a couple of issues here.  The first is that criminal sanction–imprisonment–is socially inefficient when defendants are not judgment proof.  The second is that Kemp’s lament actually supports the point I made in the previous paragraph.  Judge Miller in Houston found the existing anti-manipulation statutes unconstitutionally vague, and threw out criminal indictments against BP propane traders.  The suggestions as to how to correct the law would go a long way to addressing that vagueness problem that impedes criminal prosecution.

Speaking of econometrics, here Kemp is extremely misleading, and puts words into my mouth that I did not utter, and which do I endorse.  He says that I propose that the CFTC not “set limits or commence enforcement proceedings unless econometric tests showed an unequivocal effect” [emphasis added].

If there is anything unequivocal, it is that his statement is unequivocally false, for I never said any such thing.  Indeed, insofar as manipulation is concerned, he turns reality on its head.  For what I have shown in numerous articles, a book, and in testimony, is that econometric evidence and economic analysis generally is the best way of proving manipulation, rather than being an obstacle that makes prosecution of manipulators virtually impossible.  It is a sword that can be wielded against manipulators, not  a shied that defends them: although it is effective as a shield protecting the innocent.  Rigorous analysis of data is the best way to cut through trader BS, and prosecutor ignorance.

And that’s the point: we want methods that avoid false positives and false negatives.  My work shows that econometrics, when combined with rigorous economic reasoning and other economic tests that are not econometric per se, can do just that.

Before characterizing my views, John, you might want to be more familiar with what they actually are.

Even with respect to the issue of whether speculation has distorted prices in ways other than the Hunt-type scenario, I have been quite open about the basic limits of econometric analysis.  Here’s what I wrote in a piece in Regulation last summer:

One of the most important functions of markets is to discover prices; to provide a mechanism whereby information about supply and demand dispersed among millions can be aggregated.  Thus, no one has the information to know what the price “should” be; if someone did, we wouldn’t need markets.  But this always makes it very difficult to rebut assertions that a particular market price is distorted by speculation, or to prove that they were.

Moreover, in that article, I use some econometrics, but only very little.  I instead utilize some non-econometric approaches to test the implications of the speculative distortion story.  Thus, to attribute to me a slavish and myopic devotion to econometrics is just wrong.  I have a very catholic view of what kind of evidence is persuasive.

But I am a firm believer that data and evidence should be decisive.  Kemp argues that “policymakers must act on the balance of probabilities.”  Fine.  But just where, pray tell, are those probabilities to come from?  Kemp bashes econometrics, but advances no alternative.  Zero.  Zip.  Nada .

Sorry, but that just doesn’t cut it.  Econometrics is one tool that can be used to inform judgments about probabilities.  There are other tools–qualitative comparisons, and rigorous analysis of the economic logic of purported causal connections between speculation and price distortions, for instance–that can also inform those judgments.  The best approach integrates statistics, econometrics, qualitative comparisons and rigorous economic reasoning.  That’s the kind of approach I favor, and the kind of approach I’ve used–though you would never guess that in a million years if your only impression of my work is Kemp’s description thereof.

In the end, Kemp takes refuge in the position that as a matter of law, Congress has required the imposition of position limits, and that’s the end of that.  He worries that the CFTC could be sued if it failed to adopt such limits.

But even that legalistic defense is incomplete.  Congress has mandated the imposition of limits to achieve a specific purpose: the prevention and diminution of “unwarranted fluctuations” in prices.  Limits that are unnecessary to achieve that goal–because such unwarranted fluctuations are extremely unlikely to occur–or limits that are so overinclusive that they impede the achievement of other Congressionally mandated objectives, shouldn’t hide behind the fact that courts may find the exercise of such powers Constitutional.  “We do it because we can” is a recipe for regulatory mischief that undermines the very goals that Kemp claims to endorse.

My criticism of the CFTC NOPR is that it (a) identified a way in which large positions could cause unwarranted fluctuations, and (b) imposed limits that were completely unnecessary to address the very problem the CFTC identified.  Maybe Kemp has different theories regarding (a).  If so, he should spell them out, and specify his proposed remedies so that they can be evaluated and critiqued in order to ensure that they are indeed problems and the remedies are an efficient and effective way to address them.

In the end, I guess I do agree with Kemp on one thing: it comes down to an issue of the burden of proof.  I believe in markets more than regulators.  He apparently takes the opposite view.  I am more than willing to debate this anytime, anywhere.

But contrary to what Kemp insinuates, I do not believe that markets are unerring, that market power is not a problem, and that certain laws and regulations can improve the performance of markets.  I am not some sort of Dr. No, insisting upon unreasonable level of empirical support to reject the hypothesis that the Market Is Always Right.  (Indeed, a former colleague, upon reading my work on manipulation, referred to me as a “Chicago apostate.”)  I have a presumption in favor of markets, but it is a rebuttable presumption.  And with respect to manipulation in particular, I have both rebutted the widespread view that manipulation is not a problem, and recommended specific, targeted legal responses to mitigate that problem.

When it comes to speculation and position limits, however, those who have questioned markets have come no where near to rebutting the presumption in favor of markets.  I note–indeed emphasize–again that the CFTC does not even try beyond the specific areas identified in the NOPR: areas which Kemp believes are too narrow.  But Kemp hasn’t provided a credible alternative either.

Given the havoc that bad regulations routinely inflict on markets, a credible story and at least some evidence should be required to support a particular policy proposal.  A fair acknowledgement of the potential for unintended consequences is also appropriate.   I note too that Kemp does not even attempt to critique the unintended consequences of the CFTC proposal that I lay out in my comments.

When it comes to the specifics, Kemp ironically endorses my view–although he does not acknowledge this.  He says:

Reversing the burden of proof, it is worth asking opponents why anyone would want to run positions above the very high levels set out in the CFTC’s proposals. Are there legitimate reasons to want to run very large net positions, including in the spot month? Or is the only reason to exercise market power?

Uhm, that’s very close to what I recommend.  Give the CFTC the authority to question the legitimacy of very large positions, and intervene accordingly if there is no legitimate reason.  But that’s a far, far, different thing from a blanket prohibition of positions in excess of a particular size.

In sum, I stand by my specific criticisms of the CFTC position limit proposal.  Moreover, I emphasize that Kemp has presented a distorted view of my arguments, beliefs, and work.  His arms must be tired from giving a straw man such a thrashing.

But I’m still standing.

I have written a comment letter about the CFTC’s proposed rule on position limits, which I will submit tomorrow.  A draft is here.  It’s fairly long, so I’ll summarize it here.

I have said repeatedly that it is imperative for the Commission to identify the specific problems that it believes position limits will mitigate, and how they will do so.  Creditably, in its NOPR, the Commission does set out specific ways in which large, concentrated positions can inefficiently destabilize markets.  It is best described as a Hunt Brothers scenario, in which a levered player takes a large concentrated position in a market.  Such a leveraged player may be forced to liquidate, and the liquidation of such a large position can cause extreme price moves, and perhaps, pose a systemic risk.

Fair enough.  I’ve written about the Hunts in the past, and have made similar points. So that is a danger.  But crucially, the CFTC does not identify any other ways in which large positions can cause “unwarranted” price fluctuations, which is the basis for its position limit mandate.  Therefore, per the CFTC’s own analysis, its position  limits should focus on addressing a reprise of the Hunt situation.

But the major problem with the CFTC proposal is that it will constrain the trading of many market participants who in no way pose the dangers that neo-Hunts would.  That is, the proposed limits are over-inclusive.

In particular, they will constrain trading by exchange traded funds (ETFs) which are (for the most part) unleveraged.  Indeed most ETFs are completely collateralized.  Moreover, even if an ETF is big, it is different than a single trading entity like the Hunts because ETF trades are driven by the decisions of thousands of ETF investors.

In other words, ETFs are nothing like the kind of speculator–and the only kind of speculator–the CFTC has identified as a danger, but they will suffer collateral damage as a result of the CFTC’s limits.

They will not be the only innocent casualty.  Many other “massive passives”–such as pension funds–will also be affected, even though they do not pose the risks that the Commission uses to justify the imposition of limits.

The problems with the proposal don’t end here.  In particular, although “crowding out” is not explicitly in the new proposal (in contrast to the Commission’s proposal of January 2010), the new proposal has a feature that is just as pernicious, and just as inane: the “within-class” limit.

Due to the powers granted by Frank-n-Dodd, the CFTC now has the power to regulate positions in both OTC swaps and futures, whereas before it only had authority over the latter.  The Commission proposes to create two classes of positions: the futures class and the OTC class.  It proposes several limits imposed on the classes collectively and individually.  For one of the limits, the two classes will be netted against one another, and any speculator must have a net position for all months and a single month that are less than or equal to the speculative limit.  But in addition, each speculator’s OTC position must be smaller than the spec limit, and its futures position must also be smaller than the spec limit.

Here’s the problem.  Assume for simplicity that the limit is 100.   Consider a swap dealer who is short 150 swaps to customers, and hedges this using 150 futures.  This complies with the across-class limit, because it nets out to zero.  But it violates the futures class and the OTC class limits.

This feature therefore limits the ability of intermediaries–swap dealers–to hedge risks.  It is effectively a tax on swap dealers, and will reduce liquidity in the swap market.

There are reasonable grounds to suspect, based on the past statements of some Commissioners, that this is a feature rather than a bug from their perspective.  In my opinion, however, it is flat wrong.  OTC market making is a legitimate activity, and OTC deals (hedged by exchange transactions) are often the most economical way for some market participants to take on the investment or speculative positions they desire.  There is no reason to penalize this activity the way the proposed rule does.

Indeed, by limiting liquidity the rule threatens to exacerbate large price moves in response to shocks.  Prices have to move more in less liquid, less flexible markets in order to accommodate big shocks.  Stifling liquidity through the within-class rules is therefore counterproductive.

I would also note that the Commission provides no economic justification for this restriction.  In particular, it doesn’t even try to show how this restriction addresses the Hunt Problem that is the sole substantive justification for the limits in the first place.

The Commission also fails to justify the size of the limits it proposes, which approach 2.5 percent of open interest for large markets.  To put things in perspective, the Hunts’ position was over 25 percent of the market at times.  So maybe 25 percent held by a single leveraged trader poses a risk: how does that justify a  2.5 percent limit on everybody, including non-leveraged traders who are in fact agents for myriad individuals making independent trading decisions (e.g., ETFs)?

The Commission also fails to recognize that its limits could drive business into the physical markets, thereby distorting prices producers receive and consumers pay.  This is perverse, given that the ostensible purpose of the limits is to prevent and diminish such distortions.

In sum, the non-spot month limit proposal is fundamentally defective.  It identifies a problem, and then identifies a blunderbuss-like “solution” that will hit a lot of trading activity that does not and cannot cause this problem.

The spot-month limits are flawed too, because they are logically inconsistent.  The proposal limits caps spot-month delivery-settled derivatives positions at 25 percent of deliverable supply, but does not explicitly place a cap on the amount of deliverable supply a speculator can hold.  The proposal caps cash-settled positions at 5 times the delivery settled limit, i.e., 125 percent of deliverable supply, and also permits the holder of cash-settled positions to hold 25 percent of deliverable supply.

Spot month limits can be justified as a means of preventing corners.  Well, corners can be carried out by holders of cash-settled positions as well as delivery-settled ones.  Indeed, that happened a lot in the Brent market in the 90s and early-00s, and may in fact be happening right now.  Somebody can manipulate a cash-settled contract by buying excessive quantities in the cash market, driving up prices, and thereby artificially inflating the settlement price of the derivative.

If the objective of the limits is to prevent market power manipulations in both cash-settled and delivery-settled markets, the limits are logically inconsistent.  The delivery-settled limit implicitly assumes that it is possible to distort prices by accumulating less than 25 percent of deliverable supply.  Well, you can do that with the cash-settled contract, and then get a profit on a position that is five times larger.

In sum, the position limit proposal is a good example of bad regulation.  It inflicts harm on “massive passives” (perhaps intentionally) even though this type of trader does not pose the only threat that the Commission has identified: this is a massive fail.

I should also note that the proposed rule provides not a word of justification of the widespread view that speculation caused the price spikes of the 2007-2008 period, or is causing the current runup in commodity prices.  It certainly provides no evidence.  But such price spikes are routinely evoked in Congress, the press, and even in statements by Commissioners, as evidence of the need for such limits.  Since the Commission apparently does not have the confidence in such a belief to include it as a justification for limits in the formal proposed rule, this should play no role in deliberations over the rule going forward.  To do so would be to play bait-and-switch.

Instead, the rule should be evaluated solely on the basis of its efficacy and efficiency in addressing the specific problems with speculation that the Commission has identified.  When this is done, it is clear that the rule is grossly excessive because it impedes legitimate conduct that poses none of the risks that the Commission believes warrant regulation.  The rule should therefore be rejected, and if replaced at all, replaced with something that is targeted at the specific ill that the Commission has diagnosed.

The US Department of Justice’s Antitrust Division hardly covered itself in glory the last time it weighed in on derivatives market structure when it criticized vertical integration of trading systems and clearinghouses in 2007 (if memory serves), in the aftermath of its (apparently grudging) approval of the CME-NYMEX merger. I excoriated that “analysis” on SWP, and I have been told that the posts I wrote made the rounds on Capitol Hill, causing (in the words of somebody in a position to know) one senator’s “head to explode” in anger (at the DOJ, not me) when he read them.

Well, the Antitrust Division is at it again. They submitted a comment letter in response to the CFTC’s proposed rulemaking on conflicts of interest at exchanges, SEFs, and clearinghouses. It is slightly better than the Parthian shot fired at the CME in 2007, but that is praise only in the “you don’t sweat much for a fat girl” variety, for the economic analysis in the comment is weak on the issues it discusses, and completely ignores salient economic considerations.

In brief, the DOJ recommends that the CFTC adopt a tougher rule that imposes “an aggregate ownership cap on major derivative dealers” because it fears that the absence of such a cap would “[preserve] the opportunity for these powerful entities to achieve majority ownership in DCMs/SEFs” thereby jeopardizing competition.

The Department argues that “limiting aggregate ownership and imposing stringent governance requirements . . . may prevent the emergence of a dominant trading platform controlled by major dealers to the detriment of other market participants.”

Let’s unpack that particular set of claims.  Is it the “emergence of a dominant trading platform” that bothers the DOJ, or the fact that it might be “controlled by major dealers”?   It is quite possible–and indeed, I would claim likely–that the nature of liquidity (specifically, its network aspects) strongly–strongly–favors the “emergence of dominant trading platforms.”   If market power is the concern, who controls the dominant platform is of secondary or tertiary importance, at best.  Does the DOJ believe that multiple platforms that compete aggressively are likely to emerge if dealers are precluded from controlling them?  What is the basis in economics for this claim?  I’m not aware of any.  I would argue that the tendency for a single entity to emerge is driven by liquidity, and technological scale and scope effects (e.g., the ability to trade multiple instruments on a single platform).

There is, in fact, a stark example of this phenomenon staring the DOJ in the face: the very same CME that exercised the DOJ so mightily in 2007.  The CME is not dealer dominated, but it has emerged as the dominant exchange in the US in the past decade.

This means that the Division’s belief “that an aggregate ownership cap on Enumerated Entities may facilitate competition by encouraging the creation of new DCMs/SEFs” is seriously misguided.  What is going to drive market structure is the economics of liquidity (which could, in fact, be affected by CFTC SEF regulations, with exchange-like limit order book systems more susceptible to natural monopoly) and the economics of scale and scope driven by technology.

The Division anticipates this argument by saying that “[i]t could be argued that economies of scale in trading are so pronounced that derivatives markets will best be served by a single trading platform.”  It then rejects this by saying “[t]his claim would seem to be inconsistent with developments in other financial markets–for example, cash equities–where multiple trading platforms have flourished.”

Two responses.  First, that claim is not inconsistent with developments in most derivatives markets in the US and overseas, which are the markets of interest.  Those markets are almost universally dominated by a single large exchange.  (With respect to options, (a) index options are still dominated by single exchanges, and (b) in the US, for options on individual stocks, order handling rules effectively socialize order flows in a way that eliminates tipping that creates a dominant exchange).

Second, in equity markets, many of the trading platforms (e.g., dark pools) are means by which demonstrably uninformed traders reduce trading costs.  As I’ve written before, it is price discovery that is the natural monopoly: dark pools and other mechanisms (e.g., internalization) that don’t contribute to price discovery aren’t subject to network effect driven economies of scale.  Moreover, those mechanisms have not, heretofore, developed in derivatives markets, likely because the information intensity of trading is not as acute.  Moreover, Reg NMS in US equities essentially socialized order flows and created a network of interconnected platforms, where the interconnection is mandated and regulated; prior to RegNMS, a single exchange dominated equity trading in the US, and single exchanges dominate equity trading in most other markets (that lack a RegNMS-type rule).  Without a similar regulation in derivatives trading, the tipping tendency will prevail, leading to the dominance of one or a small number of platforms, ownership restrictions or no.

The kind of “competition for monopoly” story that DOJ tells (p. 6) is a more reasonable one, but ownership and governance restrictions are not going to affect one whit whether such competition occurs.  Regardless of who owns a dominant exchange, there is a lot of money to be made displacing it, giving an incentive for somebody–anybody–to attempt to displace it.  All that takes is money and technology, which is pretty widely available.

I also consider it ironic in the extreme that DOJ holds up BrokerTec as an example of an entity that spurred technological innovation through a competition for the CBT’s monopoly on Treasury futures.  It’s ironic because BrokerTec was a dealer initiative.  Similarly, the most recent competitor for the CME (which is not dealer owned or dominated) is a dealer dominated ELX, and CME’s strongest competitor in energy is the dealer-dominated ICE.  And dealer dominated Turquoise has tried to oust non-dealer dominated LSE in British equities.  So, if anything, dealer ownership limits would have hamstrung these competitors to dominant exchanges.

The focus on control of a dominant entity by dealers seems to reflect politics, rather than economics.  The Antitrust Division’s concern should be about competition and market power generally, not about who collects market power rents. It has definitely not made the case–nor do I think it is possible to make the case–that restrictions on ownerhsip will have a material effect the magnitude of market power rents.

That said, (a) I’m not advocating intrusive regulation of competition in derivatives trading, and (b) I’m not advocating RegNMS-like rules for derivatives.  I’m just saying that if your desire is to create multiple competitive platforms, something like RegNMS is necessary, and governance and ownership restrictions are superfluous at best, and counterproductive at worst.

The DOJ’s discussion of joint ventures (p. 6) suggests they just don’t understand the economics of exchanges and financial trading.  They are concerned about a joint venture between dealers that admits too many members!  The concern should be quite the opposite.  As shown in my 2002 JLEO paper, exchanges can exercise market power by (a) admitting enough members that allow them to achieve scale economies that make them immune to competitive entry, but (b) which have fewer members than optimal.  This is a consequence of the liquidity network effect.  DOJ should be concerned about limits on membership, not that membership is too inclusive.  The analogy between exchanges and airline alliances is completely off point.

With respect to clearing, the DOJ’s concern that restricting access to CCPs could serve to reduce competition is well-grounded; indeed, that’s exactly the kind of point I just made in the previous paragraph.  I made that argument long before they did.  But what is missing from its analysis is any consideration of the effects on ownership and governance regulations on (a) the willingness of institutions to commit the capital necessary to ensure that CCPs have the financial wherewithal to absorb large defaults, thereby mitigating systemic risk, and (b) CCP decisions on margins and capital levels that also impact their financial soundness and ability to withstand large price, volatility and liquidity shocks.  As I’ve argued over and over, it is difficult to balance these considerations.  But given that the whole purpose of clearing mandates is to reduce systemic risk, you’d think that these considerations should predominate.  What’s more, it’s just inexcusable to ignore the financial safety/systemic risk issue altogether.  Trade offs are hard, but ignoring them is unpardonable.

Indeed, the DOJ treats this issue dismissively: “[t]hese actions against potential new clearing members could be explained away, for example, by expressing risk management-related concerns.”  Yeah, sure, somebody is likely to make that argument, and it deserves consideration rather than dismissal because these concerns are of first-order importance.  Not that you’d learn that from reading the DOJ comment.

This is a very important issue, one that deserves careful, honest, and balanced analysis, none of which the DOJ provides.

With respect to governance recommendations, the DOJ comment is similarly incomplete and superficial.  It focuses on conflicts of interest, but says nothing about ensuring that ownership structures align the incentives of those bearing the risk and those making the decisions.  Misalignment would court disaster.  To overlook this issue completely is quite disgraceful.

All in all, this is a fundamentally flawed analysis of the economics of derivatives trading and clearing, competition in those markets, and the benefits of restrictions on ownership and governance.  Despite its crowing about its expertise in these markets, DOJ exhibits glaring deficiencies in its understanding of the economics of competition in trading and in clearing.  As a result, if the CFTC has any sense, it will dismiss DOJ’s recommendations out of hand.

Yeah.  I know.

The scariest kind of counterparty risk is “wrong way” risk.  This kind of risk occurs when there is a dependence between the size of the exposure (i.e., the amount that can be lost in the event of a default) and the probability of the counterparty’s default.  In particular, wrong way exists when the exposure is large when the probability of a counterparty default is large.

A canonical example of wrong way risk is a firm that writes a put on its own stock.  If the firm goes bankrupt, and its stock becomes worthless, it defaults.  When it defaults the exposure is as large as it can be: the strike price of the put.  In contrast, a firm that writes calls on its own stock has “right way” risk.  If the firm does badly, and indeed goes bankrupt, default losses on the call are zero because the call is out of the money.

Central counterparties–clearinghouses–are touted specifically as ways of mitigating counterparty risk.  Post-Financial Crisis, they have been particularly advanced as a means to reduce systemic risk by reducing counterparty risk absorbed by big financial institutions.  This raises interesting questions: Do CCPs have a wrong way risk problem?  If so, what implications does this have for the performance of CCPs during systemic crises?

The answers in brief: yes, they may well have a wrong way risk problem, and that means that it is dangerous to rely on them as a means of reducing the likelihood and severity of truly systemic crises.

As I noted before, the defining feature of wrong-way risk is a dependence between default probability and the size of exposure.  This is often characterized as a “correlation” between default risk and exposure.  But as I’ll discuss below, “correlation” is too limiting a concept.  Correlation implies dependency, but dependency does not imply correlation.

The magnitude of wrong way risk depends on the nature of transactions and counterparties involved.  In particular, out-of-the-money options exposures, very senior tranches of structures, and highly rated counterparties are most vulnerable to wrong way risk.  (For a good book on this subject, see Jon Gregory’s descriptively titled Counterparty Credit Risk.)

Moneyness matters because a deep out of the money option generates an exposure only if the underlying price moves a lot.  But if the underlying price and the creditworthiness of the option writer tend to move in the same direction, a big movement in the underlying that puts the option in the money also tends to be associated with a dramatic erosion in the creditworthiness of the writer. Thus exposure and default risk peak simultaneously.

The seniority of a tranched structure matters for a similar reason.  There will be losses on a senior (or supersenior) tranche only in the event of an extreme adverse shock hitting near simultaneously many of the credits underlying the structure.  If this same adverse shock puts the writer of protection on the tranche into financial difficulties, the writer is most likely to default at the same time that it is supposed to payoff on the protection it sold.  Think monolines, or AIG.

The credit quality of the counterparty matters because a high quality counterparty is likely to default on a contract only if it suffers a severe adverse shock to its balance sheet.  With the right kind–or should I say wrong kind?–of dependence between the exposure and the counterparty’s balance sheet, this big adverse shock leads to a big move in the value of the contract.  Thus, exposure is big precisely when the counterparty is highly likely to default.

Let’s see how this relates to CCPs, and in particular to the default funds of CCPs that are the ultimate backstop of cleared contracts.  Default funds are analogous to protection written on supersenior tranches.  The collateral (margin) that firms must post to CCPs when they hold derivatives positions absorbs most of the losses due to movements in market prices.  Indeed, margins are usually set to absorb 95-99 percent of market moves.  Beyond margin, CCPs often have their own financial resources to cover the losses associated with the default of any member firm not covered by margin.  If the margin and CCP-resource elements of the CCP “waterfall” (note the similarity of terminology used to describe tranched structures and CCPs) are breached, then the members must absorb the remaining default losses, up to some pre-established commitment level.

This means that CCP members must cover defaults only in extreme circumstances, just like writers of protection on supersenior tranches must cover defaults only under extreme circumstances.  Indeed, the oft-touted features of CCPs, such as collateralization create the seniority/out-of-the-moneyness that gives rise to wrong way risk if the pre-requisite dependencies also exist.

So it seems that CCPs are potentially vulnerable to wrong way risk.  They are effectively financial structures of a type that can, given the right (or wrong, depending on your perspective) dependence, give rise to a serious wrong way risk problem.  Which raises the question: are the dangerous dependencies likely to be present?  That is, are the contributors to a CCP default fund likely to be in bad financial straits just when their contributions are needed to absorb default losses? Are those that are insuring default losses (through mutualization) likely to be in dodgy condition precisely when they are most likely to have to pay off on that insurance?

Given that we are talking about tail events, it’s difficult to assess that question analytically and empirically.  But there are reasons to believe that these dependencies are in fact lurking.

A big financial shock that is sufficient to cause movements in derivatives prices big enough to breach margin levels, and/or which damages a CCP member’s balance sheet (or multiple members’ balance sheets) severely enough to force it (them) into default is likely to be associated with severe financial difficulties at other CCP member firms.  For instance, during the financial crisis all banks were cratering simultaneously and prices were moving dramatically; their stock prices all plunged together and their CDS spreads all spiked togehter.  They were all exposed to the same big underlying risk–in the event, real estate prices.  When those prices went south, all financial institutions were in distress, most of them in severe distress.  The financial tumult also resulted in big moves in stock prices, interest rates, credit prices, and commodity prices–all of which could have and did create widening exposures on derivatives trades.  Indeed, since CCPs have zero net positions, a big move in any price is going to create a big exposure for the CCP.

And it’s not just price movements that matter.  Financial and economic shocks are also associated with big changes in volatilities that affect exposures on non-linear positions (notably options or contracts with embedded options). Moreover, big volatility makes it more likely that exposure values and creditworthiness will move substantially.

Perhaps even more crucially, big financial and economic shocks tend to result in correlations in prices shooting towards one and minus one.  This has both direct and indirect effects.  The direct effect is to move–often by a lot–the mark-to-market values on correlation-sensitive positions (e.g., CDOs, multi-product options).  The indirect effect is perhaps even more pernicious, as it is exactly these high correlations between the value of assets on financial institutions’ balance sheets and the values of derivatives exposures that generate acute wrong way risks.  That is, the effects of stressed–crisis–financial conditions on correlation creates the very form of dependency that gives rise to wrong-way risk.

Liquidity effects of crises can also create dependencies.  Liquidity tends to decline during crises, which tends to increase volatilities, thereby exaggerating movements in exposures and creditworthiness.  It also makes it more difficult to manage the risk on exposures, and to trade out of positions in order to reduce exposures.  (The common liquidity shock may be one reason why correlations tend to risk towards one in absolute value during crises.)

These dependencies can be especially exaggerated for certain kinds of products and CCPs.  Consider, for instance, a CCP that clears CDS, a substantial portion of which are written on financial names, and which has financial firms for members.  Exposures tend to spike for such a CCP at the very same time its members are suffering dramatic declines in creditworthiness.  Not good.

Thus, in crisis periods, dependencies between the value of the backers of CCPs–the member firms (often banks)–and the exposures that CCPs are effectively writing protection against are highly likely to be of the wrong way variety.

This means that CCPs offer dubious protection against systemic risk.  A huge economic shock, like that suffered in 2007-2008 creates dependencies that give rise to wrong way risks.  They also give rise to big changes in exposures.  The structures of CCPs have features that are particularly vulnerable to these dependencies.

Even if a CCP does not fail during a crisis, the wrong way risk problem means that the financial institutions that backstop it will have to make payouts at precisely the times that they are under strain.  That is, CCPs load risk onto big financial institutions precisely during crises that are already stressing them.

This is not to say that CCPs cannot share garden variety default risks more efficiently than bilateral arrangements.  But that’s not what the advocates of CCPs hyped when arguing for clearing mandates.  No, these advocates repeatedly and specifically held them up as an antidote for crisis, as a bulwark against systemic risk.

The foregoing analysis of wrong way risk implies, however, that CCPs themselves are most vulnerable to default precisely at the time that their advocates look to them to be the breaks that contain financial firestorms.  Consequently, any sense of security against financial contagion that they provide is very likely a tenuous one, and arguably a false one.  Such complacency is particularly worrisome as it can undermine the urgency to find more effective and reliable measures to reduce the vulnerability of the financial system.

I am not saying that CCPs are as defective in concept as monoline insurers, or as AIG was.  (Jon Gregory argued back in 2008, and argues again in his book, that the monolines and AIG were fundamentally, fatally and irredeemably flawed.)  I am just pointing out that they share key features with those casualties of the last crisis, and as a result, may well be casualties in the next one.

It should also be noted that the Basel III capital requirements for CCPs that I discussed in an earlier post do not capture this risk in any meaningful way.  They cannot provide, therefore, an incentive to reduce it in any meaningful way.

In a classic Rocky and Bullwinkle episode, Captain Peter “Wrongway” Peachfuzz sailed his ship up Wall Street. Let’s hope that’s not a metaphor for the effect of mandated clearing.  But you should be concerned that clearing concentrates wrong way risk, and that this guy becomes the poster child for Frank-n-Dodd and its clearing mandates:

My post on the “points” system under which the CFTC would monitor positions, and then intervene on a discretionary basis when any position breached pre-set levels (“points”) brought to mind a story about the famous–or notorious, depending on your perspective–speculator, Arthur Cutten. Cutten engaged in massive speculations in wheat during the 1920s.  In 1925, he made the largest income tax payment up to that time in the history of northern Illinois–over $500,000.  Importantly, as a result of his market activities, Cutten attracted the attention–and the ire–of the government.

The Grain Futures Act of 1922 required large speculators to report their positions to the government.  Speculation continued apace despite this requirement, and the authorities were impatient to do something to stop it.  Calvin Coolidge’s Secretary of Agriculture, W.M. Jardine, demanded that the Chicago Board of Trade do something to stop the “gambling” in grain. In response, the CBT created the Business Conduct Committee.

Even in the aftermath of the creation of the BCC, Cutten continued his speculations.  Cutten bought millions of bushels of May, 1926 wheat.  The Grain Futures Administration, the division of the Department of Agriculture responsible for enforcing the GFA, “suggested to the Board of Trade that Cutten’s holdings were too large for one person” (Ferris, The Grain Traders, p. 180).  The BCC swung into action and called in Cutten for a little chat.

When Cutten arrived for the meeting May wheat was selling at $1.65/bu.  (He had bought at around $1.50/bu).  His arrival at LaSalle and Jackson* was observed, and traders soon discerned its import: wheat began selling off as he ascended in the elevator to the conference room where the BCC was meeting.

The BCC told Cutten: “the Grain Futures Administration has made the complaint that you are carrying too much open stuff.”  Cutten resisted selling, but the committee persisted.  Finally, one of the committee members put his arm around Cutten, and told him: “You ought to sell some wheat for the sake of the Board of Trade.  You know, this committee is the device we settled upon to keep the government from taking fuller control of trading in futures.  They get the figures and watch the accounts from day to day.”

Cutten still resisted: “Why should I sell before I’m ready?”  The committee member responded: “For the sake of the Board of Trade.”

Cutten finally relented.  Prices fell further.  He later lamented that the elevator ride to the BCC meeting had cost him a million dollars.

The mechanism that forced Cutten to sell looks remarkably similar to that proposed under the point system.  The government monitored large positions, and exerted pressure on a particular trader–in this case, through the CBT–and that trader eventually capitulated.

What is worrisome about this story is that the intervention that forced Cutten to sell occurred in an overtly politicized environment.  The Secretary of Agriculture, in step with a long line of Senators and Representatives viewed commodity speculation as a social ill.  Jardine had demagogued the issue repeatedly: he had dragooned the CBT into creating not only the BCC, but to mandate clearing of all grain transactions as well.  A speculator who had gained considerable notoriety for his previous operations in the market was targeted for pressure.  At least insofar as the public record is concerned, there is no evidence that the GFA or its handmaiden BCC undertook any serious inquiry to determine whether the speculator’s actions had or threatened to distort prices.  Similarly, there is no evidence that less intrusive measures were considered or proposed: to mitigate concerns about a corner, for instance, the BCC could have limited Cutten’s ability to take deliveries of wheat in quantities necessary to effectuate a squeeze.

Thus, one reasonable interpretation of the events of 1926 is that the GFA–the great-grandfather of the CFTC–intervened in the market for political purposes, rather than on the basis of a well-reasoned and empirically supported concern that the market had in fact been distorted by the actions of a particular individual.

Having watched closely–and up close–the fevered battles over commodity speculation in the past several years, I have no confidence that the same thing wouldn’t happen under the points system.  In fact,  I would put that more strongly: I have every confidence that the same thing will happen again.   Discretionary authority is subject to political pressure, not to mention the whims of regulators.  Consequently, it is inevitable that such authority will be abused.

Yesterday was the 5th anniversary of Streetwise Professor.  Time do fly.

I’ll try to keep the navel gazing to a minimum, but I think a few comments are warranted.

The blog, and most notably its reception, have exceeded all the expectations I had when I started it.  I originally envisioned it as a place to think out loud on relatively arcane issues related to financial markets and market structure, and thought that if a few readers stopped by from time-to-time, that would be nice.  It has played that think-out-loud role, but it has attracted many more readers than I had ever anticipated.  Not a huge number by blog standards, but given the rather arcane and arguably eccentric content, a surprising number.

I think a couple of things are responsible.  The first is the wholly unplanned foray into writing about Russia.  That subject generates by far the most comments, and certainly the most heated and passionate ones.  Given the fact that there would be no readily apparent reason for me to write about Russia, it has also resulted in some rather puzzled inquiries from friends and acquaintances, who have offered some rather entertaining hypotheses to explain it.

There is an explanation, convoluted, but an explanation nonetheless.  Several interests serendipitously converged on the subject of Russia.  I attended the Naval Academy in the Cold War, which generated an initial interest in Russia.  I took a year long Russian Civilization sequence at the University of Chicago after I transferred from Navy, taking classes from major scholars Arcadius Kahan and Richard Hellie (both now passed, sadly), which fed that interest.  The interest went into hibernation as I launched into my profession, but as my career developed, I became deeply involved in energy issues (an unexpected departure in its own way with its own story), and also became very interested in institutional economics issues, including property rights economics and political economy.  Russia represented a fascinating case study regarding energy and institutions, and that’s what started me down the path of Russian commentary.  After that, my tendency towards serial intellectual obsessions (which started with Civil War history as a kid) took over, and led me to read and write more; one damn thing led to another, and reading about one thing led to related issues and on and on.  Conditioned response played a role too: I naturally wrote more about the subjects that generated the most feedback.

The second major factor explaining SWP’s unanticipated trajectory was the financial crisis.  As a result of the crisis, aracana that I’d written and researched about for years–financial market structure and clearing, most notably–to the collective indifference of a big swathe of the economics/finance academy all of sudden became extremely topical.

It’s funny, actually.  In October, 2008, (note the timing) I received a rejection letter from a journal for a paper I’d written about the economics of clearing and OTC markets and which had been under review since mid-2007.  The letter said that the topic was of insufficiently general interest to warrant publication.  (It took 18 months to figure that out?)  Well, virtually all of the issues discussed in that paper were soon at the center of debates over financial reform and clearing mandates.  If the journal had actually published it in a timely manner, the editor would have looked prescient.  Instead . . .

But the blog gave me the opportunity to write about topical things in a timely way without having to deal with editorial gatekeepers (whose value added is not necessarily positive).  Although I know a number of who come here to read about Russia, or broader financial issues, groan when they see another clearing post or market structure post, these have served their role as first drafts for some serious academic work, and moreover, have had some influence in business and policy circles.  I’ve been gobsmacked on more than one occasion when some pretty prominent people have mentioned a specific blog post–by title–that had influenced their thinking.  I’ve also had the pleasure of hearing, sometimes directly, sometimes through back channels, that I’ve ticked off a few people.  Given who said people are, I consider it an honor.  I’ve been warned that if I want to have more influence, I need to be more politic.  (The other day somebody at a major financial institution told me that I risked being burned for heresy.)  Well, that cuts against my personal (Jacksonian) grain, and what’s more, being “politic” usually involves pulling punches and leaving important things that need to be said unsaid.  So, that’s not likely to happen.

Where will things go from here?  Who knows?  The moral of the story so far is that the trajectory of SWP is highly contingent on developments in finance, regulation, and yes, Russia, and those are all extremely dynamic.  The subject matter will probably stay in the same general ballparks–financial markets, especially their regulation; Russia; energy; climate issues from time to time–but the specifics will depend on how the world turns.  And the past five years have shown that the world does turn in highly bizarre directions.

I appreciate all of you that have come to visit SWP over the past five years.  It is truly gratifying, and completely unexpected.  It’s been an interesting and rewarding five years, and I look forward to engaging with you all in the years to come.  Thanks, and Happy New Year.