Streetwise Professor

I’m sure that no one would be surprised that CFTC Commissioner Bart Chilton was not pleased by my recent post that lambasted his equation of the activities of ETFs with manipulation.  Well, the sarcasm was arguably overdone (that NEVER happens, I’m sure you’re saying), but I stand foursquare by the substance.

Well, now Commissioner Chilton penned an editorial in the Des Moines Register that lays out his argument for the need to restrict speculation.  It is a very weak argument indeed, and it would be a tragedy if anything like it is the basis for major changes in the regulation of derivatives markets.

He starts with a wild mischaracterization of history:

For a hundred years, farmers in Iowa and around the nation have been able to hedge their business risks in the futures markets. The entire endeavor has worked well for farmers, futures exchanges and our economy. In the last few years, however, things have changed. New “non-traditional” speculators, such as hedge funds, index funds, pension funds and endowments, have all entered the futures markets, bringing with them massive new liquidity but also some very real concerns. Unlike commercial speculators – for example, farmers, processors and refiners who actually do business in the underlying commodity, be it corn or beans, natural gas or crude oil – the new speculators have no such similar interests. The new speculators are only interested in one thing: increasing long-term profits in their investment portfolios. Therefore, their trading strategy differs significantly from the commercial traders who move in and out of the markets on a regular basis, depending upon many market-based factors.

This is to suggest that speculators looking only to make money, without “do[ing] business in the underlying commodity” are a new phenomenon.  I’m sure that readers of the Register in 1909 or 1899 or 1889 would have begged to differ.  Moreover, speculators of whatever age “have moved in and out the markets on a regular basis, depending on many market-based factors.”

This argument seems to make motive the primary criterion for determining whether somebody is eligible to trade a futures market.  This is truly disturbing.  It also suggests that Commissioner Chilton believes that commodities should be fenced off from other financial markets.  This is bad finance, and actually harms market users by interfering with the efficient transfer of risk.

Chilton also says: “The new speculators buy into the markets for years, and stay there.”  And we are to conclude . . . ?  And again, there have been many speculators that have made it their living for long periods.

Additional remark (9/2/2009): I find this criticism of Chilton’s ironic that the classical criticism of speculators is that they are quick buck artists that have no long term stake in any market or company, and hence trade on meaningless short term information.  Now, we have a class of speculators that are not short term, quick-buck traders, but are instead patient investors in the market for a long haul–but that’s bad too.  Damned if you do, damned if you don’t.

As for evidence, Commissioner Chilton relies on one of the least creditable tropes: the “some suggest” argument:

Due to the influence some suggest the new speculators may be having on prices, however, there may be some changes on the horizon for these new players.

I (and others) suggest otherwise.  So where does that leave us?

Then he pulls out the “it’s possible” justification:

Just as the tide raises all boats, it is possible that this massive influx of capital helped to raise commodity prices beyond what the simple forces of supply and demand would dictate. The crude oil “commodity bubble” is a good example. To date this year, crude oil is trading at roughly $70 a barrel. While that is a far cry from the incredible (and some say irrational) high of $147 last summer, the current price is still up over 60 percent from the beginning of this year. Does that make sense?

A lot of things are possible.  Some evidence would be helpful.  The role of evidence is to help sort out what’s probable from what’s possible.  You can’t make policy on the possible, since so much of the possible is contradictory.  X may be possible.  Not X may be possible too.  We’re right where we started.  Reasonable analysis requires effort to determine which of these possible outcomes is more likely, and to estimate the costs of incorrect conclusions.  Identifying the possible is the beginning of an inquiry.  It clearly cannot be the end.

And note the second helping of the “some say” trope: “incredible (and some say irrational) . . .”

In fact, economists have known for a long time that commodities can exhibit substantial variability, and that in particular, in models where only fundamentals drive prices, prices spike and crash with regularity.  That’s exactly what you’d expect in a market for a commodity like oil.  There’s no reason to invoke the “bubble” word to explain big moves in commodity prices.

Indeed, the reason speculators are attracted to commodities is the volatility.  That’s a lot more plausible statement than to say that the speculators cause the volatility.

Now we get to the punchline:

Supply is at a 10-year high and demand is at a 10-year low. You do the math; prices should be lower. And if the cause was uneconomic speculative activity (that is, not caused by the forces of supply and demand), then regulators have a responsibility to act.

There is no doubt that the current commodities market is more puzzling on the surface than what happened in 2008 or early 2009.  But speculation by financial players in the US or the UK is hardly the first thing that bears scrutiny.  Indeed it should be about the last.  In all major commodities, the big buyers have been China, China, and China.  China has engaged in a stimulus that beggars the imagination, and probably in part to reduce its exposure to the dollar, a lot of that money has gone into commodities from aluminum to zinc.  The CFTC–with considerable Congressional cheerleading–is on a snipe hunt, and ignoring major factors in the market.  If Commissioner Chilton is puzzled, he needs to read more.

And note the tricky segue in the argument: “if the cause was uneconomic speculation . . . then regulators have the responsibility to act.”  But the “if” remains just that.  Chilton certainly has not provided a scintilla of evidence to support that contention.  He mentions the CFTC hearings on position limits, which generated zip, zero, nada in terms of anything that would pass the laugh test in terms of evidence.

And Commissioner Chilton then fails to man up and take a stand himself, instead invoking the “some say” argument yet again (for the third time!):  he describes the hearings as a step in a process “to address what many call ‘excessive speculation’ in our futures markets.”  Again.  Many say it ain’t.  “Some say”–even “many say”–is hardly a legitimate basis for any major policy initiative.

Amazingly, Commissioner Chilton repeats the “unintentional manipulation” gaffe:

The clear message is that physical commodities – like those in the agricultural, energy and metals arenas –  are too important to our nation to allow even the possibility of price manipulation, intentional or unintentional.

He will undoubtedly say that he is using the word “manipulation” in some common-sense use of the term to mean the actions of traders that affect prices.

That doesn’t cut it, for at least three reasons.

First.  There is no common-sense use of the term.  That’s been a problem for a long time–and is exactly why I quoted the Texas cotton broker in my original post.  Or to quote my book on manipulation, if Ambrose Bierce was writing the Devil’s Dictionary of Finance, I would define manipulation as anything that causes me to lose money.

Second, this is sort of the immaculate conception theory of prices.  If trading activity doesn’t affect prices, what does?  Surely public information releases (e.g., a crop report) have an effect, but people still interpret those releases differently and trade on their interpretation.  Moreover, some traders have private information, and trading on that information moves prices.  That tends to make prices more informative.  That’s a good thing.  It’s called price discovery.  How can you have price discovery if trades don’t affect prices?  I should also note that hedgers’ trades can affect prices.  Putting on a big hedge may require a move in price to find somebody willing to take the risk.  Here the market is discovering the price of risk, and consenting adults will negotiate a mutually agreeable price.  And such a price will almost certainly be different than if no such trade had taken place. Thus, hedgers can have a price impact.  Are they manipulators too? (And, I might add, hedgers will have a bigger price impact if speculation is constrained.  So, if trades that impact price are manipulative, and hedgers have a bigger price impact when speculation is constrained, wouldn’t that make the party that constrains the speculation an accessory in the manipulation?  That question is only half in jest.)

In other words, defining manipulation to mean any trade that has a price impact is complete non-sense, not common sense.  Such markets exist in textbooks, and nowhere else.

Additional remark (9/2/2009): Price impact may be a necessary condition for concluding that regulatory intervention is needed.  It is definitely not a sufficient condition as Chilton suggests.  A regulatory intervention should require a showing that a certain kind of trading moves prices away from competitive values.  Even if a price impact is demonstrated, it is absolutely wrong to conclude that this is inefficient.

Third, and most importantly, Commissioner Chilton is one of those responsible for enforcing the anti-manipulation laws.  These laws make manipulation a felony.  They also subject manipulators to the prospect of heavy fines, and great reputational damage.  As a result, no CFTC Commissioner should use this term imprecisely, or make statements using words that have legal meaning in such a cavalier way.  In other words,  I don’t believe that someone in the position of enforcing the law has the luxury of making such implicit distinctions on matters of potential legal import.

The term is provocative, and its use suggests that the markets have been manipulated.  People believe that manipulation is wrong, and many know that manipulation is a crime.  This creates a presumption that there is something wrong–manipulated–in the markets that need correction.

I would also suggest that this could lead to serious difficulties for the Commission, and for Commissioner Chilton, if the Commission ever has to rule on a manipulation case.  I can see a defendant appealing an adverse Commission decision on manipulation by saying that one of the Commissioners had written in a way that could suggest ignorance of the law, and/or a prejudicial view of the activities of speculators, and/or is inclined to see a manipulator lurking behind every trade.

It seems to me that Commissioner Chilton is attempting to have it both ways: to insinuate that the markets have been manipulated to persuade people of the need to regulate more aggressively and intrusively, while avoiding having to provide evidence to support his insinuation, escaping instead with evasions about how he’s not using the term in the legal sense, just in some “common sense” way.  But if the activities aren’t illegal, then what is the justification for the regulation?  And if there is a justification other than manipulation as legally defined, why use such an inflammatory term that has a specific legal meaning, rather than explain precisely what that justification is?  Why not set out in plain terms exactly what he thinks is wrong with the activity of speculators, and their effect on prices, and let people analyze that contention without waving the bloody shirt of manipulation to inflame passions?  And maybe, just maybe, provide some reliable evidence in the bargain, rather than relying on the “some say” evasion.

I don’t think that’s too much to ask of those responsible for the regulation of markets with huge sums on the line.  In fact, I think it’s far too little to ask.  But I’ll take it as a start.

Trying to figure out what is going on with the Chinese economy is a first-order issue.  Superficially, everything looks great; growth is right on official targets, and is at levels that the world would envy even during boom times.  In spite of that–no, because of that, among other things–there are many reasons for disquiet.

An article in today’s Reuters strikes a very odd note:

A report that Chinese state-owned companies will be allowed to walk away from loss-making commodity derivative trades provoked anger and dismay among investment bankers on Monday as they feared it may set a damaging precedent.

The State-owned Assets Supervision and Administration Commission, the regulator and nominal shareholder for state-owned enterprises (SOEs), told six foreign banks that SOEs reserved the right to default on contracts, Caijing magazine quoted an unnamed industry source as saying in an article published on Saturday.

While the details of the report could not be confirmed, it was Monday’s hot topic in financial circles from Shanghai to Singapore as commodity marketers feared that companies holding underwater price hedges could simply renege on the deals, costing banks millions of dollars in profit.

This could be a very big deal.  A major default on derivatives by huge Chinese SOEs would hurt the banks on the other side of the deal, but more importantly, raise huge questions about the reliability of Chinese SOEs as counterparties not just on derivatives, but on other transactions as well.

But this is all very inscrutable (stereotypically?) as one of the companies allegedly involved denied it sent any letter.  From Bloomberg (no link yet):

China Eastern Airlines Corp., which  had $916 million of unrealized losses last year on wrong-way  bets on fuel prices, denied a Reuters report that it sent a  letter to banks about its futures contracts.

Air China Ltd. and China COSCO Holdings Co. also sent  letters to banks about futures contracts, Reuters reported today,  citing an unidentified Singapore-based banking executive who had  heard of the letters. Companies owned by China’s central  government may terminate derivative contracts with six foreign  banks that provide over-the-counter commodity hedging services,Beijing-based Caijing Magazine reported earlier on Aug. 29.

“No, we didn’t” write letters to banks about futurescontracts, China Eastern Board Secretary Luo Zhuping said byphone today without elaborating. Air China spokeswoman Rao Xinyu  declined to comment. China COSCO spokeswoman Yang Ling didn’t  immediately answer calls to her office today seeking comment.

Now, both stories could be true.  Note that Reuters reports that the threat came from State Assets Supervision and Administration Commission, which oversees companies like China Eastern.  The Reuters story does not claim that the companies wrote the letters on their own behalf: it claims instead that SASAC wrote the letters in its role of regulator of these companies.  So, the Reuters story could be true AND China Eastern’s denial could be true too.

But this raises the question of why would such a course be contemplated, let alone threatened.  One interpretation is that these companies are in financial trouble, and the government doesn’t want to spend its money making western banks whole.  Another interpretation is that the government wants to clamp down on speculation in general, and derivatives speculation in particular, by Chinese companies, and figures that raising doubts about the reliability of Chinese companies as counterparties is a very effective way to do that: It may be very hard to crack down on trading by Chinese companies directly, but if they have nobody to trade with because no banker in his right mind would take the risk of giving away a free default option, the “problem” is “solved.”  Although this may seem to be limited to Chinese SOEs, it will no doubt have the effect of raising doubts about the reliability of all Chinese counterparties, thereby making it costlier for them to trade, and perhaps shutting them out of the market altogether.

There is some hint of this in the Reuters article:

The warning from SASAC follows a series of measures from Beijing this year to crack down on the sale of derivative products by foreign banks to Chinese enterprises, principally big consumers, who bought protection against higher prices last year only to watch the market collapse — leaving them with losses.

There may also be an old school-new school battle going on:

SASAC took over the job of overseeing SOEs’ derivatives trading from the securities regulator in February after several Chinese firms reported huge losses from derivatives.

I would wager that SASAC is dominated by old school industrial types and party types who are not in the least financially sophisticated, and who are probably not all too down with the idea of derivatives anyways, thinking that they smack of speculation, even if they are used for hedging.  (I’ve taught at some Chinese SOEs, and the level of finance knowledge is pretty thin even among higher level execs–or should I say especially among such types.  I imagine that goes exponentially for the SASAC.)

But, if my conjecture that this is an effort to tamp down speculative trading, it would fit in with a good deal of other stories coming out of China that it is struggling mightily with its efforts to stimulate the economy.  These efforts are leading to manifest distortions, and reports suggest that the authorities are operating in a very ad hoc way to try to control the distorting effects of the stimulus.  Like a financial sorcerer’s apprentice, China has unleashed a massively power monetary, fiscal, and credit stimulus, but cannot control it.

The Chinese stimulus is immense, as I’ve written before. The fiscal stimulus is on the order of 15 percent of GDP.  Chinese banks have created huge amounts of credit:

In the first half of 2009, bank credits increased Rmb7,300bn, above the official target for the full year. Credit growth was surprisingly high, and the same was true of the broad money supply, M2, which grew at a record rate relative to GDP. As a result, the inter-bank money market has been inundated with liquidity.

But these efforts have led to the growth of bubbles in real estate and the stock market.  The government is trying to tamp down on the flow of funds into these areas, and it is evidently having some effect: the Shanghai stock index was down 23 percent in August, far and away the worst performer among major world markets.  Moreover, the market is extremely sensitive to signs that the government is tightening credit.

Moreover, there is other evidence that the deluge of spending has led to severe dislocations in the allocation of resources.  Some amazing figures from the same FT article just quoted, by Chinese economist (and former central banker) Yu Yongding:

To maintain decent growth and avoid massive unemployment, the Chinese government was left with no option but to replace flagging external demand by domestic demand. But in the short run it is difficult to stimulate domestic consumption; investment demand became the only alternative. As a result of the stimulus package, the growth rate of fixed asset investment hit 36 per cent year-on-year in the first half of 2009, and China’s investment rate may have surpassed 50 per cent of GDP.

The government knows very well that the economy has been suffering from overcapacity. This is why government-financed investment in the stimulus package is concentrated in infrastructure, rather than new factories. However, there are still problems with an investment-centred expansionary fiscal policy. Due to the hasty and under-supervised implementation, waste in infrastructure construction is ubiquitous, and the prospective returns of this big push into infrastructure are less than promising.

Investing 50 percent of GDP, a nearly 50 percent increase from an already huge 36 percent of GDP, means that it is almost certain that many of the projects are hastily conceived, and ill conceived to boot.  I think that Yongdong is a master of understatement when he opines that “the prospective returns of this big push into infrastructure are less than promising.”  That is the gravamen of the analysis I gave on BNN (Canadian Business Television) earlier in the month.

And indeed, there is evidence that the government is trying to get control of the brooms its fiscal and monetary spells have brought to life.  Not so much in infrastructure, but in other parts of the economy:

China’s cabinet said it’s studying curbs on overcapacity in industries including steel and cement as policy makers seek to rein in investment growth fueled by a record credit expansion this year.

The government will also increase “guidance” over parts of the coal, glass and power industries, the State Council said on its  Web site today. Controls on stock and bond sales by companies in targeted sectors will be strengthened, it said.

China is aiming to prevent excessive investment in the world’s biggest user of steel and cement without imposing restrictions that may endanger an economic recovery. The nation’s  benchmark stock index has dropped 15 percent from its Aug. 4 high on concern banks may tighten credit after extending a record $1.1 trillion of loans in the first six months.

There is a very Austrian lesson in this Chinese story.  The government may be able to manipulate aggregates, but its attempts to do so can aggravate resource misallocations.  In the Austrian story, these misallocations eventually come back to haunt: eventually they result in a contraction that is necessary to force resources out of bloated sectors and into more productive uses.  The Chinese government apparently recognizes this, and is attempt to fall back to its comfort zone–state directed allocations of resources.  But that just raises another problem the Austrians were quite familiar with: the Knowledge Problem.  How can the central planner know where resources should go?  Answer: He can’t.

I don’t think this will turn out well.  There’s no Big Sorcerer to sweep in and undo Apprentice Sorcerer’s mischief.  The Apprentice learned, it’s easy to unleash the magic, but it’s very hard to direct it.  In the Chinese case, it’s easy to go on a spending binge, but it’s hard to ensure that the money is spent well.  It may result (especially given the idiosyncrasies of Chinese income accounting) in high rates of measured growth, but this growth is likely to be chimerical, and even destructive in the long run as resources spent today may prove very unproductive months from now when the world economy begins to turn around and the stimulus-driven investments are ill-suited to serve the resulting demand.

In other words, China may represent history’s biggest free cash flow problem.  (A reference to the finance literature that suggests that companies with free cash flow tend to fritter it away on unproductive investments).

The effects of this will spill over far beyond China, most notably in the commodity sector.  China has been on a commodity import splurge, but apparently that is another thing that is already slowing down, and likely to slow down even further soon.  And that is already having an effect on the canary in the commodity coal mine: shipping rates.  From another Bloomberg story:

Just as global trade starts to recover, the shipping market is crashing for the second time in a year as China reduces raw-material imports and record numbers of new vessels set sail.

The rate for leasing capesize ships, boats three times the size of the  Statue of Liberty, will drop about 50 percent from the current price of $37,865 a day to as low as $18,000 before the end of the year, according to the median in a Bloomberg survey of six analysts and fund managers. Forward freight agreements traded by brokers show the fourth-quarter average price will be 7 percent lower.

Shipping rates, which already fell 59 percent from this year’s high, are retreating as the  Organization for Economic Cooperation and Development predicts a 16 percent drop in world trade for all of 2009. China’s State Council called for curbs on steel and cement production last week.

. . . .

From their low of $2,316 in December, rates rebounded to $93,197 in June as China imported record amounts of everything from coal to  iron ore, used to make steel. Almost two in every five tons of steel are  made in China, according to the Brussels- based World Steel Association. The nation consumes the same proportion of the world’s coal, BP Plc estimates.

Industrial Overcapacity

Rates are poised to keep falling, the survey shows. China’s State Council, the nation’s cabinet, said it’s studying curbs on overcapacity in industries including steel and cement. The government will provide more “guidance” over parts of the coal, glass and power sectors, the group said in a statement.

Imports of refined copper fell 23 percent in July from the previous month. Coal shipments shrank 13 percent, customs data show.  Iron-ore purchases will likely average about 16 percent less in the remainder of the year than in the first seven months, according to  Will Fray, an analyst at Maritime Strategies International Ltd. in London.

“China could very easily turn the taps off,” Fray said. “Rates will keep sliding.”

The commodity import channel is the primary mechanism connecting the Chinese stimulus to the rest of the world.  It’s hard to explain the robustness of commodity prices in recent months (which has redounded to the benefit of Australia–and Russia) on the basis of conditions in OECD countries.  The EU, US, and especially Japan have hardly done well during that period, with the first maybe experiencing an anemic recovery, the second bottoming out at best, and the third still imploding.  The most likely explanation is that this is the direct consequence of the Chinese stimulus, and the related policy of accumulating strategic inventories of everything from aluminum to iron ore to oil to zinc.

But all of the foregoing suggests that this is coming to an end, if it hasn’t come to an end already.  And that’s why very peculiar stories like the one about a threatened default on derivatives trades may just be shadows of larger, looming developments.

Short answer: not much.  But here are some fun facts to know and tell that do tend to deflate any grandiose assertions about the effects of speculation on oil prices:

1. Changes in non-commercial positions did not Granger Cause crude oil returns in the 1986-2009, 2001-2009, or 2006-2009 periods in bivariate Granger Causality analyses.  Not that this is a surprise; if one could predict future oil price changes based on the publicly released COT numbers, one could make money.  But it does belie the Medlock-Jaffe claim that non-commercial positions are a “leading indicator” for oil prices.
2. In a vector autoregression including crude oil returns, the percentage change in the Baltic Freight Index, the percentage change in the dollar index, and the change in non-commercial positions, the non-commercial positions do not Granger cause the crude oil returns in the 1986-2009, 2001-2009, or 2006-2009 periods.  The percentage change in the BFI does Granger Cause crude oil returns in all three samples.  This might be surprising, at it would seem to suggest that one can make money in oil by making trades based on moves in the BFI.  However, it is more likely that the movements in the BFI forecast time varying expected returns.  The BFI is a proxy for industrial activity, and thus likely reflects systematic risk.
3. In the entire sample, crude oil returns Granger Cause (i.e., forecast) changes in non-commercial positions.  This is not true in the 2006-2009 period.
4. In the entire sample, commercial positions Granger Cause non-commercial positions, but the reverse is not true.  In the 2001-2009 and 2006-2009 periods, the causality runs both ways.
5. In regressions of crude oil returns against percentage changes in the BFI, percentage changes in the dollar index, and changes in non-commercial positions, all three explanatory variables are statistically significant in the entire sample and the two later subsamples.  Changes in commercial positions are associated with changes in crude oil prices of the same sign.
6. The magnitude of the coefficient on the change in non-commercial positions is relatively small, and has been declining over time.  In the entire sample, a one standard deviation move in the change in the non-commercial position is associated with a 2 percent change in the crude oil price.
7. However, by 2006-2009, the alleged period of speculative excess, the coefficient on the non-commercial position change is less than half its value in the entire sample.  During 2006-2009, a one standard deviation move in non-commercial positions (corresponding to about 17 mm bbls of crude in a week), is associated with a less than one percent move in the crude oil price.  Given that the standard deviation of returns (this is weekly data) during this period was over 5 percent, this is a relatively modest association.
8. Moreover, speculative positions rose and fell throughout the period of alleged speculative excess.  Using the estimated coefficient on the change in the non-commercial position from the multivariate regression, and the movements in non-commercial positions from the beginning of 2006 to the height of the oil prices in early-July, 2008, the cumulative effect of speculative trading on the price of oil was . . . wait for it . . . 2.56 percent.  Not 25.6 percent.  2.56 percent.  And this over a period when the price of oil rose from $63 to over $141 dollars.  That means, that speculation might have “caused” the price to move from $63 to not even $65.  Big whoop.
9. The correlation between changes in non-commercial positions was .36 in 1986-2000, .5 from 2001-2005, but fell to .3 in 2006-2009.
10. Thus, the data do not support the contention that speculation–at least as measured (or mis-measured) by the COT have played an increasingly important role in affecting oil prices.  Indeed, the association between non-commercial futures trading and oil prices was weakest during the period of time of the purported speculative Bacchanal.
11. Conversely, the relationship between the crude oil price and the dollar index has strengthened over time.  In the 1986-2000 period, the coefficient on the dollar index in the multiple regression was -.023; during the 2001-2006 period, -.77; and from the 2006-2009 period, -2.03.  During this last period, a one standard deviation move in the dollar index is associated with approximately a 2.5 percent move in the price of crude oil.

This all took about 40 minutes to figure out.

So what does it all mean?  Well, even without grappling with the causation issue, the data provide virtually no support for the hyperventilating assertions that speculation dominates oil prices, and that this domination grew over time, reaching a frenzied peak in 2006-2008.

In contrast the data provide better support for the view that the price of oil became more dollar driven.  Thus monetary policy should deserve more scrutiny, and speculation less, in trying to understand what happened to oil prices.  The attempt by Medlock-Jaffee to attribute the decline in the dollar to oil speculation is implausible.

But even though there is a modest, contemporaneous association between non-commercial positions and oil prices, that provides only the weakest support for the view that speculation distorted prices.  There is the correlation-causation issue.  What caused the changes in non-commercial positions?  Could they have moved in response to oil prices?  Could both have been driven by common factors?  Moreover, even if speculation moves prices, it can move prices towards where they should go.  That is, informed speculation tends to move prices towards their full-information value.

As I’ve written often, looking at prices alone is often inadequate to diagnose speculative distortions.  Prices are important because they provide signals that affect the allocation of resources.  That is, prices affect decisions about quantities.  If prices are distorted, quantities should be distorted too.  For the commodities allegedly affected by speculative excess in the 2006-2008 period, there is no evidence that this was the case.  In fact, for the commodities for which the data are best (industrial metals, where daily inventory data are available), the evidence is quite to the contrary.  The inventory data provide strong evidence of fundamental tightness, rather than speculative excess, as the cause of high prices.  (This will the subject of a chapter in my forthcoming book.)

The COT data are also dubious for a variety of reasons, including their crude categorization of traders, their lumping together of positions in all delivery months, and the fact that they cover only exchange-traded positions, and not the OTC market.

So, bottom line.  The association between speculative trading (as measured by the COT) and oil price movements is weak.  Given this association, and the movements in non-commercial trading during the 2006-2008 period, the cumulative impact of speculation on the price of oil during the spike was miniscule.  Moreover, one cannot conclude that the measured association quantifies a causal relationship, and even if it was causal, you can’t conclude that it caused prices to move away from a level justified by fundamentals.  The non-price (i.e., quantity) evidence for price distortion is lacking.

In one sentence: The COT data that have been used repeatedly to support contentions that speculation distorted oil prices provide no evidence whatsoever that speculation in the 2006-2008 time period materially contributed to the dramatic rise in the price of oil during this period.

In an apparent attempt to make Michael Masters look good, Rice University’s Baker Institute has released a report on oil speculation, that concludes that increasing volumes of speculation have caused oil prices to be higher than they would otherwise be, and in a novel twist, have caused a higher correlation between the dollar and the price of oil.  It also lays blame on everybody’s favorite whipping boy, the Commodity Futures Modernization Act of 2000.

In a nutshell, this report is bilge.  It relies on no rigorous economic analysis to support its contentions.  Moreover, it is unscientific, eschewing any serious statistical analysis.

The report first sets out its evidence that speculation has increased, and that this increase is due to the CFMA.  It attempts to argue that speculation increased 15-fold, while commercial trading only doubled, by adding non-commercial outright futures, options, and spread positions, as measured by the CFTC Commitment of Traders Reports.  The vast bulk of the increase in speculation is attributable to spread positions.

But it is odd indeed to argue that a massive increase in speculation caused higher oil prices when the bulk of this increase in speculation occurred in spread positions.  Such positions, which involve the purchase and sale of oil for different delivery dates, are speculations on the shape of the oil forward curve, not on the absolute price level.  Indeed, it is very difficult to imagine how such spread positions would cause prices to rise since they involve purchases and sales in equal magnitude.  Certainly the authors of the Baker study provide no rigorous justification for any such connection.  For that matter, they don’t provide any non-rigorous justification either.

Tying the massive increase in speculation as they measure it to CFMA is particularly bizarre.  As they note, the main provisions of the CFMA eased restrictions on trading on the OTC market, and in non-US markets.  As a result, if anything, the CFMA favored these other markets over NYMEX.  But all of the data in the “study” pertain to NYMEX futures markets.  How can you attribute a rise in trading on NYMEX, and a change in the composition of that trading, to regulatory changes that would tend to shift trading to venues not covered by the data?  (You could make an argument that the increase in off-exchange activity lifted NYMEX volumes due to arbitrage, or to the use of futures to hedge OTC positions.  But the Baker boy and girl don’t do that.  And if some non-commercial NYMEX positions are actually hedges of OTC positions, you can’t conclude the futures positions are speculative without knowing about the related OTC positions).

In other words, report authors Ken Medlock and Amy Jaffee play the drunk looking for a wallet under the lamppost.  The COT data is the only data relating to speculation that they can get their hands on, and they use it even though it is peripherally related to what they want to demonstrate, namely, that a set of regulatory changes that mainly benefitted non-NYMEX markets led to a dramatic increase in speculation.

This is the crudest post hoc, propter hoc reasoning.  CFMA happened in 2000.  Speculative futures positions increased, especially post-2003.  Therefore, the former caused the latter.  (Why the big lag?  Don’t bother looking for answers in the report.  You won’t get one.)  This is about as weak as it gets.

When they get to analyzing the effects of speculation on prices, the spreaders are out the window, and Medlock and Jaffee focus on net non-commercial positions.  (This could be viewed as a tacit admission that there is no basis to believe that spreaders could have an effect on price levels.)

Do the study authors utilize statistical techniques, like Granger Causality or the like, to document such a connection?  Surely you jest.

They use a much more sophisticated diagnostic instrument.  Their eyeballs.

Seriously.

They present a graph of net non-commercial positions overlaid on prices, and say:

Generally, movements in price over the last few years have coincided with trends in open interest by noncommercial traders.  We can see that during periods where [sic] speculators have been net short, prices typically declined, even if only slightly.  When speculators are net long, the general shift in the market has been upwards, in some cases to a dramatic extend.  Some exceptions have occurred when speculators were generally in a net long position, but were moving to liquidate positions.  In this case, such as the late spring/early summer 2008, prices responded by moving sharply lower.

Well, when I look at their Figure 5 with my eyeballs, I note numerous instances when the changes in net non-commercial positions were of a similar magnitude to what occurred in spring-summer 2008, and the price movements were nowhere as large as in the late-summer/fall of 2008.  I see other periods (fall, 2008) when net long positions spiked, but prices fell.

I just wonder: think the financial crisis might have had something to do with the collapse in prices?  What financial crisis you might ask, after reading the report: if this was the only information you had, you’d never know there was a financial crisis.

Also, why the asymmetry?  Why do net shorts often result in “slight declines” while net longs can lead to big spikes?  It is not obvious a prior that this should be the case, and Medlock and Jaffee certainly provide no explanation.

There is no way in hell that such a casual, visual analysis of that Figure can provide a basis for their grandiose conclusions.  To say that this is unscientific is far too kind.  It would be too kind to call it junk science.  It’s just junk.

Medlock and Jaffe also interpret the data, uhm, flexibly, in order to make their case.  On the one hand, they claim, prior to 2006 “the open interest of noncommercial players” was a “lagging indicator” of prices.  (If it lags, how can it cause?)  But then, in a “striking” development, it becomes a “leading indicator of price around January 2006.”

Do they present a rigorous test of this assertion?  No.

Do they provide a coherent explanation as to why it would go from a lagger to a leader?  They provide an explanation, but it is not coherent.  It is in effect the story of a perpetual motion machine.  Speculators buy so prices go up so people think prices will go up and so they buy and force up prices more yadda yadda.  This is, at best, ex post rationalization, fitting their story to the data rather than coming up with a rigorous hypothesis without peeking at the data and then testing it.

How do they address the problem that if COT data is really a leader, and leads by months (according to their eyeballs, anyways), why did all of these greedy speculators leave money on the table?  As soon as they recognized that COT data lead oil prices, they would trade on the COT data, and voila!, the relationship would disappear.

Again, the more obvious answer: there is no causal relationship between COT numbers and prices.

A more reasonable explanation is there is no connection between movements in net noncommercial positions and prices.  Sometimes positions lead price, then sometimes the reverse is true, but there is no causal connection, just chance in action.  This makes Jaffee and Medlock look like fools for randomness.

The asserted connection between oil and the dollar resulting from increased speculation is bizarre.  For starters, I contest their statistical results, such as they are.  They report a correlation between the dollar and the price of oil of -.82.  I can reproduce that number by calculating the correlation between the levels of the dollar index and the price of oil.  However, since both time series have unit roots, such high correlations are extremely suspect: highly persistent time series can be highly correlated even if, in fact, there is no economic relation between them.  This is the spurious regression problem.

A more reasonable method is to look at correlations between percentage price changes.  This number is much smaller (in absolute value) for 2001-2009: only -.22.  It is bigger than observed in 1986-2000, but so what?  What’s more, that -.22 isn’t nearly as eye-popping as -.8, is it?

And what theory do these people advance to explain why an increase in speculation would increase the correlation?  They tell a story–and it’s no more than that–about speculation causing high oil prices causing higher trade deficits causing a lower dollar.  There is no evidence supporting any one of these alleged causal connections.  And considering the trade deficit–like, have these two heard of China?  Or any other factor that might have influenced the trade deficit?  This is more post hoc, propter hoc mumbo jumbo, with myriad omitted variables.  A serious study would (a) estimate the relation between the trade deficit and the dollar index, controlling for other factors that could affect the dollar; (b) estimate the effect of the price of oil on the deficit, and combine this with (a) to get an effect of the oil price movements on movements in the dollar, and (c) estimate the effect of speculation on the price of oil, and combine with (a) and (b) to get an estimate of the contribution of speculation to changes in the value of the dollar.  Or include oil speculation as an explanatory variable in a model of the dollar that also includes other relevant explanatory variables.

But that would be, as I say, a serious study.  This one is a joke.

There’s also a serious issue regarding the direction of causality.  Why should it go from oil prices to the dollar?  A decline in the dollar represents a fall in its value relative to other currencies.  The factors that lead to such a fall (e.g., a US monetary policy that is looser than the monetary policies of other nations) also plausibly lead to a decline its value relative to goods, including oil.  A decline in the purchasing power of a dollar means that the prices of goods, including oil, rise in nominal terms.

Here’s a final, telling example of the level of rigor in the report: “While correlation does not imply causation [really?], the trends evident in the open interest data are impossible to ignore.”

Is that so?  Just watch me.

Historically, the CFTC has not been an overly intrusive regulator.  It has not attempted to push its jurisdiction to its limits, and in most areas it compares favorably to other federal regulatory agencies.  Under pressure from Congress, and exploiting the opportunities presented by the financial crisis, however, the CFTC is becoming much more aggressive and ambitious.

The most recent cases in point: its actions to clamp down on index funds, and now exchange traded funds (“ETFs”).  Last week, the agency revoked position limit exemptions for two ETFs offered by Deutsche Bank.  Seeing the threat from restrictions on the ability of ETFs to hold positions, several sellers of the funds, such as Barclays and the UNG fund, have announced that they will not issue new shares, even though these shares are selling at a premium.

Just what is the theoretical or empirical basis for these restrictions on commodity ETFs?  Beats me.  It is possible that these funds affect prices when they roll from an expiring contract into the next one, but there is a self-correcting mechanism that would mitigate these effects: the funds demand for liquidity is known, both in its approximate magnitude and certainly its timing.  This permits the flow of additional capital into the market during roll periods to mitigate the price impacts.   Moreover, to the extent that ETFs affect prices during the roll, they tend to move prices against them.  That is, their price impact raises their cost and reduces their performance.  Since the funds have to compete with other investment vehicles for funds, if these costs become too large and thus impair performance sufficiently, the flow of money to the funds will decline.

But I don’t think it’s the roll issue that exercises certain CFTC commissioners.  I think that they really believe that these ETFs distort prices.  The basis for that belief escapes me.  The Commission surely has produced no reliable evidence of such an effect, nor have I seen any reputable academic studies documenting such an effect.  Moreover, although many of these funds are “long only,” leading some to claim that they inflate prices, there are also funds that profit when prices go down, meaning that there is no necessary structural bias towards purchases.

Before interfering with the ability of investors to allocate capital across alternative vehicles, a government regulator should have a very strong logical and empirical basis to conclude that free choices are inefficient, and are distorting prices.  It should identify a market failure, and provide empirical evidence that this market failure is resulting in a material distortion in prices and resource allocations.  Moreover, it should analyze rigorously the effect of its actions: How will investors respond to the regulation?  If the flow of funds is distorting market X, will limiting the flow into X just divert monies into markets A, B, and C, distorting those prices?  Or, will investors respond to constraints on the size of a given fund by splitting investments across multiple funds, thereby sacrificing management scale economies and inflating costs?

The CFTC has done none of these things.  None.  It just justifies them with vacuities such as:

Cutting out individual investors isn’t the goal, said Bart Chilton, a CFTC commissioner, in an email. “The Commission has never said ‘You aren’t tall enough to ride,’  ” Mr. Chilton said. “I don’t want to limit liquidity, but above all else, I want to ensure that prices for consumers are fair and that there is no manipulation — intentional or otherwise.”

The CFTC seems hell-bent on segmenting commodity and financial markets, apparently viewing the commodity markets as some kind of ghetto, or insufficiently responsive to normal economic forces to be largely self-regulating.  This is bad finance.  The goal of public policy should be to encourage the integration of financial markets to ensure the efficient allocation of risk across investors and market participants, and the consistent pricing of risk across these markets.

Chilton’s statement is shocking for another reason.  Consider the last sentence: “I want to ensure that . . .  there is no manipulation — intentional or otherwise.”  Now, note that as a CFTC commissioner, Chilton may have to rule on manipulation cases.  Therefore, although it would be nice if he knew economics, it is imperative that he at least know the law.  But Bart Chilton apparently does not, or is in the habit of speaking so carelessly as to give the impression that he does not.  In fact, under existing case law, including CFTC decisions, to find someone guilty of manipulation under the Commodity Exchange Act, four conditions must be met.  One of these conditions is that the accused have a specific intent to cause an artificial price.  (See especially the Commission’s decision in the in re Indiana Farm Bureau case.)

In other words, “unintentional manipulation” is a legal oxymoron, at least so far as the CEA is concerned.

So, here we have one of the commissioners with responsibility for enforcing Federal anti-manipulation laws who apparently does not know the law.

Rather than speaking carefully, and expressing views that are consistent with the laws and precedents that he is charged to enforce, Chilton appears to be the poster child for the arch comment of a Texas cotton trader testifying before the Senate in 1928:  “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.”

ETFs apparently do not suit Bart Chilton.  God knows why.  But to justify his dislike of them, he throws around the very, very heavily freighted word “manipulation” in a way that is inconsistent with its meaning under the laws that he is responsible for enforcing.  That is very disturbing.  Very.  If you use that word, you better have a high degree of confidence that you have the law, the economics, and the facts on your side.  On that score, Chilton strikes out.  Ignorance of the economics is, alas, pretty common.  Ignorance of the law is inexcusable.

Yesterday I wrote about the German financial regulator Bafin seeing no evil in what the data strongly suggest was one of the largest manipulations in history.  Today I write about a US regulator who sees manipulations where there is no evidence that they exist.

Keep this in mind when anybody–a Congressman, a regulator, or a talking head–tries to convince you that more regulation is the key to reducing the prevalence of misconduct in financial markets, and ensuring that these markets work more efficiently.  Regulators can make both Type I and Type II errors: false positives (Chilton) and false negatives (Bafin).  I would suggest that the rates for both type of error is extremely high, especially when policies are predicated on as little logic and evidence as the crackdown on commodity ETFs.  I would further suggest that the costs of these errors are very high, and importantly, those that make the errors do not incur the costs–which would tend to explain why they make so many of them.

The CFTC is getting vast new powers, and asking for even more (cf. Chairman Gensler’s letter to the Congressional Agriculture committees regarding the Administration’s draft OTC regulation bill).  It does not inspire confidence that at least one of the commissioners who will exercise these powers does not even know one of the very fundamental tenets of the law governing the powers he already has.

About 10 months ago I wrote about a massive squeeze on VW stock, associated with the revelation that Porsche had accumulated an immense options position on the larger company’s stock. For a brief time, the squeeze made VW the largest capitalization firm in the world.  The only comparable event in historical record that I am aware of is the Northern Pacific corner of 1901.

The German financial regulator, Bafin, investigated.  But, apparently channeling its inner Sergeant Schultz, it concluded: “I see nuthink!  I know nuthink!”  Disregarding the obvious evidence of a massive manipulation floating before it very eyes, Bafin declined to proceed against Porsche, stating  “We didn’t find any indications for a share manipulation.”  I am speechless.  No indications?  Did you, like, you know, look at the stock chart?  Just what exactly caused that massive spike in price?  That is all, Sergeant.

But, apparently either Sergeant Schultz was sent to the Eastern Front at long last and replaced by a more vigilant overseer, or the threat to do so finally caused him to open his eyes.  For German prosecutors, acting on a referral from Bafin, dramatically raided former Porsche CEO Wendelin Wiedeking’s home, and the home of Porsche’s former CEO:

German prosecutors are investigating Wendelin Wiedeking, Porsche’s former chief executive, and other people close to the sports car maker, alleging market manipulation and the leaking of inside information in the failed takeover attempt of Volkswagen.

Prosecutors in Stuttgart yesterday raided the headquarters of Porsche, which recently agreed to merge with VW after an attempt to acquire the much bigger rival had pushed it to the brink of bankruptcy.

. . . .

Claudia Krauth, a prosecutor at the regional court in Stuttgart, said the investigation had been launched after a complaint from Bafin, Germany’s financial regulator.

Bafin launched an investigation into market manipulation this year after a German press report suggested that Porsche had misled markets about its ambition to take over VW.

Actually, changes in political fortunes are the best explanation for Bafin’s change of heart.  Porsche’s wild gambit failed this summer, resulting in the acquisition of the company by VW, and the ouster of its CEO  Wendelin Wiedeking.  When Wiedeking was riding high, and was still a power in Germany, Bafin had little appetite to take him on:

Last month, VW’s shares rocketed after Porsche unexpectedly disclosed that through the use of derivatives it had increased its stake in VW from 35 to 74.1 per cent, prompting Bafin, Germany’s financial regulator, to launch a formal investigation into possible market manipulation.

But analysts blamed Bafin for allowing Porsche’s use of options to secure secretly a dominating stake in VW.

Investment bankers said Bafin felt little appetite for pursuing an investigation of Porsche as it lacked political support for such a move. [Emphasis added.]

So, Wiedeking is on top–no manipulation.  Wiedeking is down:  Into the cooler!

I guess late is better than never, but this correlation between Wiedeking’s power and the posture of German regulators and prosecutors is unseemly, to put it mildly. There can be little new information about the squeeze itself that would explain the timing; Wiedeking’s precipitous fall seems the most salient development.  It hardly inspires confidence in Bafin’s independence and probity to observe this pattern of conduct.  It strongly suggests that financial regulators in Germany are captured by those whom it is supposed to regulate.  Not that this phenomenon is limited to Germany, but on its face this is a particularly egregious example.

The Treasury Department has released its draft OTC derivatives regulation bill, “The Improvements to Regulation of Over-the-Counter Derivatives Act.”  The actual language of the 115 page proposal follows quite closely what Geithner has been floating for several months–a clearing mandate for standardized derivatives, attempts to force OTC derivatives trading onto execution facilities, differential margin and capital requirements for cleared and non-cleared products.

My initial reactions:

First, there’s a whole lot of delegatin’ goin’ on.  A good part of the bill sets out the haziest general objectives, and then directs the CFTC, SEC, and “the Prudential Regulator” (either the Fed, the Office of the Comptroller of the Currency, or the FDIC, depending on a bank’s charter status) to come up with specific rules on what constitutes a standardized derivative, capital and margin requirements, position limits and so on.  There is an aggressive timeline for most of these rules–180 days.  Given the depth and breadth of the issues, and their contentious nature, and the needs to coordinate among disparate agencies, this will be very difficult to do at all, and extremely difficult to do well.

Second, the Treasury has finessed the jurisdictional issues by giving multiple regulators authority over OTC derivatives markets, with the injunction that everybody share and play well together.  Many of the provisions require that the CFTC and SEC issue rules jointly, with the proviso that if they cannot, the Treasury will prescribe them.

Given the delegation-heavy aspect of the proposal, there are few specifics to analyze.  But there are some aspects of the proposed bill that are spelled out with sufficient detail that deserve comment.

I’ve beaten the clearing mandate horse repeatedly before, so I won’t do more than repeat my previous conclusion that the mandate approach is wrongheaded, and ignores crucial economic issues.  The proposal does not require clearing when “one of the counterparties to the swap— (i) is not a swap dealer or major swap participant; and  (ii) does not meet the eligibility requirements of any derivatives  clearing organization that clears the swap.”  This would seem to permit an end user (e.g., a gas producer) to enter into a swap with a dealer without triggering the clearing mandate.

This is a desirable feature, and would permit end-users to enter into swaps without having to clear them; this could be especially important for end users concerned about the cash flow and liquidity risks associated with daily mark-to-market.  However, there are some peculiarities as to what constitutes a swap dealer or major swap participant that confuse me, and create ambiguity in the application of this exemption from the clearing requirement.  For instance:

The term ‘swap dealer’ means any person engaged in  the business of buying and selling swaps for such person’s own account, through a  broker or otherwise.

“(B) EXCEPTION.—The term ‘swap dealer’ does not include a person that  buys or sells swaps for such person’s own account, either individually or in a  fiduciary capacity, but not as a part of a regular business.”

“As part of a regular business”?  As opposed to what?  An irregular business?  A hobby?  I think most involved in this industry have a pretty good idea of what a swap dealer is, but would have a hard time recognizing one from the language just quoted.  A dealer is a firm that stands willing to quote prices at which it is willing to buy and sell products–a market maker.   The dealers/market makers usually enter into large numbers of off-setting positions.  Those features are totally absent from the bill’s definition of dealer.

Here’s the definition of a “major swap participant”:

The term ‘major swap participant’ means any  person who is not a swap dealer and who maintains a substantial net position in  outstanding swaps, other than to create and maintain an effective hedge under generally  accepted accounting principles, as the Commission and the Securities and Exchange  Commission may further jointly define by rule or regulation.

It seems the key phrases here are “substantial net position” for a purpose “other than to create and maintain an effective hedge.”  So, they’re not hedgers, and they have a substantial net position.  The addition of the “net position” language would seem to mean that swap dealers often don’t have net positions, which is true.

So, it would seem that what Treasury is trying to say is that a major swap participant is not a dealer and not a hedger, so that would suggest speculator.  But what about a hedge fund that is basis trading, or spreading between some cash instrument or commodity and a derivative?  A lot of speculators do just that.  Are they hedgers?  You could argue that the derivative is hedging the cash position, and under that interpretation any deal involving a hedge fund engaging in this strategy would be exempt from the clearing mandate.  I doubt that’s what Treasury means, but their drafting leaves a lot to be desired.  This imprecision will become a litigation magnet if it makes its way into law.

This is true not just because the clearing mandate turns on the classification of the counterparties, but because the execution facility mandate does so as well:

Except as provided in paragraph (8), a swap that is  standardized shall be traded on a board of trade designated as a contract market under  section 5 or on an alternative swap execution facility registered under section 5h.

“(8) EXCEPTIONS.—The requirements of subsection (j)(1) and (7) do not apply to  a swap if—  “(A) no derivatives clearing organization registered under this Act will  accept the swap for clearing; or

“(B) one of the counterparties to the swap—

“(i) is not a swap dealer or major swap participant; and

“(ii) does not meet the eligibility requirements of any derivatives  clearing organization that clears the swap.”.

So, if our hypothetical hedge fund doing a basis trade is deemed a hedger, any trade it does needn’t be executed on an alternative swap execution system (e.g., an electronic trading platform) that is subject to various requirements and obligations similar to those imposed on exchanges.

This whole regulatory schema is based on creating distinct classes of market participants, with different rights and obligations.  Given that the mandates in the proposal turn on the classifications of both parties to a trade, and that there is notable ambiguity in the definitions of the classifications, this will likely lead to some legal disputes.

The proposal also addresses the “standardization” issue, but again in an unsatisfactory way.  This is also crucial because the clearing and trading mandates also turn on standardization.  Most of the specifics are punted to CFTC and SEC, but the proposal does set out some criteria that the agencies should take into consideration when determining whether something is standardized.  These criteria include whether trade terms (including prices) are distributed, or relied on in determining the prices of other deals, and the volume of trade.  Unfortunately, however, most of the other criteria refer to the “terms” of the swap as the criteria by which CFTC and SEC assess standardization.  Are the terms of swap A like those of swap B that is cleared?  Are the differences in terms economically significant?

But it’s not just the terms that matter in determining suitability for clearing.  The risk characteristics of the instrument, and the availability of pricing information are also relevant.  Two deals with very similar terms may differ along these economic dimensions in ways that make one efficient to clear, and the other not.  (The volume of trading requirement is a crude way of assessing the price information availability issue.)  Moreover, these economically relevant factors may vary over time.  Is a CFTC/SEC determination permanent?  This would be problematic.  It should also be noted that due to economic differences, and variations of these economic conditions over time, that clearinghouses may not price risks appropriately, and that as a result the mandate could discourage mutually beneficial trades that parties would be willing to enter bilaterally because it is cheaper to do that than to clear.

The proposal also sets out rules for capital requirements and margins on non-cleared deals, but these aren’t that helpful:

BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—In setting  capital requirements under this subsection, the Prudential Regulators shall  impose:

“(i) a capital requirement that is greater than zero for swaps that  are cleared by a derivatives clearing organization; and

“(ii) to offset the greater risk to the swap dealer or major swap  participant and to the financial system arising from the use of swaps that  are not centrally cleared, higher capital requirements for swaps that are not  cleared by a registered derivatives clearing organization than for swaps  that are centrally cleared.

“(B) NON–BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—Capital  requirements set by the Commission and the Securities and Exchange  Commission under this subsection shall be as strict as or stricter than the capital  requirements set by the Prudential Regulators under this subsection.

So, capital requirements on cleared deals are positive, and requirements on cleared deals are higher than that.  That’s a huge help, guys.  This will touch off huge efforts to influence the determination of these requirements, and regulators will quite honestly not have the knowledge or information to set them efficiently.  I foresee reliance on crude proxies for risk, such as . . . wait for it . . . credit ratings.  Heaven help us.

Margin requirements are similarly fuzzy:

Prudential Regulators shall impose both initial and variation margin requirements  under this subsection on all swaps that are not cleared by a registered derivatives  clearing organization, except that the Prudential Regulators may, but are not  required to, impose margin requirements with respect to swaps in which one of  the counterparties is—

“(i) neither a swap dealer, major swap participant, security-based  swap dealer nor a major security-based swap participant;

“(ii) using the swap as part of an effective hedge under generally  accepted accounting principles; and

“(iii) predominantly engaged in activities that are not financial in  nature, as defined in section 4(k) of the Bank Holding Company Act of  1956 (12 U.S.C. 1843(k)).

“(B) NON–BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—Margin  requirements for swaps set by the Commission and the Securities and Exchange  Commission under this subsection shall be as strict as or stricter than margin  requirements for swaps set by the Prudential Regulators.

So, again: virtually no guidance on the principles regulators shall use to set margins, the counterparty classification issue, and the need to get numerous regulators to play nicely.

The proposal also opens the way for the vast expansion of position limits.  Swap execution facilities are required to set accountability or position limits, which means that the reach of these limits is extended to the swap market.  Moreover, Section 723 states:

The Commission may, by rule or regulation,  establish limits (including related hedge exemption provisions) on the aggregate number  or amount of positions in contracts based upon the same underlying commodity (as  defined by the Commission) that may be held by any person, including any group or class  of traders, for each month across—

“(A) contracts listed by designated contract markets;

“(B) contracts traded on a foreign board of trade that provides members or  other participants located in the United States with direct access to its electronic  trading and order matching system; and

“(C) swap contracts that perform or affect a significant price discovery  function with respect to regulated markets.

The definition of “significant price discovery function” is very broad:

SIGNIFICANT PRICE DISCOVERY FUNCTION.—In making a determination  whether a swap performs or affects a significant price discovery function with respect to  regulated markets, the Commission shall consider, as appropriate:

“(A) PRICE LINKAGE.—The extent to which the swap uses or otherwise  relies on a daily or final settlement price, or other major price parameter, of  another contract traded on a regulated market based upon the same underlying  commodity, to value a position, transfer or convert a position, financially settle a  position, or close out a position;

“(B) ARBITRAGE.—The extent to which the price for the swap is  sufficiently related to the price of another contract traded on a regulated market  based upon the same underlying commodity so as to permit market participants to  effectively arbitrage between the markets by simultaneously maintaining positions  or executing trades in the swaps on a frequent and recurring basis;

“(C) MATERIAL PRICE REFERENCE.—The extent to which, on a frequent  and recurring basis, bids, offers, or transactions in a contract traded on a regulated  market are directly based on, or are determined by referencing, the price  generated by the swap;

“(D) MATERIAL LIQUIDITY.—The extent to which the volume of swaps  being traded in the commodity is sufficient to have a material effect on another  contract traded on a regulated market;

These criteria would apply to most important, heavily traded OTC products.  Thus, the bill would give the CFTC tremendous power to impose position limits on combined OTC and exchange-traded positions.  Given the contentiousness of the position limit issue in energy alone, one can only imagine the difficulties that await when the CFTC’s powers to set limits extend to everything.

Overall, I think that it is a travesty to call this the “Improvements to regulation” act.  All of the substantive elements–the clearing mandate, the trading mandate, the setting of capital and margin requirements by relatively uninformed regulators subject to influence and pressure, the position limits–have no solid economic justification.  Indeed, the stronger justifications cut the other way in virtually every case.  Moreover, the ambiguities in the definition of key terms that determine the reach of the mandates are a recipe for trouble later on.  The delegation of virtually all implementation details to regulators, the rapid time frame for the formulation of specific rules, the need for coordination across regulators, and the lack of anything more than the haziest guidance will create immense implementation problems and lead to enormous influence activities.

All in all, therefore, this would be better titled “The (further) Bollixing of the Regulation of Over-the-Counter Derivatives Act.”

The Federal Trade Commission issued its final rule on market manipulation, as authorized by Congress under the Energy Independence and Security Act of 2007:

The  final Rule prohibits any person, directly or indirectly, in connection with the purchase or sale of crude oil, gasoline, or petroleum distillates at wholesale, from (a) knowingly engaging in any act, practice, or course of business – including the making of any untrue statement of material fact – that operates or would operate as a fraud or deceit upon any person, or (b) intentionally failing to state a material fact that under the circumstances renders a statement made by such person misleading, provided that such omission distorts or is likely to distort market conditions for any such product.

The rule, and the enabling legislation, are patterned on the anti-manipulation provisions of the securities laws, rather than the commodity laws.  And therein lies a problem, and renders the rule another monument to Congressional cluelessness on commodity market manipulation.

The emphasis on “fraud and deceit” makes some sense in securities markets.  Securities values are information-driven, and hence manipulative schemes in such markets frequently rely on fraud and deceit to distort investors’ information sets, and thereby distort securities values.

Things are quite different in commodity markets.  Although some manipulative schemes do rely on making untrue statements (e.g., false price reporting), by far the most important type of manipulation in commodity markets–including oil markets–involves the exercise of market power.  It is nigh on to impossible to wrench the concept of “fraud and deceit” to cover genuinely manipulative exercises of market power in the oil markets.  So, one of two things will happen.  Either the rule will prove completely useless, because it does not touch the most troublesome form of conduct in commodity markets; or the FTC will play legal Twister to try to interpret a rule written to attack information-based manipulations in order to take action against market power manipulations.

I would bet that the latter alternative is the more likely outcome, for a several reasons.  First, it is in the nature of regulator agencies to extend their power as far as possible, and stretch the rules to the breaking point to do that.  Second, the FTC will be under pressure from Congress to act in the event somebody does try to execute a market power manipulation.

I spoke with a group of FTC staffers while the rule was being drafted.  It was discouraging in the extreme to hear, that when I told them that the rule did not touch the most important form of manipulative conduct in commodity markets, that they were completely unaware that there was such a thing as market power manipulation.  I participated in a workshop on the rule that the Commission held in November, and hammered home the issues of market power manipulation.  But to no avail.  As stated in the final rule:

Some commenters argued that the final Rule should extend to conduct such as speculative activity or the unilateral exercise of market power, because in their view such conduct is inherently manipulative.   See, e.g., CFA at 8 (arguing that the Commission “could have considered the exercise of market power and excessive speculation as manipulation” because they “have no economic justification”); Greenberger at 1 (opining that the proposed Rule could offer a tough enforcement mechanism against speculative activity); Senator Cantwell at 2-3 (asserting that Congress intended for the FTC’s rule to reach a broad range of conduct, including the withholding of supply); Pirrong, NPRM, at 2 (arguing that the proposed Rule should not focus on fraud or deceit, but rather on the exercise of market power).   However, the rulemaking record does not support extending the final Rule to cover such conduct, except to the extent that the practices used are part of a course of conduct that otherwise violates the final Rule.

Whatever that means.  Translation: we had already released a Notice of Proposed Rulemaking that was totally silent on the issue of market power manipulation, so the train had already left the station and we weren’t about to look like fools and start over.

Actually, the FTC doesn’t bear the primary culpability.  Congress is the one that put the train on the wrong track.  It wrote the “fraud and deceit language” in the statute.  It was the one that had no clue about what manipulation in a commodity market really involves.

Sadly, it’s not the first time that Congress made the same mistake.  The law giving FERC anti-manipulation powers does as well, and as a result, FERC’s rule is also fundamentally flawed.

The Congressional cluelessness on all things derivative does not stop with manipulation.  It is pervasive.  It is on display daily in the myriad efforts to completely reshape derivatives regulation.  The ACES (Waxman-Markey) climate change bill contains several sections that would take derivatives regulation back to the days of rumble seats and the Charleston.  Other regulatory proposals bouncing around Capitol Hill would do the same.

What’s their motto?  “Today we screw up the energy markets! Tomorrow, the world!”?  It would fit.

The SEC letter granting ICE Trust the exemptions necessary to clear CDS transactions provides a perfect illustration of the extraordinary shallowness that characterizes policy analysis of the subject of clearing:

The Commission believes that using well-regulated CCPs to clear transactions in CDS would help promote efficiency and reduce risk in the CDS market and among its participants. These benefits could be particularly significant in times of market stress, as CCPs would mitigate the potential for a market participant’s failure to destabilize other market participants, and reduce the effects of misinformation and rumors. CCP-maintained records of CDS transactions would also aid the Commission’s efforts to prevent and detect fraud and other abusive market practices.

A well-regulated CCP also would address concerns about counterparty risk by substituting the creditworthiness and liquidity of the CCP for the creditworthiness and liquidity of the counterparties to a CDS. In the absence of a CCP, participants in the OTC CDS market must carefully manage their counterparty risks because the default by a counterparty can render worthless, and payment delay can reduce the usefulness of, the credit protection that has been bought by a CDS purchaser. CDS participants currently attempt to manage counterparty risk by carefully selecting and monitoring their counterparties, entering into legal agreements that permit them to net gains and losses across contracts with a defaulting counterparty, and often requiring counterparty exposures to be collateralized.11 A CCP could allow participants to avoid these risks specific to individual counterparties because a CCP “novates” bilateral trades by entering into separate contractual arrangements with both counterparties – becoming buyer to one and seller to the other.12 Through novation, it is the CCP that assumes counterparty risks. For this reason, a CCP for CDS would contribute generally to the goal of market stability.

As part of its risk management, a CCP may subject novated contracts to initial and variation margin requirements and establish a clearing fund. The CCP also may implement a loss-sharing arrangement among its participants to respond to a participant insolvency or default.

Stop right there.   So, in a bilateral market firms

“carefully manage their counterparty risks because the default by a counterparty can render worthless, and payment delay can reduce the usefulness of, the credit protection that has been bought by a CDS purchaser. CDS participants currently attempt to manage counterparty risk by carefully selecting and monitoring their counterparties, entering into legal agreements that permit them to net gains and losses across contracts with a defaulting counterparty, and often requiring counterparty exposures to be collateralized”

but once things are cleared, it’s apparently: “No worries!   The CCP takes care of everything!”   These sentences represent one of the greatest logical leaps–that is to say, non sequiturs–that I have read in a long time: “Through novation, it is the CCP that assumes counterparty risks. For this reason, a CCP for CDS would contribute generally to the goal of market stability.”

Uhm, yes, the CCP assumes counterparty risks.   But they don’t disappear.   Given the size of trading positions, the total losses resulting from a particular default result in the same size of loss in bilateral or cleared markets; clearing just changes the allocation.   Indeed, it can make this allocation worse, not better.   Moreover, a CCP concentrates counterparty exposure, meaning that there is a concentrated point of potential failure.   That hardly contributes to market stability.

Note too that the SEC completely ignores any incentive issues.   It recognizes that bilateral counterparties spend considerable resources to manage counterparty risk because they bear the loss in the event of a default.   The letter is completely silent on the incentive of the CCP (compared to bilateral counterparties) to manage this risk.   It is also completely silent on the information available to the CCP as compared to bilateral traders to evaluate, manage, and price counterparty risk. The letter is also silent on the potential moral hazard problem that mutualization of performance risk through a clearinghouse creates.

Thus, in expressing a preference for one way to manage performance risk over another, the SEC makes not the slightest effort to analyze the incentives or abilities of agents to perform this task under alternative arrangements.   It just makes conclusory statements with no logical, factual, or analytical basis.

To put it bluntly, the mere fact that a CCP “assumes” counterparty risk in no way implies that it improves market stability.   The chasm between one the conclusion (clearing improves market stability) and the alleged basis for that conclusion (the mere fact that a CCP assumes performance risk) is wider than the Grand Canyon.   Assumption of risk is not the same as making that risk disappear.   Given the incentive and information issues, it is quite possible that it makes the risk worse.

The SEC then falls back on the other main justification for clearing:

A CCP would also reduce CDS risks through multilateral netting of trades.13 Trades cleared through a CCP would permit market participants to accept the best bid or offer from a dealer in the OTC market with very brief exposure to the creditworthiness of the dealer. In addition, by allowing netting of positions in similar instruments, and netting of gains and losses across different instruments, a CCP would reduce redundant notional exposures and promote the more efficient use of resources for monitoring and managing CDS positions. Through uniform margining and other risk controls, including controls on market-wide concentrations that cannot be implemented effectively when counterparty risk management is decentralized, a CCP can help prevent a single market participant’s failure from destabilizing other market participants and, ultimately, the broader financial system.

Most of the benefits of netting mentioned are private benefits.   If they are so large, market participants would have been incentivized to capture them long ago.   Instead, they are only forming CCPs under the threat of even more draconian government intervention.

Sadly, this letter is representative of virtually every regulator’s and legislator’s advocacy of clearing.   That includes the US Treasury, CFTC, various legislators (e.g., Barney Frank and Colin Peterson), and the EC.   Based on such shallow justification, said powers are about to re-engineer the largest and most sophisticated financial markets in the world.

Following the CFTC hearings on position limits in energy reminds me of Through the Looking Glass:

‘Let the jury consider their verdict,’ the King said, for about the twentieth time that day.

‘No, no!’ said the Queen. ‘Sentence first – verdict afterwards.’

‘Stuff and nonsense!’ said Alice loudly. ‘The idea of having the sentence first!’

‘Hold your tongue!’ said the Queen, turning purple.

‘I won’t!’ said Alice.

‘Off with her head!’ the Queen shouted at the top of her voice. Nobody moved.

Chairman Gensler is an odd casting choice for the Red Queen, but he clearly has his heart in the part, given his opening remarks at the hearing:

But Gensler, the former Goldman Sachs’ executive who almost didn’t get the chairman’s nomination this year because of his past role in shielding over-the-counter derivatives from regulation, adopted a tough tone throughout the hearing.

“No longer must we debate the issue of whether or not to set position limits,” he said.

Then what are the hearings about?

And there’s this:  “There seemed, at least, that the commission is hearing support. I think it’s more a question of how, than whether.”

And his understudy, Bart Chilton, is clearly ready for the part:  “Whatever manner the agency proceeds, ‘going slow’ is not an option.”

Given that position limits are a mantra of the Senators to whom Gensler genuflected to get the job, it’s not really a surprise that they are now deemed inevitable.

Position limits in general are dubious at best.  There is little in the way of viable theories, and even less in the way of persuasive empirical evidence, that speculators distort prices in general, or cause prices to be excessively volatile.  There is no plausible theory or evidence that speculators caused energy prices to be artificially high in 2008.  As a consequence, position limits will almost certainly not reduce volatility for energy products, or reduce the frequency of price spikes.

After all, we’ve had considerable experience with position limits in agricultural commodities.  Note that the CFTC is essentially proposing to extend to energy and other commodities “in finite supply” (again, and examples of other types of commodities are . . . ) the same type of regime that has been in place for ags for years.  Yet, despite these limits, there has been substantial volatility in ag prices–including last year.  Moreover, there have been large spikes and crashes in ag prices despite the existence of a position limit regime there.  This should not be a surprise, as the theory of storable commodity pricing predicts that such price behavior is characteristic of efficiently functioning, competitive markets undistorted by speculation.

This perhaps explains the monomaniacal focus on index investors.  Via hedging exemptions, these types of firms have been able to amass positions in individual commodities (as parts of larger portfolios) in excess of the position limits.  Since position limits are in place in ag commodities, the fanatical opponents of speculation (fanatical in the Churchillian sense of “can’t change their minds and won’t change the subject”) need to focus on participants not subject to the limits.  Never mind that extant empirical evidence provides no support for the hypothesis that index investors are moving prices.  Or that the “theory” that these funds contribute to “demand” are completely bogus.  (It would be interesting for someone to see whether price correlations across components of major commodity indices have increased in recent years; if index investors are the dog and prices are the tail, since index investors act in a mechanical fashion across markets, they should induce very similar price movements across markets.)

Position limits have been around since the Grain Futures Act was supplanted by the Commodity Exchange Act in 1936.  I’m sure you’ve noticed what a dramatic effect they had on volatility–even before the rise of index investors.

So, we’re about to go for yet another run on the hamster wheel.

It is interesting to me to note that something that is almost impossible to be distorted by speculation–shipping rates–experienced almost the same spike and plunge as energy over the 2007-2009 period.  Shipping rates aren’t assets; they are the rental rate on assets.  Even if you have a speculative bubble in the prices of ships (i.e., a lot of ships are built on spec in anticipation of higher rates in the future), this should result in a fall in shipping rates; the entry of large numbers of ships should depress charter rates.  You can’t store the ability of a ship to make a voyage today for use in the future; you either use the space today, or you don’t.  You can’t buy up today’s space in anticipation of a higher rate in the future.  So, when you have price spikes in a non-storable like shipping space, you can’t attribute that to a speculative asset bubble, cuz it ain’t an asset.

What’s more, shipping rates are driven by global industrial activity.  The eerie similarity of the trajectory of oil prices and shipping rates (as measured by the Baltic Freight Index, for instance) therefore strongly suggests that underlying fundamentals, namely strong world industrial demand, drove both oil prices and shipping prices over the period of the energy price spike.  Indeed, I have some preliminary econometric evidence (more to come later) that shows that the Baltic Freight Index is strongly correlated with, and in fact leads, the price of oil.  (Lutz Killian has similar evidence, up through 2007: mine goes through April, 2009).

And then there’s  the issue of the details of implementation.  Given the complexity of the markets, the greater variety of products and instruments, and the greater variety of market users and strategies, designing a coherent position limit regime will be nigh on to impossible.

One disturbing matter relates to the aboveforementioned index investors, and financial market participants in commodities more generally.  Gensler stated:  “While I believe that we should maintain exemptions for bona fide hedgers, I am concerned that granting exemptions for financial risk management can defeat the effectiveness of position limits.”

So, “financial risk management”–by which I presume Gensler means investors that use commodity derivatives to improve the risk-return performance of their portfolios–are not bona fide hedgers apparently.

This reflects a widespread mindset, redolent of what Thomas Sowell calls the “physical fallacy” that physical commodity derivatives are properly for physical market players, and that others should not participate.  That is, commodity markets and financial markets should be separate.  To put it more pungently, those holding this mindset endeavor to make the commodity derivatives markets a kind of ghetto, limited to a certain group of players.

This makes no sense from the perspective of financial theory.  Integration of disparate markets with disparate risks improves the sharing of those risks, leading to a more efficient allocation and pricing of those risks.  Segregated markets–ghettoized markets–don’t permit the full scope of risk sharing, and lead people to bear more risks than is necessary.

In earlier posts I have explained why some commodity market participants may prefer that these markets be ghettoes, rather than having them integrated in the broader financial markets.  This can explain the support for position limits from some quarters of the commodity community.  No doubt these are some of the sources of support Gensler has been hearing from.

Thus, the whole position limit hysteria–which is a particular symptom of the broader underlying disturbance of speculator hysteria–is, as Alice said, stuff and nonsense.*

And for saying that, I may anticipate the sentence: “Off with his head!”

*”Stuff ‘n’ Nonsense” is also the title of an excellent Supersuckers rocker.