Streetwise Professor

The EU is proceeding with plans to take a much more aggressive regulatory approach in commodity markets.  The scheme will empower the to-be-established European Securities and Market Authority (ESMA) broad powers to intervene in commodity markets.  These powers would include the ability to impose “ex ante” position limits.  These proposals are included in a massive, sweeping proposal to regulate financial markets.  The new powers include:

— supervisors should have powers to intervene at any stage during the life of a derivative contract

— supervisors could require any holder of a contract to provide a full explanation for the position, provide all relevant documentation, reduce the size of the position in the interest of an orderly market and investor protection

— EU regulators to propose standards for setting position limits for derivative contracts traded on and off exchanges and define when such limits should be triggered

. . . .

— a separate “chapter” should be introduced into MiFID to “help ensure that sufficient clarity and regulatory focus are devoted to how commodity derivative markets function in the future”

— there is a need for a position-reporting obligation by categories for traders for contracts trade on all EU venues

— to avoid problems with convergence between futures and spot prices in commodity derivatives, a requirement could be added to the way commodity derivatives contracts are designed to ensure price convergence

— currently commodity trading for own account is exempt from MiFID rules but this waiver should be narrowed

— if an off-exchange, physically settled contract is like an exchange traded contract and standardised then it should also be centrally cleared

John Kemp of Reuters has more detail (sorry, no link: the story was emailed to me and I can’t find it on Reuters):

Under enhanced position management, position holders could be required to provide a full explanation for the position, including relevant documentation, to show whether the purpose is hedging or speculation. They could be required to reduce the position in the interest of an orderly market, investor protection or market integrity. The authorities could intervene at any time in the life of a derivative contract.

. . . .

But the consultation envisages that the future European Securities and Markets Authority (ESMA) would be given a powerful coordinating role and empowered “to propose technical standards to set ex-ante position limits both for derivative contracts traded on exchange and OTC [over-the-counter]” when necessary to address “risks to the overall stability or delivery and settlement arrangements of physical commodity markets”. That looks like a direct reference to preventing squeezes in the delivery mechanism.”New implementing measures could further define the details of when the powers to propose position limits may be triggered. For example, these could be triggered when conditions in a given market in terms of liquidity or market concentration jeopardise market efficiency or integrity,” according to the consultation document.

Decisions about when to invoke enhanced position management powers would be taken by the ESMA rather than left to exchanges. ESMA would set overall principles to be applied at national level. But it could also intervene directly when there is a threat to the orderly functioning and integrity of financial markets and national authorities have not taken sufficient measures to address the issue.

This implies a much bigger, more direct role for the regulator in handling the issue of dominant positions and market squeezes.

The Kemp piece, and some of the elements of the proposal (e.g., the focus on convergence) suggest that the focus of the new position control regime will be to prevent manipulation.  That focus is laudable, in contrast to the vague, obscure, untestable, theoretically and empirically unsupported goal of eliminating “excessive speculation” that underpins the CFTC’s authority to impose position limits (now vastly expanded).  (Give me a few minutes, and I’m sure I could come up with many more pejoratives.)  Manipulation (in its most important forms) is something, in theory and in practice, that can be defined, understood, and empirically identified.  In contrast, determining when speculation is “excessive” is a nebulous task, with no grounding in proper economics and impossible to implement in practice.  As a result, what happens in markets tends to be a Rohrschach Test, with some people (e.g., Bart Chilton, Michael Masters) seeing excessive speculation everywhere, and others not.

Kemp notes that the EC initiative is an implicit rebuke of Britain’s Financial Services Authority, which has argued that position limits are unnecessary. Kemp further notes that the FSA already has many of the powers outlined in the EC proposal, but delegates their implementation to exchanges.  As was seen in cocoa over the summer, and has been seen chronically in the metals markets for decades, that basically means in practice that “light touch” is a massive understatement, and that market participants can undertake some blatantly egregious–manipulative conduct–with little fear of hearing even a whispered “boo” from the exchange or the regulators.

Nor is it evidently much better on the Continent.  Although not related to commodities, the Porsche corner of VW shares, which I’ve written about extensively, was about as brazen and extreme as it gets, but the German regulators played Sergeant Schultz, and saw nothink.

So, in principle a manipulation-focused bolstering of regulatory powers is a good thing.  (See, I’m not an anarchist, despite what some think.)  That said, a highly discretionary system that relies on ex ante intervention is inefficient, compared to a realistic alternative.  I’ve written for what seems forever (although it’s only about 16 years or so) that an ex post regime that imposes sanctions on those that manipulate the market is highly preferable.  It economizes on resources committed to supervision.  Moreover, true corners and squeezes can be identified reliably ex post, and the perps are not judgment proof, and hence can be deterred by the prospect of severe sanctions imposed in the event of a determination that they have manipulated; a determination that can be made with considerable precision, and little likelihood of falsely convicting the innocent.

The EU/EC is in an excellent position here to do something constructive, because it starts with a blank slate.  Unlike the US, which is hamstrung by poorly crafted laws that provide little guidance to judges and regulators, thereby permitting the proliferation of economically deficient (and precedential) decisions, the EU has the ability to create an anti-manipulation statute that is grounded in economics, which provides specific guidance and tests to triers of fact.  My suggestions along these lines are here, amongst other places.  (Hint, hint, nudge, nudge.)

Permitting a private right of action would also be quite beneficial, because those harmed by squeezes are highly motivated to take action if they can be compensated for the damages that they suffered.  As the US experience shows, relying on regulators alone to punish manipulative conduct after the fact, even when they have the power, is all too often woefully inadequate.

Moreover, even if there is a focus on ex ante regulation, that regulation would be more effective, with lower probabilities of inappropriate intervention and inappropriate failures to intervene (cf. cocoa, July, 2010) if it were predicated on a firm economic understanding of manipulation, and if it were to set out in detail the indicia of manipulation and manipulative conduct that would attract regulatory scrutiny.  There is always a fear that a broad, vague grant of discretionary power to regulators can lead to a proliferation of both Type I and Type II errors.

Along these lines, although the descriptions of the EC consultation document suggests a focus on manipulation properly understood, the statements of the politicians in charge of the effort raise serious concerns that the regulation might be used to attack any form of conduct that doesn’t suit the person speaking at the moment.  For instance, EU commissioner Michel Barnier, who is driving the reform effort, has said:

If someone is doing something which affects the market then he or she must be held to account.  Hyper-speculation is scandalous.

“Affects the market” is pretty broad.  The broadside against “Hyper-speculation”–as opposed to manipulation–smells suspiciously like the pernicious “excessive speculation” language in the Commodity Exchange Act.  It doesn’t take too much of an imagination to picture that during some future energy or ag price spike, a regulator subject to political influence would intervene in a destructive way, chasing some chimera of hyper-speculation.  Politically influenced regulators (and there is no other kind) are great at killing the messenger.

Which all means that it is difficult to be too enthusiastic about the proposal.  Yes, a rule focused on manipulation, properly understood, would be an improvement.  But ex ante measures are inferior to ex post, and I strongly suspect that whatever emerges will give regulators a lot of discretion that can be abused–and will be abused, in the event, the next time developments in the commodity market leads to a popular and political hue and cry to “do something.”

In my recent piece on clearing in the Journal of Applied Corporate Finance, I wrote:

It is equally unknown what clearing market structure will evolve, and how close this structure will come to approximating the ideal structure.  In this regard, it is essential to keep in mind two facts.

First, the extensive scale and scope economies associated with clearing make it likely that the clearing industry will be highly oligopolistic, and that strategic considerations will influence decisively the way that the industry develops.   Moreover, scope economies across trade execution and clearing (Pirrong, 2010b) will also affect the strategic and efficiency forces that will shape industry structure.  Strategic considerations will almost certainly drive a wedge between what is optimal for the individual decision makers, and what is optimal for the economy.  This is particularly true inasmuch as there is no market mechanism evident that would induce CCPs to internalize the systemic externalities associated with their failure.

. . . .

Second, industry evolution will inevitably be a highly politicized process.  Dodd-Frank gives regulators enormous discretionary authority over the operation of CCPs.  Interested parties will influence the regulatory process for their private benefit.  Political tradeoffs, rather than efficiency considerations, also threaten to cause serious divergences between the structure that evolves in practice, and the one that would optimize the relevant economic tradeoffs.  The effects of politics are particularly pronounced in this context because finance is a truly international industry, and hence jurisdictional issues and competition between jurisdictions will play a decisive role in determining the industry’s ultimate configuration.  For instance, governments in major financial centers (e.g., the US, London, the EU, and individual countries in the EU, Japan, Singapore, and Hong Kong) have all expressed a strong interest in domiciling CCPs, for both economic and political reasons.  But accommodating these interests would fragment clearing, reducing netting benefits and raising serious concerns about coordination during a crisis.  Moreover, regulatory competition between jurisdictions to favor their local CCPs could compromise financial market stability.

There is another mandate in Frank-n-Dodd, this one for reporting all swaps transactions to trade respositories.  The scale and scope economy issues, and the jurisdictional and political issues are also present for repositories, and a recent article in eFinancial News demonstrates that the problems in the likely evolution of clearing market structure that I identified above, with the associated inefficiencies, are coming to pass with the repositories:

However, repositories are not a cure all. While the concept of a trade repository is not controversial, there are issues to address. Most notably, the sudden explosion of repository providers is leading to fragmentation, a problem familiar in other areas of the market, such as the clearing landscape.

Market participants are concerned that fragmentation would undermine the purpose of repositories to provide a single integrated view of derivative risk. The DTCC’s Douglas said: “The problem with trade repositories is that if everyone wants to build their own, how can regulators be sure that they are seeing the whole picture?”

l;”>The market has also raised concerns that multiple repositories may lead to double-reporting, while others highlight the implicit problem of dividing repositories along asset-class lines.

Richard Metcalfe, head of global policy at the International Swaps and Derivatives Association, which supports repositories in principle, warns that this approach does not show the trade data in its fullest context. He said: “You are looking at derivatives in isolation from positions that dealers might be hedging or adding to.”

This problem may be partially addressed by developing interconnectivity between the different trade repository providers. Interconnectivity would help build a full regulatory picture but would still afford dealers a choice of reporting venue, according to Philip Brown, head of client relations for Europe and the Americas at Clearstream.

. . . .

“>But the legislation is not yet finalised and the industry will have to move fast before the proliferation of repositories in both US and Europe renders the task of standardisation slow, tedious, and painful.

Metcalfe said: “I think the key issue is can we ensure that supervisors work together internationally to ensure that the information can be aggregated.”

It’s easier to create repositories than CCPs.  That’s why the process of creating them is further along than for CCPs.  But you can expect that all of these problems will occur in spades as development of clearinghouses proceeds in the coming months and years.

It’s also important to remember that repositories just consolidate data, not risk, so the consequences of getting it wrong are not as severe, by far, with repositories as compared to CCPs.  Fragmentation seriously impairs the allocation of risk, by reducing netting possibilities, reducing diversification, and limiting cross margining.  It also will create the potential for serious coordination problems in the event of a crisis; poor coordination across CCPs could greatly exacerbate the effects of a crisis.

Which all means that when you see the difficulties already becoming manifest in trade repositories, you should be very concerned about the effects of a clearing mandate.  Frank-n-Dodd, and what the EC is doing, can mandate clearing, but they can’t mandate market structure.  That is going to evolve in a messy way, driven by the nature of indivisibilities and politics–as the repository experience is showing.  And a messy evolution in clearing is a very sobering prospect, given that our legislative and regulatory betters have decided it wise to put all our eggs in that basket.

This was unintended, but not unpredictable.  At least it shouldn’t have been.  But one hopes that even for the dreamers and the slow learners, that what is happening in trade repositories is a cautionary tale that will open their eyes to what is likely to transpire in clearing.

Frank-n-Dodd mandated clearing.  The CFTC is now promulgating a raft of rules regulating the clearing process.  One of these rules limits the ability of clearinghouses to determine to whom they offer clearing services, and how:

The Commodity Futures Trading Commission approved a proposed rule to force the world’s largest banks to offer swaps clearing services to smaller firms, a change that would promote competition in the $615 trillion market.

. . . .

“Swaps dealers or major swaps participants are prohibited from interfering with or attempting to influence decisions related to the provision of clearing or the acceptance of clearing customers,” according to the proposed rule. The potential regulation now enters a 60-day public comment period before any final CFTC vote.

I’ll defer comment now on this particular rule because it hasn’t been posted on the CFTC website yet, and want to read the full rule rather than going on just the news report.  But this does relate to a general issue that I’ve been thinking about lately: CCP governance.  So I’ll provide some general analytical observations on this subject that are likely to be relevant as the CFTC and SEC proceed on clearing issues.

I’ll focus on CCP membership and its implications for the way CCPs are run.  In particular, in addition to controversy about who should be allowed to open clearing accounts and who should have a say in who can do so, there is also controversy about who should be able to become a CCP member, and CCPs’ ability to set membership standards and to exclude some firms from membership.  This issue came up at the roundtable I participated in on 22 October.  There is a group of smaller banks and brokerage firms that are pressing to become CCP members, and to limit the ability of CCPs to set standards that could result in their exclusion.  This is likely to be a big issue going forward.

As I’ve written for years, there are difficult trade-offs here.  On the one hand, there is the issue of market power.  I’ve shown–in work going back into the 1990s–that when there are substantial scale economies, as is the case in clearing, it is possible for a CCP–even if it is member-owned, and a not-for-profit–to exercise market power by limiting membership.  That is, a suboptimally small “club” of intermediaries can get together and form a CCP, without fear of competition from another CCP due to the scale economies.

On the other hand, allowing open access can jeopardize the financial security of the CCP.  I want to focus on this issue.

A key point here is heterogeneity.  CCPs with heterogeneous members, in particular firms that vary in their financial strength, risk management capabilities, etc., face difficulties that CCPs with more homogeneous members do not.  These difficulties, in fact, can undermine the ostensible public purpose behind mandating CCPs: reducing systemic risk.

CCPs are firms that have to be governed and managed.  It is well known that heterogeneity increases the costs of governing cooperative organizations.  Henry Hansmann’s The Ownership of Enterprise provides numerous examples of this.  Conflicts between members are more likely, the more heterogeneous they are.  In particular, some members can attempt to use the organization to transfer rents from other members.  In my 2000 JLE paper “A Theory of Financial Exchange Organization” I explain a lot of the supposedly inefficient and cumbersome governance mechanisms in futures and stock exchanges as a rational way of mitigating rent seeking among the heterogeneous members of these exchanges.

Let’s take the case of a CCP in particular.  A CCP mutualizes risk, and therefore creates potential moral hazard problems.  The CCP can mitigate these problems by imposing capital requirements, and crucially, by choosing margin/collateral policies.

When CCP members are heterogeneous, in particular, when some are better capitalized than others, or when some incur higher costs to post collateral than others, the members will disagree on what the appropriate margins should be.  The better capitalized firms and those who incur lower costs to post collateral will prefer higher margins.  The more poorly capitalized firms and those who incur higher collateral cots will prefer low margins.

The well capitalized firms are concerned that since clearing makes the cleared products fungible, customers don’t care who they trade with.  Since risks are shared, every member is effectively a perfect substitute from the perspective of customers.  Thus, clearing tends to make it easier for less-well capitalized firms to get business.  But since default risk is mutualized, this reallocation of trading activity towards the less-well capitalized firms tends to force the better-capitalized firms to suffer more default losses.  One way (albeit, imperfect) to control this problem is to raise the costs that the less-well capitalized firms incur (relative to the costs of the better-capitalized ones).  Since collateral is typically costlier for the lower-cap firms, this can be done by charging relatively high margins.

Thus, I would expect that more highly capitalized firms would prefer higher margins than the less highly capitalized firms.  (Similar arguments can be made relating to other risk control policies that CCPs might adopt.)  The more heterogeneous the membership, the more acute the conflict between the members.

The CCP governance mechanism has to have some way of dealing with these conflicts, and making decisions.  Some decisions are going to be made by voting.  With one-member, one-vote kinds of systems, the median member will drive the outcome.  A CCP with a few big members and a larger number of small members may therefore tend to choose policies that favor the smaller members.  This is not likely to be optimal from a systemic risk perspective, and is also likely to result in larger members doing things to limit their exposure.  This in turn limits the risk sharing benefits that a CCP can offer.

Other kinds of voting rules can mitigate these problems, e.g., rules that are based on size or capitalization in some way, with bigger/better-capitalized members having more votes.  But smaller members are unlikely to be satisfied with merely belonging to a CCP but having to defer to the bigger members on key policy issues.  Hence if they pressure regulators and Congress to craft regulations that require CCPs to admit them, they are also likely to pressure regulators and Congress to craft regulations of CCP voting rules that give them some influence over CCP decisions.

Other decisions will be implemented by CCP management.  But CCP managers will be accountable to the members, and subject to influence by them.  Here again, voting rules will matter.  Moreover, Peltzman-Becker pressure group considerations suggest that managers, like politicians, will adopt policies that balance support among the various constituencies.  Median-voter type considerations again exist.  This means that CCPs with more heterogeneous members are likely to adopt policies that appeal to the median member.

In brief, when trying to determine the riskiness of CCPs, you have to consider how they are governed and managed.  Moreover, you have to recognize that governance and management depend on the composition of the membership.  And in particular, that CCPs with more heterogeneous members will behave differently than CCPs with more homogeneous ones.

One concern that is oft-expressed is that there will be a “race to the bottom,” with CCPs competing on margin and thereby compromising safety and creating systemic risks.  Given the economies of scale and scope in clearing, I doubt that the competition between CCPs will end up being all that intense, although there may be an initially period of intense competition that results in the market tipping to one or two dominant CCPs.

This analysis of CCP governance suggests another concern, and one that I think is more of a real worry.  Namely, that member heterogeneity can lead CCPs to adopt policies that benefit the median member, but which are not optimal from a systemic risk perspective.   Clearing inherently faces a moral hazard problem.  This moral hazard problem can create systemic risk.  Member heterogeneity makes it more difficult to control this moral hazard problem.  Internal pressures from riskier members–who can essentially pass their risks and the associated costs on to less risky ones–can lead CCPs to choose margin and other risk control policies that are not systemically optimal.  Internal pressures to reduce margins, rather than a race to the bottom between competing CCPs, is something to be concerned about.

One other historical note that illuminates another important cost of heterogeneity.  In Banking Panics of the Gilded Age, Elmus Wicker shows that with one notable exception (the Panic of 1873), the New York Clearinghouse was unsuccessful in dealing with financial panics and contagion.   (NYCH was a bank clearinghouse, not a derivatives clearinghouse, but there are important similarities.  Most importantly, NYCH had the ability to mutualize some risks.)  Wicker argues that conflicts between heterogeneous members were the main impediment in dealing with panics.  Although mutualization of risks would have mitigated panic (because the banks collectively were more likely to be solvent than any individual bank), mutualization transferred wealth from the stronger banks to the weaker ones.  The inability to overcome this distributive conflict stymied the ability of the NYCH to respond to crises in an effective way.   Thus, not only can heterogeneity increase the likelihood of a problem at a CCP (due to its effect on the severity of moral hazard problems), it can reduce the effectiveness of a CCP in dealing with a crisis situation.

This means that regulators should be extremely careful when crafting rules for CCP membership and voting policies.  Yes, there are legitimate grounds for concern that CCPs will use membership policies to exercise market power.  But there are also grounds for concern that forcing CCPs to admit more firms will lead to more heterogeneity, and that this can raise governance costs and jeopardize the financial safety of CCPs.  Similarly, regulation of governance and voting procedures to give more power to smaller members can also raise governance costs and jeopardize safety.  Inasmuch as the ostensible purpose of CCPs is to improve the stability of the financial system, it would be perversely ironic if political pressures induced regulators to adopt rules on CCP membership and governance that created systemic risks.  Tread carefully, people.

Testifying before the Senate in 1928, Texas cotton broker William Clayton responded to an accusation that he had manipulated the market with this drily arch remark: “The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

I’m sure Mr. Clayton is long dead, but his spirit lives on in the CFTC’s just proposed manipulation rule.  It is broad, sweeping–and maddeningly vague.  It basically promulgates a we’ll-know-it-when-we-see-it-and-tell-you-when-we-do-(with-a-subpoena) “standard.”

The rule itself just regurgitates the language of Frank-n-Dodd.  The explanation of the rule contained in the Federal Register provides ample evidence that the Commission views the rule as a fishing license to catch pretty much anything that damn well strikes its fancy.  Some key quotes:

Likewise, the Commission proposes to interpret CEA section 6(c)(1) as a broad, catch-all provision reaching fraud in all its forms–that is, intentional or reckless conduct that deceives or defrauds market participants. [Emphasis added.]

. . . .

The Commission proposes to continue interpreting the prohibition on price manipulation and attempted price manipulation to encompass every effort to improperly [sic] influence the price of a swap, commodity, or commodity futures contract. [Emphasis added.]

. . . .

Consistent with judicial interpretations of the scope of SEC Rule 10b-5, the Commission proposes that subsection (c)(1) be given a broad, remedial reading, embracing the use or employment, or attempted use or employment, of any manipulative or deceptive contrivance for the purpose of impairing, obstructing, or defeating the integrity of the markets subject to the jurisdiction of the Commission. [Emphasis added.]

. . . .

The Commission proposes to continue interpreting the prohibition on price manipulation and attempted price manipulation to encompass every effort to influence the price of a swap, commodity, or commodity futures contract that is intended to interfere with the legitimate forces of supply and demand in the marketplace.   The Commission reaffirms this broad reading of the term “manipulation” with respect to new CEA section 6(c)(3), while also recognizing that manipulation cases are fact-intensive and that the law in this area will continue to evolve largely on a case-by-case basis.

It is quite clear from all this that the Commission wants broad authority, and the maximum discretion and flexibility, to reach any operation of the market that does not suit it at the moment.  Willie Clayton lives.

I’ve written before that by attempting to craft anti-manipulation rules that are so broad to catch everything, Congress and the Commission in fact make it very difficult to catch anything, including the most egregious manipulative conduct.  That is a real risk under the new rule, which just compounds the vagaries and definitional imprecision of the existing laws, regulations, and precedents by adding new ones.  What is a manipulative contrivance or device?  I have no clue–and the proposed rule provides none.

The Commission gives itself an out by saying that manipulation cases are fact intensive, and that “the law in this area will continue to evolve largely on a case-by-case basis.”

Well, that’s the problem, isn’t it?  Anti-manipulation laws have been on the books since 1922, and there have been quite a few cases brought under the laws.  But to characterize the result of this process as “evolution” would be far too charitable. “Chaos,” “confusion,” “muddle,” and/or “devolution” would be far more apposite.  And it got that way precisely, exactly, because Congress and the various regulators charged with enforcing the law did not provide any real structure or guidance, again acting under the misguided notion that a broader, less precise law would be a more effective one.  The problem is not that the CFTC has not possessed the powers to reach truly damaging manipulative conduct; it’s that it has employed these powers in a scatterbrained way.  And that has happened, in large part, because the relevant statutes are vague and provide no structure or guidance.

I’ve written ad nauseum for almost two decades on the problems in the law relating to market power manipulation.  Despite the fact that economics provides the logical and empirical basis to permit determination with considerable precision whether a market power manipulation has occurred; who committed it; and whether he intended to do so, the Commission has never succeeded in bringing a successful market power manipulation case.  (As the discussion in the Federal Register notice makes clear, the CFTC’s much ballyhooed victorious DiPlacido case was not a market power manipulation case.)  That is particularly disturbing because market power manipulation is likely to be the most damaging and socially costly type of manipulation that can occur in derivatives markets.

I’ve advanced recommendations as to how it would be possible to craft fairly specific rules that would make it easier to prosecute market power manipulations.  More specificity would make it more likely that the CFTC could actually crack down on truly damaging conduct.  Laying new broad, vague terms on top of old broad, vague terms won’t do that.

Just how, exactly, will the new rule address the problems that have stymied the Commission in cases like in re Indiana Farm Bureau? How does it correct the problems (most notably vagueness) that Judge Miller tellingly identified in Radley?  (It does address some of the issues relating to jurisdiction.)  Answer: not at all.  Meet the new rule, same as the old rule–at least in its defects.

Moreover, the vagaries of the new rule will inevitably create uncertainty in the minds of market participants about what conduct is and what conduct is not a “manipulative contrivance or device.”  More legal risk is not exactly what the markets need right now.

In other words, the new rule will raise the frequency of both Type I and Type II errors.  Truly manipulative conduct will continue to go unpunished, and perhaps aggressive but legitimate conduct will not suit some enforcement guy at some moment.  The new rule threatens to make all too real the old lawyer’s joke: “I won half the cases I should have lost, and lost half the cases I should have won, so justice was done.”  Not really.

In brief, the new rule doesn’t fix the well-known problems with the existing regulations, statutes, and decisions: it just repeats them, and arguably adds some more.  Since the reach of the new rule will be far greater than the old one–extending to every swap, for instance–the potential for damage is commensurately greater as well.

I found one part of the FR notice particularly amusing.  Specifically, there’s this “we don’t need no steekin’ economists” language:

The conclusion that prices were affected by a factor not consistent with normal forces of supply and demand will often follow inescapably from proof of the actions of the alleged manipulator.

. . . .

Cases of this nature, where distorted prices foreseeably follow from the device employed by the manipulator, do not require detailed economic analysis of the effect on prices.

Yeah.  And then there are all those other cases where conduct is not sufficient to infer price distortion.  Which happen to be the far most important ones.

I understand that a lot of lawyers don’t like to have to rely on economists.  I will pass over in silence why that’s true.  Suffice it to say that the lawyers would be more successful if the laws and regulations reaching economic conduct were based on coherent, precise economics, rather than gassy generalities about “devices” and “contrivances.”

CFTC Chairman Gary Gensler gave an extended interview with Reuters on Friday.  A good part of the discussion revolved around budgetary matters, but this gem caught my eye:

The agency likely will stagger deadlines for traders to become compliant with the new regulations — including speculative position limits, Gensler said, declining to give any details about a long-awaited proposal that the agency will unveil in the next month.

Investment funds, which make up as much as quarter of trade in markets like cattle, have already looked for alternative ways to buy commodities, with some buying physical products instead of futures and swaps.

That’s OK by Gensler.

“Congress asked us to do a job, we gotta do what Congress asked us to do,” he said, adding cash markets are not part of his mandate.

Wait just a cotton pickin’ minute.  The whole point about limiting speculation in derivatives markets is that such speculation allegedly distorts prices for the commodities that consumers actually buy and producers actually sell.  That is, that such speculation allegedly distorts cash prices.  Listen to all the crying and moaning and gnashing of teeth about the alleged effects of speculation, and the tales of woe focus on the impact of speculation on cash prices.

I remember distinctly when I testified before Congress on speculation in the summer of 2008: criticisms of speculation at the hearing focused on the impact of derivatives trading on physical commodity prices.  Battling Bob Etheridge of NC took time out from assaulting college students to bewail the plight of trucking companies in his district forced to pay higher fuel prices due to speculation.  The head of the Industrial Energy Consumers of America claimed that chemical producers and others had to pay higher prices for natural gas and crude feed stocks because of speculation in derivatives.

I could multiply these examples by the hundreds, and probably the thousands.  In the 1930s, speculative limits were rationalized as a way of bolstering the prices farmers received on the cash market for their grain.  Suffice it to say that it is beyond cavil that the drive to restrict speculation in derivatives is all about the cash markets.

For Gensler, at this late date, to claim that’s not part of his (or his agency’s) job description beggars belief.  Congress mandated the imposition of position limits for the express purpose of reducing the impact of speculation on cash market prices.  That’s what Congress “asked” CFTC to do.  To proceed with a plan to impose speculative position limits on derivatives, without regard to how said limits could have the unintended consequence of distorting cash market prices is both irresponsible, and at odds with the purpose of the regulation.

Now, obviously, I do not agree with the beliefs underlying the legislative mandate for speculative position limits.  But given that the mandate exists, and that Congress has delegated to the CFTC the authority to implement said limits to achieve a purpose set out in the statute, you’d think CFTC should devise those limits with an eye as to their real effect.  There is now substantial credible evidence that one effect of limits on derivatives will be to shift some activity into the physical markets directly in a way that has more potential for adverse effects on these markets.  It is therefore incumbent on CFTC to take that into account when designing its limits, as otherwise it would impose restrictions that would be directly contrary to the entire purpose of the limits in the first place .

I mentioned the JPM physical copper ETF.  BlackRock just announced another.  This is a growing trend.

Goldman and Standard Chartered argue that physical ETFs should have a limited effect on the market.  In most circumstances, I believe that’s true.  But we’ve seen in the Treasury markets that the limited “float” of some Treasury issues that results from bonds and notes being locked up in pension funds and other buy-and-hold investors can lead frictions that distort prices, and in particular can make it easier to squeeze the market.  Physical ETFs could have the same effect.  Moreover, as a general matter, and as I opined in my original piece on the subject, whereas with derivatives investors can get exposure to particular risks without holding the actual underlying, if physical ETFs are the only way to get exposure to particular commodity price risks, there is an additional constraint that can effect prices as operating under the constraint, to meet portfolio objectives investors may decide to hold inventories of copper that would be released for consumption had investors been able to achieve these objectives through the derivatives market.

At the very least, CFTC should investigate thoroughly the effect of speculative limits on the scale of physical ETFs, and the effect of physical ETFs on the cash markets.  But Gensler’s remark in the Reuters interview makes it evident that he, at least, considers the entire issue irrelevant to the entire position limit exercise.  That’s wrong, and just plain wrongheaded.

You might argue that this development was unintended by the drafters of Frank-n-Dodd.  You can no longer say that it is unanticipated.  Regulators should attempt to determine how market participants will react to their dictates, and plan accordingly.  Saying “it’s not my problem, man” doesn’t cut it.

The next brawl on the Frank-n-Dodd fight card is over segregation of customer funds in the clearing model.  From the FT:

The “risk” that is in the spotlight centres on how customer assets, such as margins required to cover potential losses on derivatives trades, are held.

Under the current futures model, “futures clearing merchants” (FCMs), which handle cleared derivatives hold these assets in pooled accounts. If one of the FCMs’ customers defaults, and causes the FCM to go under too, then the clearing house can tap into this pooled account – also called an “omnibus” account – to cover any losses that are not met by margin payments or the clearing house’s default fund.

For investors these accounts are an important safety net. And they want the pooled accounts to be replaced by a system of separate, or segregated, accounts. Then, if another investor defaults, their assets are safe.

“It is an extreme event, but it is not impossible,” said Richard Prager at BlackRock at the meeting organised by the CFTC.

. . . .

If regulators opt for segregated accounts, clearing houses won’t be able to tap into these in the event of a default. Instead, clearers say the current system of using omnibus accounts gives them an extra shield. The removal of this shield would mean they would have to find funds elsewhere, potentially driving up clearing costs for users.

Kim Taylor from CME Clearinghouse said the removal of omnibus accounts could require a 60 to 100 per cent rise in the default fund, the capital put up by the backers of clearing houses. Such a rise in capital costs could lead banks to “think twice” about being in the clearing business, she said.

Point number 1 (which everybody saying anything about clearing should repeat until they internalize it): a primary effect of any priority rule–and the difference between segregation vs. omnibus accounts is first and foremost a difference in who is in what loss position in default–is to shift risk around.  Under the omnibus model, the customers of an FCM are at risk to its other customers and the FCM itself.  If some customers default, and the FCM does not have the resources to cover this, under the omnibus system the clearinghouse can seize the entire customer margin held in the omnibus account to make whole those at other FCMs (including the other FCMs themselves) who are owed money.  This means that non-defaulting customer funds at the defaulting FCM can be used to cover the losses of the defaulting customers at that FCM (though not the losses on the FCM house account).  Under segregation, this can’t happen.  But that doesn’t mean the losses go away: they are borne by the other clearinghouse members who don’t default.  These firms are obligated to pay up to make those owed money whole.

In other words, with an omnibus account system, customer default losses are shared among FCM customers and members of the CCP.  Under segregation, they are shared only among members of the CCP.  The rule shifts losses around.

Note that this is somewhat ironic if the policy objective of a CCP mandate is to reduce the counterparty risk losses suffered by the large, systemically important financial institutions that are among the members of CCPs.  Segregation rules force said firms to bear larger default costs than omnibus rules: losses are shifted in their direction.  (And compared to bilateral markets, it can also be the case that large systemically important financial institutions will bear larger default losses under clearing than without it.)

In other words, just looking at the risk piece, the choice between segregation and omnibus is a choice between different sharing rules.  Default losses are actually spread more widely under the omnibus system, as non-defaulting customers are in a potential loss position.

But whenever you look at insurance arrangements, you have to consider the incentive effects, and most notably, the potential for moral hazard.  The crucial thing to understand here is that the segregation system is more vulnerable to moral hazard than the omnibus system.

This is true for at least a couple of reasons.

First, customer incentives to monitor FCMs are stronger with omnibus accounts.  A customer realizes that if the FCM doesn’t monitor its customers appropriately, or lets them assume excessively risky positions, he is at risk of loss from the FCM’s carelessness.  He therefore has an incentive to choose an FCM carefully, and to monitor that FCM, and potentially move to another FCM (“exit”)  or raise hell with his current one (“voice”) if he finds that FCM is slacking in watching its customers.

Second, under segregation, customers don’t care about the riskiness of the FCM’s trading or financing.  Remember a customer is in a loss position under an omnibus system when (a) there is a default in some customer accounts, and (b) the FCM can’t cover this loss.  Condition (b) is more likely to occur, the riskier the FCM’s own trading, financing, etc.  Therefore, a customer is more likely shy away from a high flying FCM that trades aggressively, or levers up to the max, or chooses fragile forms of leverage when under an omnibus system.  Under segregation, the customer channels Alfred E. Newman: “What, me worry?”  He will choose an FCM only on the basis of commissions, services, the quality of the Christmas party and golf outings, etc.  This means that under segregation, customer accounts will be at riskier FCMs, on average, than under omnibus accounts.

More moral hazard means that default losses will be greater on average under segregation.  And since non-defaulting CCP members are on the hook for the entire default loss with segregation, this means that CCP members have more capital at risk under segregation than with an omnibus system.  That’s why Kim Taylor concludes: “Such a rise in capital costs could lead banks to ‘think twice’ about being in the clearing business, she said.”  A bigger share of a bigger amount translates into a lot more capital.

Given this, it’s no surprise that the omnibus account system has had survival value.  It is a way of controlling moral hazard.  It reduces the insurance benefits of clearing (from the customers’ perspective), but it reduces the costs of providing this insurance.  As is the case with virtually every insurance system, including the most prosaic automobile policy, you need something like a deductible to mitigate moral hazard. Insurance is almost never complete due to the perverse effects of moral hazard. Omnibus accounts play the role of mitigating some moral hazards in clearing.

I would hope that regulators ask why the omnibus system evolved, survived, and dominated before prescribing the sharing rule that CCPs adopt.  (I’ve told one regulator exactly that.)  The survival principle tells you something.  Before changing what is, ask why it is.  Believe it or not, there is very likely to be a good reason for it.  And with omnibus accounts, that reason is control of risk.

I have to quote just one more thing from the FT article:

But the issue highlights the complexities – and costs – of reforms.

Well, no sh*t.  Some people (sounds of throat clearing) have been saying that for literally years.  If only the Sorcerers’ Apprentices had appreciated that before passing Frank-n-Dodd.

Unintended consequences, that is.

ETFs have been a big deal for several years now, including commodity ETFs.  Heretofore, the big commodity ETFs have been in energy, but now several firms have metals ETFs in the offing.

Most traditional ETFs have bought futures contracts.  So the US Oil Fund, for instance, buys NYMEX light crude futures.  As the contracts it holds near expiry, it rolls forward into deferred contracts, buying the deferred and selling the nearby.

But the new metals ETFs will invest in, and hold stocks of, physical metal rather than derivatives.  FT Alphaville, quoting from a JP Morgan prospectus for its new copper ETF, has the details:

Firstly, being physically backed and not futures-based — the trust will escape all regulatory restrictions governing the size and scope of its speculative commodity positions (since there’s no exchange presence). No USO or UNG implosion danger here.

As the documentation states:

The Trust will take delivery of Physical Copper in the form of LME Copper Cathodes. Because the Trust will not trade in copper futures contracts on any futures exchange, the Trust will not be regulated by the CFTC under the Commodity Exchange Act as a “commodity pool,” and will not be operated by a CFTC-regulated commodity pool operator. Investors in the Trust will not receive the regulatory protections afforded to investors in regulated commodity pools, nor may the COMEX or any futures exchange enforce its rules with respect to the Trust’s activities. In addition, investors in the Trust will not benefit from the protections afforded to investors in copper futures contracts on regulated futures exchanges.

Note, too, that as a result it is likely that the ETF will not be subject to position limits.  And I think this is a big part of the reason for going physical.

The construction of the fund to avoid regulation is clear as day.  The effects are not likely to be good.  The advantage of using derivatives (futures or swaps) to construct ETFs is that it makes it possible to achieve an arbitrarily large exposure to the price risk of the underlying (oil, or copper, or whatever) without ever handling the physical.  That is, derivatives allow the unbundling of the price risk and the holding of the physical product.  This lowers transactions costs, and crucially permits investors to achieve portfolio and risk objectives without being constrained by the size of the physical market.

In contrast, physical ETFs cannot exploit this unbundling.  But apparently, the benefits of avoiding position limits and other regulatory costs are sufficiently great to justify the loss of efficiencies associated with this unbundling.  (If the bundled risk-physical solution were better than the unbundled one, you would have seen physical ETFs when the regulatory constraint wasn’t a real threat.)

There is a perverse irony here.  The whole rationale (supposedly) for position limits is that speculation somehow distorts physical markets.  There is precious little evidence, outside of a few extreme examples (e.g., the Hunts) that this is a real problem.  But by driving those that want exposure to metals prices, either for speculative reasons, or for portfolio balancing reasons, regulations are making it more likely that speculation will distort prices and the physical markets.

I’m not saying this will happen, or will be chronic.  Only that distortions are more likely in the bundled world than the unbundled one in which ETFs trade in derivatives rather than the physical.  ETFs that roll aren’t in the physical market, rolling out of expiring positions before they can go physical.  This limits, and likely eliminates, their effect on prompt prices and consumption, production, and storage decisions.

In contrast, ETFs that hold the physical are by definition in the physical market, and there can be a conflict between the risk and profit objectives of physical ETF holders and the efficient allocation of physical supplies; those desiring exposure to metal price risk might hold onto stocks when it would be optimal to consume them instead.  Conversely, in an unbundled world, traders can maintain exposure to the price risk without having any influence on the use of the metal.

I can also imagine some manipulation strategies that exploit the physical ETF.  For instance, somebody could obtain a big physical position via the ETF, and use that to create or enhance market power in the derivatives market.  That is, the ETF can be a way of “locking up” metal that would otherwise be available for delivery, thereby enhancing market power in the derivatives market.

I said this was a perverse irony.  It’s actually more perverse than ironic.  A policy intended to reduce (probably chimerical) distortions in the physical market actually increases the likelihood that such distortions will occur.  That’s the kind of havoc that Sorcerers’ Apprentices wreak.  Get used to a lot of that going around.

I was in DC yesterday, participating in a joint SEC/CFTC Roundtable on CDS clearing.  These Roundtables are intended to provide information to staffers charged with the daunting task of writing the avalanche of rules mandated by Frank-n-Dodd.  This particular Roundtable focused on margin setting, default resolution, and CCP access and governance.

The quality of the panelists was quite impressive, and the discussion largely informative.  My main impression was that in 3 hours the panelists were able, at best, to scratch the surface of the surface on a relatively small subset of issues confronting the agencies.  That’s a pretty sobering fact.

Substantively, the issue that engendered the most back-and-forth related to the access and governance issue.  Not to say I told you so, but I told you so–and have been doing so since about 1997, and especially since 2006 or thereabouts.

As I’ve written, the fundamental tensions are clear-cut (no pun intended).  Yes, limiting access can be a way of exercising market power, and those on the outside might lose out on economic rents.  But against that, more expansive rules on CCP access raise serious concerns about risk and governance.

More expansive access means that less financially secure firms are in the CCP, which increases default risks.  But that’s not all.  More expansive access means that CCP membership will be more heterogeneous. This opens new cans of worms.

First, CCP margining and guarantee fund calculations depend primarily on the risks of the portfolios of cleared derivatives, but the default risk posed by any individual member depends not just on those risks, but on the interaction between these risks and the balance sheet risks posed by that member’s other assets and liabilities.  CCPs generally take that risk into account in a crude way, if at all, and do not really take into account the correlation between balance sheet risks and the portfolio risks–which is absolutely critical.

This is problematic because it means that the price levied for default risk does not vary across members in a discriminating way.  This distorts the trading activity across members: riskier ones tend to trade too much, and less risky ones too little.  The more heterogeneous the membership, the more difficult the problem.  A one-size-fits-all margin calculation (or one with limited conditioning on member-specific information) inevitably distorts incentives, all the more the more heterogeneous the members.

Second, heterogeneity raises governance costs.  Heterogeneity means that members differ in their desired margining and capital policies.  There is more politicking and rent seeking, the greater the heterogeneity.  This is costly in and of itself, and also can lead to distorted decisions regarding risk pricing and policy.  Indeed, this heterogeneity tends to lead to more cumbersome, committee-driven governance processes.

Things will only become more problematic if, as seems almost inevitable, there is a requirement to include other constituencies, such as end users, in critical governance functions (most importantly, the risk committee).

This is an interesting economic issue, in the abstract, related to club theory: what is the optimal membership of the clearing “club”?  It is a hard question, but heterogeneity imposed by regulatory fiat–engineering of the organization and governance of CCPs–is rife with potential for disaster.  There is a serious potential for misalignment of incentives and distortions in risk taking.  Which kind of defeats the entire purpose of a clearing mandate.

The issues in clearing are all the more acute because fundamental economic forces, related to the nature of netting and diversification, create economies of scale and scope that make clearing a natural monopoly, or at least a natural oligopoly.  This means that the normal club good outcome in the absence of such strong economies, with the formation of multiple heterogeneous clubs with relatively homogeneous memberships, isn’t viable in this context.  So the market power-access-governance battles are likely to be intense and never-ending.  We’ve seen such battles in security markets for years, and they will be coming soon to a derivatives market near you.  No need to hurry to watch, though, for they will never go away because the fundamental economic drivers are enduring and  inhere in the nature of the service.  (This is the subject of my next book, BTW.)

One question from an SEC staffer made me uneasy.  (I’ll try to remember to post a link to the transcript when it comes online here.)  The premise of the question was that a premise of Dodd-Frank was that the OTC market is too concentrated, and insufficiently competitive, and that clearing was a way of opening up the market and making it more competitive.  The staffer expressed concern that access policies would have to be regulated to achieve this outcome.

That would make access policy a political football.  Again, I am sympathetic to the view that CCPs can potentially utilize their membership and access policies to exercise market power.  But I am also very sensitive to the very real possibility that a la Fannie and Freddie, political pressure to benefit some market participants will lead to policies that compromise the financial strength of CCPs.

My response to the staffer’s question was that it was mistaken to start from the premise that the market was too concentrated and insufficiently competitive.  I said that before making policy choices, it was imperative to try to understand why the market structure evolved as it had.  Concentration was not mandated.  It was the result of an economic process.  I can think of “bad”  reasons why the market became too concentrated (TBTF subsidies, for instance), but I can also think of “good” reasons (economies of scale and scope).  Policies not based on an understanding of the underlying economics are likely to have fundamental flaws that will manifest themselves in the worst way.  Fighting against fundamental economic forces is a recipe for policy failure.

I am appreciative of the opportunity to have participated in this Roundtable, and hope I made a positive contribution to the debate.  I am sure, however, that I will have other opportunities to do so–as will many others.  That is because we have not yet even begun to fight, really, on matters of clearing market structure, organization and governance.  The war will be a long one.  This is a reflection of the fact that Frank-n-Dodd failed to come to grips with most of the most fundamental issues inherent in its litany of mandates.

PS.  Here’s an article by Matt Leising and Shannon Harrington at Bloomberg that mentions some of my remarks at the Roundtable.  Thanks, as always, guys.

I would have to say that this is unprecedented, at least I hope so:

Commodity Futures Trading Commission (CFTC) Administrative Law Judge George H. Painter made serious allegations regarding fellow CFTC judge Bruce Levine in announcing his retirement.In a notice sent to complainants and their attorneys, Judge Painter claims that Levine  told him that he had promised former CFTC Chair Wendy Gramm “that he would never rule in a complainants favor”. Painter’s notice goes on to say, “A review of his rulings will confirm that he has fulfilled his vow.”

In the notice Painter recommends the CFTC request the services of an administrative law judge to be detailed to the Commission from another regulatory agency to handle the remain cases on his docket. Painter writes, “If I simply announced my intention to retire, the seven reparation cases on my docket would be reassigned to the only other administrative law judge at the Commission, Judge Levine. This I could not do in good conscience.”

Yes, I’d say those charges are pretty serious, and disturbing.  Judges don’t, as a rule, criticize one another.  Things must have been pretty bad for Painter to break that rule.  But it doesn’t seem that in the end it will have a real effect.

Painter’s criticisms are limited to reparations cases (basically cases where customers of brokerage firms claim their brokers have failed in their duties towards them, and cost them money).  But he raises questions about the possibility of an ideological bias that could have affected decisions in other cases too.

I have been involved in a couple of Levine’s cases.  I’ve heard stories, but this is neither the time nor the place.  I would hope that there is some mechanism for investigating Painter’s allegations, and either clearing Judge Levine’s name if they are baseless, or holding him accountable if they are not.

CFTC Commissioner Bart Chilton never struck me as the Claude Rains type, but he recently did a good Capitaine Reynaud imitation:

“The number of people that have come in requesting to be exempt from the law, or to have the law delayed has literally shocked me,” said Bart Chilton, 50, a Democrat who has served as one the agency’s five commissioners since 2007. “A lot of folks are having problems coming to grips with the fact that they do have a new law, and will have to change their business models.”

. . . .

“The volume and intensity of the lobbying is unprecedented in my experience at the agency,” Chilton said. “They all have an ask. The types of loopholes that people are suggesting exist are either non-existent or very farfetched.”

Neither Chilton nor anybody else should be even mildly surprised, let alone shocked.  The requirements of Frank-n-Dodd are so extensive, and so intrusive, that they will impose substantial costs on derivatives market participants.  Said participants have every incentive to try to influence the rules.  And the time is now.  What’s more, they have every incentive to try any argument that might work.  What’s to lose?

The pace and intensity of the lobbying will no doubt ease after the rule making process winds up next summer.  But no matter how carefully-crafted the rules (hah!), they will not anticipate all contingencies, and will have ambiguities and contradictions.  Moreover, market participants will take unanticipated actions that will raise issues about interpretation of the rules.  Hence, for years to come market participants will continue to try to affect the agency, ask for interpretations or no comment letters, or do things that lead to an agency reaction and market participant counter-reaction.  The CFTC will also find it necessary to issue policy statements to clarify the inevitable confusions.  There will be litigation arising from the legislation and regulations that will result in decisions and findings that lead to yet more changes.

In no time, there will be a thicket of decisions and interpretations that will in turn raise new issues.  And the market will continue to adapt and innovate and evolve, both in response to the regulations and technology and market shocks.  These adaptations and evolutions will present further challenges to the regulations and the regulators.

All this will generate more lobbying and lawyering.

When this happens nobody–nob0dy–should express the slightest shock.  Unless, that is, they relish the role of laughingstock.