Streetwise Professor

From the solons of Time’s Curious Capitalist blog, an assertion that Chris Cox is “An American Hero” because he opposed the Commodity Futures Modernization Act of 2000. Apparently, blogger Justin Fox believes that OTC derivatives are somehow responsible for the current financial mess. Just how, exactly, Justin doesn’t feel obliged to tell us. The logic seems to be: (a) The Act was passed in 2000 in a hurry in the dark of night, (b) OTC derivatives are waaayyy complicated and unregulated and really scary financial instruments, (c) we’re experiencing a financial crisis 8 years after the Act was passed, and (d) Phil Gramm had his hand in it. Or something. There isn’t even a semblance of an attempt to make a connection between a change (a clarification really) of the rules for OTC derivatives and the current financial crisis.

That’s probably a smart move on Justin’s part, because it is very hard to see any such connection. The main problems with the financial system stem from exposure to real estate markets that financial institutions incurred due to their purchase of mortgage SECURITIES regulated by the SEC. This includes massive purchases by securities firms regulated by the SEC.   Moreover, the ratings firms that provided credit ratings for these securities are already SEC regulated.

The closest immediate connections of big, bad “unregulated” OTC derivatives to the current crisis are (a) the collapse of AIG, due to its huge net position in credit derivatives tied to mortgage securities, and (b) the systemic risks posed by the interconnections of parties who engaged in derivatives transactions.

Even here, though, the case is not altogether clear. Consider AIG (and monoline insurers that also sold protection on various credit risky instruments.) AIG was a big seller of protection against the decline in the values of mortgage securities. But the derivatives market is a zero sum game. If AIG lost zillions, somebody made zillions. Who? Some might have been hedge funds or others taking a speculative position opposite AIG. Others, however, were purchasing protection as a hedge of positions held in their portfolios. Absent AIG’s sale of protection to them, they would have suffered unhedged losses on their underlying positions in the securities. Absent this protection, some–perhaps many of them–would have gone bust. AIG’s failure is big, ugly–and noticeable. The failures avoided could well have been bigger (because the protection buyers were even less well-capitalized than AIG, a difference which created the gains from the risk transfer in the first place) and uglier, but as they didn’t happen, they aren’t noticeable.

Put differently, the existence of derivatives affected the distribution of wealth resulting from changes in the prices of the underlying securities. It did not affect total wealth–somebody’s loss was somebody else’s gain, penny for penny. The whole motivation for derivatives is that changes in the distribution of wealth contingent on the state of the world leads to a more efficient allocation of risk, making the transacting parties better off ex ante. AIG put its capital at risk insuring (it is an insurance company, after all) contingencies that others didn’t want to bear. In the event, AIG suffered huge losses, but in many cases, absent the existence of a credit insurance market its losses would have been borne by firms less-well capitalized to bear them.

Earthquakes and hurricanes put some insurance companies out of business because the resulting claims exceed their capital. Does that mean we should ban insurance against such natural disasters? If we did, you bet–no insurance company would fail! But millions of homeowners would bear greater losses. It is better to have an insurance market where insurers sometimes fail, than to have no insurance market at all. The fact that insurance companies fail just means that risks are not fully insured. The policyholders of the failed company don’t get all their claims covered to the extent that they are contractually entitled. But they usually get some coverage. This leads to a better allocation of risk than would occur with no insurance market at all.

The real root of the current crisis is securities that have plummeted in value. This decline in value represents a decline in wealth, not, as in the case of derivatives, a zero sum change in the allocation of wealth. The CFMA had nothing whatsoever to do with the plunge in the value of these instruments, and the concomitant loss of wealth. Indeed, there is a strong case to be made that the liberalization of the OTC derivatives market and the subsequent growth of the credit derivatives market actually mitigated the adverse impact of this decline in the value of these securities.

For his part, however, Chris Cox stills sees the derivatives boogey man under his bed. To wit, from Market Movers, Cox’s testimony on the need to regulate credit derivatives:

There is another similar regulatory hole that must be immediately addressed to avoid similar consequences. The $58 trillion notional market in credit default swaps — double the amount outstanding in 2006 — is regulated by no one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market.

This is an area that our Enforcement Division is focused on using our antifraud authority, even though swaps are not defined as securities, because of concerns that CDS offer outsized incentives to market participants to see an issuer referenced in a CDS default or experience another credit event.
Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS. Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based. This means CDS buyers can “naked short” the debt of companies without restriction. This potential for unfettered naked shorting and the lack of regulation in this market are cause for great concern. As the Congress considers fundamental reform of the financial system, I urge you to provide in statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets.

In other words, show Chris Cox a derivative, and he just sees an evil manipulative tool. (Or maybe he just has some sort of Puritanical hang up with nakedness. One can almost sense the frisson every time he utters the words “naked short.”)

I have already taken Cox to task for his dim understanding of the economic functions of financial markets, but since he won’t go away, I guess I shall have to taunt him a second time. First, shorting is not per se bad. It can make markets more efficient, and indeed, markets where shorting is not possible are more vulnerable to bubbles than those where it is. We WANT markets to reflect bad news too–we want prices that reflect all information, not just happy talk. Second, buying CDSs is often a risk reducing transaction–those long the underlying credit hedge their exposure (as discussed above). Third, although it is possible that someone long a CDS would profit if the price of the underlying instrument declines, or experiences a credit event, and thus may be tempted to do something to cause such a price decline or credit event, if Chris Cox has a particular example in mind, he should share it with the class. Better yet, he should bring an enforcement action. Even if the CDS is not regulated itself, the underlying security would be subject to SEC regulation, and any attempt to manipulate its price would be actionable. (This also shows that the “loophole” is a figment of Cox’s fervid imagination. A manipulation than enhances the profit of the CDS position would necessarily distort the price of the underlying security. This would involve some sort of fraud or manipulation that would fall under SEC jurisdiction. I should also note that creation of large long CDS positions is actually more likely to increase the risk of a squeeze that artificially inflates debt prices during credit events. Well, go figure–I said that 2.5 years ago.)

Chris Cox, American hero? Hardly. The title to this Green Day CD fits far better.

I have deep reservations about the Paulson-Bernanke bailout proposal. In a nutshell, they propose to buy “illiquid” assets from struggling financial institutions. This raises the question: Why are these assets illiquid? When you answer that question, the entire case for the bailout becomes dicey at best.

Illiquidity is first and foremost the result of asymmetric information–a lemons problem. If the owner of an asset has better information about its value than potential buyers, the buyers are very reluctant to make bids for them. They realize they face a winner’s curse: if the owner accepts the bid, it is because the bid is above the owner’s estimate of value. Now, in current circumstances, owners desperate for cash to survive may be willing to sell assets for less than their (relatively well informed) estimate of value. Thus, the lemons problem/winners curse may not cause a complete market failure with zero trading volume (as would be the case if there were no non-informational reasons to trade.) But severe information asymmetry drastically reduces the liquidity of the market for these assets.

Under the bailout proposal, the government will become the buyer of the assets. Regardless of the design of the mechanism for purchasing the assets, it is likely that the sellers will have a substantial information advantage over the government. Thus, the government is likely to suffer from a substantial winner’s curse problem, and end up overpaying for the assets it does buy.

This is not to say that current holders of mortgages and mortgage CDO’s have a very accurate estimate of the true value of these things. It is just likely that they have a better estimate than the government, or most potential buyers. The current owners have had an opportunity to do research on the underlying pools of mortgages. They have also observed the payment experience on what they have in their portfolios. As a result, they have some idea of which of their holdings are (relatively) good; which are bad; and which are truly ugly. The one eyed man is king in the land of the blind. The owners of these assets may have only one dodgy eye, but the government is likely to be nearly blind–so bet on dodgy cyclops.

Substantial competition between participants in an auction can mitigate the adverse impacts of asymmetric information. I am skeptical, however, that there will be a lot of competition here. The assets are so heterogeneous that the competition in the auction for any particular security (and that’s what matters) is likely to be subdued.

Another matter of concern is that although the objective of the auction is to facilitate the recapitalization of financial institutions, there are doubts as to whether the proceeds from auction sales will flow to the institutions that face the most daunting obstacles in recapitalizing in the market through sales of equity or subordinated debt. It is likely true that more desperate institutions are more likely to want to participate, and may accept lower prices for their assets. This would mean that such firms would be the most likely sellers, which would in turn mean that they would be disproportionately represented among the auction winners. Nonetheless, a good portion of the auction proceeds will likely flow to canny asset owners that could probably survive (or recapitalize) without these proceeds. Thus, the government may end up overpaying for assets, and the overpayment may do little to restore the balance sheets of the institutions that really need the help.

So, the bailout aid may not go to where it delivers the most bang for the buck. Paulson and Bernanke appear to be hoping that the bailout will inject liquidity into the market for heretofore illiquid mortgage securities. From the best I can gather, they think that these assets are selling at deep discounts to their actual value due to their illiquidity. Make the market more liquid, asset prices go up, and everybody’s happy.

I really don’t see how this will work. If the illiquidity is due to adverse selection/lemons problems, private buyers will still be very reluctant to purchase those assets the government doesn’t buy. So, in the end, the likely outcome is that (a) the government will overpay for a lot of assets due to the “winner’s curse”, (b) some of the overpayment will go to institutions that really need the capital, but some will go to to those that don’t, or who could raise it on the market, and (c) the market for problem assets will remain illiquid, with the government being the only buyer. That doesn’t seem to be the wisest way to spend $700 plus billion.

The lemons problem arises because of asymmetric information, but also because the seller has the ability to say no to the buyer’s offer. The seller says “yes” when the bidder overpays, and says “no” when the buyer underbids. The only real way to avoid this problem is to deprive the seller of the discretion to refuse offers. That is, Don Corleone (“I’m gonna make him an offer he can’t refuse”) is less subject to the winner’s curse than buyers who employ less coercive means. So, the best way that the government has to avoid the lemons problem is to approach financial institutions and say: we’re paying you X for Y. Your options are “Yes” and “I agree.”

That, of course, presents a whole slew of legal, constitutional and ethical issues. Moreover, there is still the question of to whom the government should extend these tender offers. Presumably, institutions more vulnerable to failure, and whose failure would impose more stress on the system.

But that’s in essence what the government did in the case of AIG. It decided to intervene with AIG because of its central position in the nexus of credit derivatives contracts, and because of its impending failure. It gave AIG a near ultimatum.

That seems a much better approach than playing Uncle Sucker willing to buy anything somebody’s willing to sell them. The seller is likely to have information advantages, and the payments made to winning sellers may not go to where its effect on the stability of the system would be greatest. Moreover, I am skeptical that the government’s purchase of bad assets will suddenly improve the liquidity of the private market for these assets. Instead, focusing on particular companies that are most important to the stability of the system, and which are having the greatest difficulty in financing themselves via the market, and sharply limiting the discretion of those companies to accept the terms offered, is a better way to target government assistance and to avoid the winner’s curse.

How could this restore market confidence today? If it is perceived to be a credible policy. How to make it credible? One thing that would enhance credibility would be for Congress to approve legislation and funding for such a program. This should include, of course, oversight and accountability provisions.

As ugly as they were, the Fannie, Freddie and AIG interventions make more sense than trying to create liquidity in the market for low quality mortgages through the mechanism of a government bailout. If illiquidity reflects the fundamental nature of these assets, and the distribution of private information regarding their value, the purchase program will not restore liquidity in a cost effective way.

The emerging conventional wisdom about the ongoing financial crisis is that it was the result of too little regulation, and that additional regulation will be needed to prevent its recurrence. Just what regulatory lacunae caused the current crisis, and just what regulatory changes will save us from future scourges are almost always left unsaid. Instead the word “REGULATION” is wielded like some magic incantation, which by its very utterance will protect us.

Sorry. Not good enough. Details matter. Specifics matter. Talk to me when you have some of either. Until then, talk to the hand.

One accusation that I have seen is particularly risible. That is that the 1999 repeal of the Glass-Steagall Act (by the Gramm-Leach-Bliley Act) somehow caused the meltdown. Helllooo. This would be somewhat plausible if the securities underwriting affiliate of a commercial bank imploded, causing a bank failure that sparked a general banking panic. Nothing remotely like that happened. Indeed, the crisis erupted because the very institutions created by Glass-Steagall–stand alone investment banks–blew up. Indeed, the modern, post-’99 versions of universal banks, took hits, but survived. Moreover, the last big investment banks standing–Morgan Stanley and Goldman Sachs–are rushing to transform themselves into banks. Other investment banks have been sold off–or their corpses have been–to commercial banks. In other words, the market is throwing dirt on Glass-Steagall.

The single most important factors in the meltdown (as an oped by Calomiris and Wallis in today’s WSJ points out) were Fannie and Freddie. (Although I have long believed that Fannie & Freddie were disasters, I have not been convinced that their actions in the subprime market were essential to the proliferation of bad mortgage debt. The Caomiris-Wallis piece and other things I’ve read are persuading me that F&F were primus inter pares in causing the disaster.) Fannie and Freddie were not market failures. They were creatures of the government doing the bidding of a coalition of Congressmen. I agree wholeheartedly that they were not regulated properly or sufficiently. But you are truly delusional if you believe that’s what Congress or other bloviators mean when they call for “more regulation.” In fact, the very Congressmen that aided and abetted F&F are (a) doing their level best to perpetuate that scam as long as possible, and (b) using the financial fallout from the effects of F&F to justify the imposition of regulations on other financial institutions.

One of the great lessons of the Crash of ’29 and the Great Depression is that people learned the wrong lessons from the Crash of ’29 and the Great Depression, and created regulatory “fixes” to phantom problems. Glass-Steagall, the Securities Act, the Exchange Act, the Commodity Exchange Act, etc., were all responses to defective diagnoses of what caused the Crash and the subsequent depression. Each imposed substantial costs on the economy for decades afterwards, and didn’t address the real causes of the financial and economic tumult of the late-1920s and 1930s. I fear that history is in the process of repeating itself.

More from Matt Leising at Bloomberg on yesterday’s oil squeeze:

“This sharp move reflected extreme tightness in the prompt physical market as participants that were short oil scrambled to find physical oil before expiration,” wrote the analysts, led by Jeffrey Currie. Record oil prices have made refiners rely on stocks of existing supply, the analysts wrote, creating “critically low” inventory levels.

Vulnerable to Spikes

“This tight inventory situation has left the oil market with very little cushion and therefore extremely vulnerable to price spikes,” the note said.

Trading was light on Nymex yesterday. About 41,000 crude contracts for October delivery changed hands, 85 percent less than the 15-day moving average volume of 280,000 contracts, according to Bloomberg data.

The traders who sold contracts short might have been betting on price declines due to less-than-expected damage to oil rigs and production from Hurricane Ike as it crossed the Gulf of Mexico.

“Ike did more damage than originally thought,” said Rick Mueller, director of oil markets at Energy Security Analysis Inc. in Wakefield, Massachusetts.

The most recent storm in the Gulf made landfall in Texas on Sept. 13, cutting off power and damaging some refineries. U.S. energy producers resumed output for about 23 percent of oil and 34 percent of natural-gas production in the Gulf after the storms, the Minerals Management Service said yesterday in a statement on its Web site.

This suggests that deliverable supplies were low due to Ike. Low deliverable supplies make the market more vulnerable to a squeeze. Put differently, somebody with a 10 million barrel futures position may not be able to squeeze the market profitably when deliverable supplies are 9 million, but may be able to do so when they are only 5 million or 4 million. Thus, Ike’s disruptions raised the likelihood of a squeeze.

One should not go the next step–as people often do–of concluding that Ike “caused” the price disruptions in the October contract. Just as a forest fire requires BOTH dry tinder AND a spark, a squeeze requires low deliverable supplies AND the affirmative action of a large long (or longs). A large long must demand excessive deliveries. The low deliverable supply only means that the long can get the same price effect–and a bigger profit–by demanding fewer deliveries and liquidating more contracts at an artificially high price. Put differently, the cost of manipulation is burying the corpse of deliveries. With low deliverable supplies, the corpse is small, and the manipulation is easier to carry out. To mix metaphors, and extend the forest fire example, the low deliverable supply is the dry timber, but the uneconomic demands for delivery by a large long or longs is the spark that is necessary for the fire to occur. Low deliverable supply is a precondition that makes the market vulnerable to a squeeze. But somebody has to do the squeezing. Smaller players can squeeze when deliverable supplies are small.

Since the FTC Report on the Grain Trade in 1920-1921, it has been common to label events like those of yesterday as “natural squeezes” because “natural” market conditions made the squeeze possible. The “natural” terminology has been used to excuse the opportunistic exercise of market power by those who exploit these conditions to distort prices. This “reasoning” is wrong, and highly injurious to the market. It essentially gives longs a manipulation option. Hold a large long position to expiration. If something happens to reduce deliverable supply–squeeze away, and make money. If nothing happens, just liquidate at the competitive price. When they come after you for squeezing, just say “Hey, it was a natural squeeze. And natural is good, right? That’s what they tell me at Whole Foods!” It’s worked. And it has undermined market efficiency. Regardless of whether exogenous events made a squeeze more profitable, a necessary condition for the squeeze to occur is for somebody to exercise market power opportunistically. These people should not be allowed to skate.

As commentor Scott Irwin noted, due to the fact the squeeze took place in a very short period of time, it is unlikely that it will have acute deadweight costs, although large amounts of money will change hands as a result. (The fact that the main price action took place in the last half-hour of trading that is used to determine settlement prices–and the final prices on swaps tied to NYMEX CL–suggests that somebody was long swaps as well as futures, and earned profits from the price distortion on a cash settled OTC swap position.)

The main deadweight cost is the effect that the episode will have on the speculation debate. People are already seizing on this as evidence that market manipulation is a serious problem that needs to be addressed by more draconian restrictions on market participants. My take is very different. The contrast between what happened on 9/22 and what happened in the last half of 2007 and the first 8 months or so of 2008 shows that the big price surge in oil that peaked in July was almost certainly NOT the result of manipulation.

Yesterday’s events bear all the hallmarks of a squeeze. It waddled like a squeeze, it quacked like a squeeze, it flew like a squeeze, and it swam like a squeeze, so . . . I would have a hard time arguing that what happened in the October CL price was normal and competitive.

So what yesterday shows is, yeah, manipulation can happen. What happened on 9/22 bears all the hallmarks of a manipulation—and look how different that was from what transpired over the first 7 or so months of 2008. The 9/22 event was intense, but limited to a very short period of time in a single market. It affected one price that moved a lot relative to other prices (e.g., the November price, the prices of heating oil and gasoline). It happened as the contract moved to expiration/delivery. That’s what happens during a squeeze, a manipulation.

In contrast, the runup in oil prices over 2007-July, 2008 was long, sustained, occurred in all markets, was not concentrated around contract expirations, and did not result in one price getting way out of line with all other prices.

Thus, in my view, by contrast, the squeeze of 9/22 shows that what happened in 2007 and the first 7 months of 2008 was NOT manipulative.

The events also showed that when a squeeze happens—people notice. Regulators notice. The subpoenas went out within hours of the event. People will sweat. People will pay. That’s the way to deal with it. By focusing on people who engage in demonstrable wrongdoing, and punishing them severely—not by clamping down on all speculative activity, virtually all of which is quite legitimate. Cut out the cancer—don’t shoot the patient in the head—a surefire cure, but not a very constructive one.

This episode also brings to mind a historical parallel. In May, 1921, the Senate was holding hearings on the regulation of futures trading. A representative of the Chicago Board of Trade, Julius Barnes, testified that there was no need to regulate futures trading because the exchange had the incentive and ability to prevent manipulation. The very moment he was speaking, a large grain trader named Field executed a huge squeeze of the expiring May wheat future. The price of May wheat rose $.17/bu–almost 10 percent–on the last day of trading, and the price of cash wheat fell $.20/bu the day after the contract expired. This spike and crash is symptomatic of a squeeze.

An exasperated Barnes wrote to his business partner: “nothing has embarrassed, in recent years, like the gyrations in Chicago May–the very day we were arguing before the Senate Committee that the governors of these exchanges were making some progress themselves in eliminating manipulation.” A month later, a chastened representative of the CBT, L.F. Gates, testified before the Senate that “The trade recognizes the manipulator as the enemy of the whole organization. We dislike him as much as any of you gentlemen do, and if we could find any way of shitting him out absolutely, we would do it. Maybe you can help us on some of these problems.” In other words, the CBT almost begged for regulation. The Congress obliged, passing the Futures Trading Act, the first major Federal regulation of the futures markets, and the progenitor of the Commodity Exchange Act that governs the markets to this day.

Thus, the actions of a squeezer–Mr. Field–on one day dramatically changed the political landscape, and forced a previously recalcitrant CBT to submit to Federal regulation. Sadly, whoever squeezed the October crude contract on 22 September, 2008 may have a similar legacy. Even though the October CL squeeze in no way validates the wild accusations leveled against oil speculators for causing the price runup to $147 in July, it may well become the “I rest my case” Perry Mason moment that will be used to justify wide ranging restrictions on energy trading. Restrictions that will do little if anything to prevent events like those that occurred on Monday; that will not prevent prices from rising to $147 or higher when fundamentals justify it; and that will impair the efficient operation of the market as a price discovery and risk management tool.

Thanks, buddy, WTF you are.

Sheesh, how many fans are there out there, anyways? (If you get this, and the connection to the title, you’re a Warren Zevon aficionado. If not, google “zevon lyrics laywers guns money.”)

I am referring specifically to today’s events in the NYMEX crude market. From Bloomberg:

Sept. 22 (Bloomberg) — Crude oil climbed more than $25 a barrel, the biggest gain ever, as the dollar weakened the most against the euro since January 2001, boosting the appeal of commodities as a hedge.

The October contract, which expires today, rose almost $12 more than the contract for November delivery, as traders rushed to close positions. Oil, gold, corn and other commodities climbed as the dollar dropped on concern that a U.S. proposal to buy $700 billion of troubled assets from financial firms will deepen the budget deficit.

“This looks like a squeeze play,” said Phil Flynn, senior trader at Alaron Trading Corp. in Chicago. “All of the contracts are up, but nothing like October. This is the last day of trading and someone is scrambling to guarantee supply.”

Crude oil for October delivery rose $18.05, or 17 percent, to $122.60 a barrel at the 2:30 p.m. close of floor trading on the New York Mercantile Exchange. Futures climbed as much as $25.45 to $130 a barrel, the highest since July 22. The more- active November contract rose $6.11, or 6 percent, to $108.86 a barrel.

It sure does look like a squeeze, Phil. During a squeeze the nearby price (October, in this instance) increases relative to the deferred prices (November, and later months.) On Friday, October settled $1.80 over November. At some point today, October traded at least $19.55 over November. Based on settlement prices, October gained $9.45 on November. That last number is a huge move, given the normal volatility in calendar spreads, but the $17.75 move is mind-blowing.

A squeeze would work by somebody holding a large long position refusing to liquidate that entire position. On the last trading day, refusing to liquidate is equivalent to demanding delivery. If the shorts perceive that deliverable supplies are inadequate to meet the long’s implied demand for deliveries, they are willing to bid up the price in order to offset their positions and avoid the prospect of making inefficient deliveries.

I would therefore like to see how many contracts liquidated. WSJ data report open interest of 23,130 contracts–or 23 million barrels of oil. I am pretty sure that this figure is yesterday’s open interest. That’s substantially more than the likely delivery capacity in Cushing, OK over the coming month. If one long, or a couple, held the bulk of these positions, or a large futures long also has a big long position in deliverable crude, they would possess the market power to squeeze the shorts. To the extent that the large long was also long in OTC instruments settled against the last NYMEX settlement price, they could profit even more from the price spike.

In some respects, this is a stunning development. Anybody even remotely familiar with these markets is aware of the intense scrutiny they are currently subject to. Any large long has to know that subpoenas are incoming. Knowing that the world–the regulators, the Justice Department, Congress–is watching, you would think that large longs would go out of their way to avoid doing anything even remotely manipulative. The most plausible explanation of today’s move, however, is that somebody squeezed October crude. Dunno about the guns, but money and lawyers will certainly be in play very, very soon.

Update: Another piece of information consistent with the squeeze interpretation.   October Heating oil and RBOB gasoline were up less than 5 percent on the day.   OCT and NOV HO were about by about the same amount, and OCT RBOB actually rose less than NOV.   The sharp rise in the price of nearby crude relative to products (i.e., the sharp decline in the crack spread), and the lack of steepening backwardation in products are what you would expect to observe in a squeeze of the CLV.

It is apparent that the decisive factor that drove the Treasury to intervene with AIG is the insurer’s immense position in credit derivatives, notably credit derivatives tied to various mortgage securities. Whereas it seems that in the case of Lehman’s slow motion implosion, market participants had the opportunity to move positions and thereby limit the potential for a cascade of knock-on defaults on derivatives arising from a Lehman default, AIG’s much more rapid plunge permitted no such luxury. Fearing that AIG defaults would trigger defaults or bankruptcies by its counterparties (either because they held offsetting positions with others, or because the loss of the insurance contracts would blow holes in balance sheets large enough to force bankruptcy), the government decided to step in and effectively guarantee AIG’s performance on all its obligations.

The wreck of AIG hard on the heels of the collapse of Lehman hard on the heels of the disappearance of Bear has led to repeated calls for the establishment of a clearinghouse–a central counterparty (“CCP”)–for OTC derivatives, including credit derivatives. In this post I will attempt to discuss some of the issues this possibility raise. Bottom line: a CCP could help a lot, but it is not a panacea. Moreover, the benefits of a CCP depend crucially on the answer to the question: Why hasn’t the market already created a CCP?

What does a CCP do? It insures default/performance risk by mutualization, i.e., sharing of these risks across market participants. Note that in the days (or should I say day) before the AIG collapse, the Treasury essentially tried to create such a mutualization mechanism on the fly when it attempted to coax/coerce banks into lending to AIG. Not surprisingly, this effort failed, and in the event, the government stepped in as the ultimate insurer–meaning that taxpayers are essentially bearing the risk.

One way a CCP would have definitely helped is through the netting of offsetting exposures. In the OTC market, as currently constituted, when A sells a contract to B who sells to C who sells to D, (a) B and C have no market risk exposure (because they have offsetting positions), but (b) there are four sources of performance risk; default by A, B, C, or D is a possibility. For instance, B could suffer a loss on another position that impaired its ability to perform on its contract with either A or C. With clearing, or with some sort of mandatory netting (“ringout”) arrangement, B and C would be taken out of the chain of contracts, and only A and D would pose and face performance risk. B and C could blowup and neither A nor D would care.

In brief, central clearing reduces overall credit and performance risk by reducing the overall magnitude of performance risk exposure. Without netting, performance risk is roughly related to gross positions in the market, whereas with netting, performance risk is reduced to the net exposure.

The CCP also centralizes position information, making it easier for somebody (e.g., the Fed, Treasury) to figure out market exposures. I can only imagine the nightmare that regulators lived trying to figure out who traded how much with whom, and then assembling the jigsaw puzzle to visualize the potential for systemic problems. This is especially true given the dodgy nature of documentation in the credit derivatives market. Although participants have supposedly made progress cleaning up back office problems, these problems haven’t disappeared. This would represent another benefit of a CCP–it would force a rationalization of the confirmation process.

Now let’s figure out how things would have worked out in the AIG case had a CCP been in place. I presume that AIG had a big net position (as otherwise it wouldn’t have been facing multi-billion mark-to-market losses.) So, to the extent its positions weren’t fully collateralized (and I return to the collateral issue below), AIG would have failed to the clearinghouse. These losses would have been covered, to the extent possible, by funds precommited by CCP members in the form of a default fund or its equivalent. In addition, most CCPs have credit lines with banks. If the default fund was inadequate to cover the value of the AIG’s defaulted positions, the CCP would have been able to call on these credit lines, which would have become liabilities of the remaining, solvent members of the CCP. Through this mechanism, or through the CCP’s ability to require members to make additional capital contributions, the losses would have been shared by the other CCP members. A member’s share would be, to a first approximation, an increasing function of the size of the participant and its positions.

Thus, the effects of the CCP would be to diffuse the risk of a single default among all of the members of the CCP. It is likely–though I doubt it can be proven mathematically–that this would reduce the likelihood of the default causing a cascade of knock on defaults. Under the current, non-cleared system, the exposure to an AIG default is related to the direct and indirect gross exposures of each trader in the market to AIG. A firm with a big direct, or even indirect, exposure to AIG, would suffer a big loss from the latter’s default. That big loser would be more likely to be unable to perform on its other obligations than an otherwise identical firm with a smaller gross exposure to AIG. Under a CCP, there would be less dispersion across firms in the exposure to AIG. Thus, under most circumstances it appears less likely that one firm would experience a disproportionate loss from an AIG default.

Here’s a simple example that may capture some of what I am trying to convey. A and B are sellers of CDO insurance. C and D are buyers. C and D have portfolios of CDOs that they have financed with debt and equity. To normalize things, let’s assume that each insurance buyer’s debt is 90 and equity is 10. To make it simple, to emphasize the concentration effect, assume that C buys only from A, and D buys from B. A defaults. This occurs when B has suffered a big loss on his CDO position–let’s say that the CDOs have fallen in value to 50, and instead of paying the 50 it owes, A only pays 20. B no longer has insurance over its entire position. It now a CDO worth 50, and a payment of 20 from A–it thus can only pay 70 of its debt of 90. It defaults on the loan. There is a knockon effect.

Now lets say that the default of 30 is shared among B, C, and D in equal proportions. (NB: In reality, sharing rules are much more complicated.) Let’s say too that B is sufficiently capitalized to be able to cover its insurance obligation and its 1/3 share of the 30 default. Here, C and D receive (on net) 40 of the 50 that they are owed, leaving them with assets of 90 and liabilities of 90. They don’t default. Under the CCP, B and D bear some of the loss that C bears alone with no clearing. This reduces the probability that C will default.

Now, of course exposures are endogenous. In my example, C is a fool for having put all his eggs in one basket. Therefore, you would expect traders to consciously attempt to trade with more counterparties and limit their concentration in the absence of a CCP. Nonetheless, various considerations related to asymmetric information–something I will discuss more below–may in fact induce concentration.

It should also be noted that clearing economizes on collateral. Collateral is related to gross positions in the absence of clearing; with clearing they are related to net positions. This can reduce demands for liquidity during periods of systemic stress. Firms will face smaller collateral calls, and thus have less need for credit or to liquidate assets during periods of market stress.

So if clearing is so great, why hasn’t it happened already? On the answer to that question turns the policy recommendation.

One reason is that there is a coordination or externality problem that means that although it is collectively rational to form a CCP, it is individually irrational, or that the costs of coordinating the creation of a risk sharing arrangement are too high.

For instance, I have argued that some market participants (especially big, highly creditworthy players–like AIG before its collapse’-) may oppose the formation of a clearinghouse because a CCP levels the credit playing field. The biggest, most creditworthy firms have a competitive advantage in a non-cleared OTC market, and a CCP might undermine this advantage. The big guys may therefore not want to participate. And if they don’t play, the clearinghouse will never get off the ground.

Moreover, to the extent that a systemic event caused by a chain of defaults has costs that affect parties other than the intermediaries–a plausible hypothesis–the contracting parties do not internalize all of the costs of their decisions. They therefore do not fully internalize the benefits of the formation of a CCP–and hence may not agree to its creation.

These arguments suggest that the mandatory creation of a CCP would be welfare improving.

There are arguments, however, that suggest that there are substantial costs to the formation of a CCP. In particular, asymmetric information makes it costly to share risks. To the extent that participants in a CCP have private information about their own creditworthiness and the riskiness of the positions they clear, moral hazard and adverse selection problems will occur. These are real costs of risk sharing. The greater these costs, the smaller the benefit of forming a risk sharing arrangement.

As I have argued in a working paper, these costs are greater, the more difficult it is to value the instruments being cleared. Valuation is relatively easy in instruments that are standardized and traded on transparent markets with nearly continuously available, competitively determined prices. Valuation is much more difficult for idiosyncratic instruments that are infrequently traded, and/or which are traded in opaque markets.

The former conditions describe centralized exchange markets for liquid instruments, like T-bond futures. The latter, alas, describes many OTC derivatives, especially credit derivatives, and especially credit derivatives on CDO structures. Hence, it may well be the case that the reluctance to move to a CCP system for more complex instruments is due to the fact that the costs of sharing default risk are higher for these instruments.

Of course, these explanations–coordination/externality vs. high cost–are not mutually exclusive. If I had to make a gut call, I would say that the coordination/externality problems are sufficiently acute that some regulatory effort may be warranted to require the formation of a CCP system. At the same time, any such regulation should take into account the moral hazard and adverse selection problems that are inherent in more complicated instruments, and therefore recognize that risks cannot be shared as extensively for such instruments as is the case for vanilla products traded in transparent markets. This regulation should also recognize that pricing information, transparency, and valuation expertise are required to mitigate the costs of risk sharing for more complex instruments. Therefore, the creation of a clearinghouse might also require measures to improve price transparency and share valuation expertise. This raises other possible sources of resistance. Individual traders profit from private information on prices, and hence are reluctant to share this information. Thus, formation of clearing may require the mandating of disclosure of transaction pricing information. Good luck with that.

In brief, the AIG mess would probably haven’t been as messy if a CCP had been in place. Moreover, it is possible that the absence of a CCP is due to a market failure. However, it should also be recognized that clearing of the kind of stuff that got AIG into trouble ain’t easy–it ain’t like clearing T-notes or even OTC vanilla swaps. It is almost certainly the case that it is uneconomic to share performance risks as widely and extensively in more exotic credit and mortgage products as is the case for vanilla, exchange traded stuff.

I should note that this post was written more hastily than I usually like, but I feel that the issue is sufficiently important and timely to justify a more hurried take. If, upon further consideration, I decide that this analysis is incomplete or incorrect, I’ll make the necessary changes.

During the aftermath of Hurricane Katrina, General Russel Honore castigated a reporter for being “stuck on stupid.”

For some reason, that phrase has come to mind repeatedly in the past hours. Perhaps it is due to the fact that I am sitting on the 9th floor of the Hilton in College Station, Texas, watching the rains and winds of Hurricane Ike. But more likely, it is that I am passing the time reading several of the latest “studies” purporting to lay the blame for the runup of commodity prices (especially energy prices) in 2007-2008 at the feet of speculators, and more particularly, commodity index traders.

The most widely disseminated of these is the Masters-White “Accidental Hunt Brothers” piece. Another is “The Commodities Market Bubble: Money Manager Capitalism and the Financialization of Commodity Markets” by University of Missouri-KC professor L. Randall Wray.

In a nutshell–same old, same old BS.

I could go on and on deconstructing this bilge, but even though the opportunity cost of my time is only slightly above zero, being marooned as I am, it is still positive. So I will limit myself to hitting the low-lights.

The most fundamental problem with these papers is their failure to identify any channel whereby side-bets on commodity price outcomes affect the supply and demand for physical commodities. Masters and White are particularly slippery in this regard, equating in a conclusory way the purchase of physical oil by China to the purchase of forward and futures contracts in similar notional quantities by index funds, and then asserting that the side bets contribute just as much to demand as the Chinese purchases of physical oil, and hence are just as responsible for any price increases. Similarly, Masters-White state that index traders are holding “stockpiles” of oil. Uhm, no, they don’t. They hold contractual claims on oil that they liquidate without converting them into actual, bona fide stockpiles of physical oil. The Masters-White argument is akin to saying that the bettors at race tracks own the outcomes of horse races. No, they own betting tickets–contingent claims that have payoffs that depend on the outcome of a horse race. Absent some other mechanism (e.g., bribing the jockeys), these contingent claims don’t influence the outcome of the race.

Put differently, moneys invested in indices don’t actually flow into the market for the physical commodities. Nobody uses these dollars to buy oil or corn. Instead, these funds are used to place collateralized bets on future movements in prices. The actual money invested in these strategies (if the index investor follows a fully collateralized strategy) is used to buy T-bills in dollar amounts equal to the notional value of the commodity index. The actual moolah doesn’t flow into the commodity markets, the way that it does when Sinopec or PetroChina buys a supertanker of Arabian crude.

Masters-White and Wray also fail to address the fact that index investors liquidate their positions before they become claims on physical commodities, and hence they are typically sellers at the time that spot prices are determined.

In terms of “evidence” these authors merely point to the fact that index fund investments have risen at the same time that commodity prices have risen. They do not appear to separate out the effect of increases in the amount of commodity index fund assets that was caused by the effect of rising prices on the value of existing positions from the increases attributable to the flows of new moneys into the funds. There is no effort to carry out rigorous statistical tests (e.g., cointegration tests, Granger Causality tests) to establish causation or an equilibrium relation. (It is possible that the visual relationship between two strongly trending series like an oil price and the size of index positions could be a spurious one. The authors of these studies make no attempt to explore this possibility.)

Masters-White make a big deal of the fact that all commodities in the various indices have gone up, and say that this would be extremely unlikely unless the index investment was driving all of them. But commodities not in funds, such as MGE wheat, iron ore, minor metals, have been skyrocketing in price too.

This line of reasoning does suggest one potentially rigorous test of the hypothesis. Namely, if the increasing importance of index money is injecting a common element into prices of all index commodities, overwhelming individual commodity-specific fundamentals, one should observe increasing correlations across commodities in indices, and stable or declining correlations between indexed and non-indexed commodities. This effect should be especially pronounced in high frequency data (daily, or intra-day) because the index investments are by construction made simultaneously or nearly simultaneously across commodities in the indices. Of course, Masters-White-Wray don’t even come close to identifying, let alone testing, such a refutable hypothesis.

In terms of “theory,” Masters-White and Wray put great stock in the cost-of-carry relationship between spot prices and futures prices, asserting that by buying futures, index investors drive up futures prices, which equal spot prices plus carrying costs, thereby forcing spot prices up too. But, for instance, in copper and oil, the price rises in 2007-2008 occurred simultaneously with movements from contango into backwardation.

Masters-White assert that order flow moves prices, so the predominately long order flow of index funds therefore must move prices up. There are two fundamental problems with this “reasoning.” First, when index funds roll, their order flow is on the sell side–so why don’t they move nearby prices down when they roll?

Second, and more importantly, they are very confused on the relationship between order flow and price discovery. Although Masters-White are correct that orders in futures markets are anonymous, they draw the wrong conclusion from this. The impact of any particular individual, anonymous order on prices depends on the average information content across orders. Holding the intensity of informed trading constant, increasing the intensity of index trading reduces the average informativeness of order flow. Thus, more orders are entered, but their individual impact is smaller, leading to little or no net impact on prices. (Index trades are likely to be deemed uninformative on average for reasons identified by current colleague Praveen Kumar and fellow Chicago GSB PhD classmate Duane Seppi. It is unlikely that a particular trader has private information on all components of an index, and if he has private index on any individual components, it is more effective to trade on that information in the markets for the individual components. This is why markets for index products, e.g., SP500 futures, are typically much more liquid than the markets for the individual components.) Moreover, informed traders adjust the intensity of their trading in response to changes in uninformed order flow, and generally trade to offset the effect of uninformed orders on prices. Thus, even if “dumb money” moves prices away from where they “should be,” this is an opportunity for smart money to trade against that, thereby forcing prices back towards the level justified by fundamentals.

Masters-White also make a big deal out of the fact that many market participants quote spot prices basis a futures to conclude that futures prices are driving spot prices, and hence noise injected into futures prices by index trading must therefore contaminate spot prices. In other words, futures prices are the dog, spot prices are the tail.

This is to confuse mechanics with substance. The key point is still that when it comes to determining futures prices as the market moves to expiry, participants recognize that if they hold positions to term they must make or take delivery of physical product. Thus, futures prices at expiration reflect supply and demand fundamentals in the physical market. I will not take delivery of something at a price if I do not believe that I can sell it at that price or better. I cannot sell it at that price or better unless there is physical demand for the product at that price. Thus, even though it is common to price some physical trades basis a futures price, that basis is determined in the market. Moreover, it adjusts to reflect physical supply and demand fundamentals, just as the delivery mechanism connects fundamentals to futures prices.

Put differently, basis pricing does not mean that spot prices do not reflect physical market realities. The best illustration of this (discussed in a SWP post over the summer) is the heavy/sour crude basis, which widened dramatically over the summer. This reflected the high demand for low sulfur diesel, the low yield of such fuel from heavy crude, and disruptions in the markets for sweet crude (driven primarily by problems in Nigeria.) (All of these are nuances that Masters et al, and Michael Greenberger, miss completely–even though they are salient factors in understanding the summer’s market dynamics.) Physical crude traders did not mindlessly pass on increases in WTI prices to the prices of heavy crudes. Differentials adjusted to reflect physical market supply and demand realities.

This gets back to the fundamental problem with all these analyses, one that is highlighted by Masters’ and White’s choice of a title for their opus–“Accidental Hunt Brothers.” I have said it a zillion times, but maybe the zillionth-and-first repetition will make it sink into heretofore impervious skulls: PRICES SERVE TO ALLOCATE REAL RESOURCES. IF PRICES ARE SUBSTANTIALLY DISTORTED, THAT MUST MANIFEST ITSELF IN PRONOUNCED DISTORTIONS IN THE ALLOCATION OF REAL RESOURCES. In the case of the real Hunt brothers, to keep prices high, they had to accumulate huge quantities of physical silver–real physical inventories, not phantom paper inventories. When the government propped up the price of wheat and milk, it had to buy and hold (or destroy) huge quantities of physical wheat and milk. As another example, when a manipulation takes place, the manipulation causes manifest distortions in commodity flows. For instance, in 1910 famous (or infamous) speculator James A. Patten (benefactor of the Patten Gymnasium at Northwestern University as well as the Chicago Art Institute) cornered the New York cotton market. Prices became so distorted that English spinners shipped cotton back to the US to take advantage of the price distortions–the economic equivalent of water flowing up hill.

If speculators are distorting prices, that necessarily causes distortions in stocks or flows of physical commodities. If index investors, or other speculators, were Hunt brothers, accidental or otherwise, they would necessarily find themselves in the same circumstances–paying for, holding, and financing large positions in physical commodities. Positions so large–if the price distortions are as large as asserted–that could not escape notice. Neither Masters-White, Wray, nor any of the other critics of index investment have provided any evidence of such distortions. Indeed, they haven’t even tried to do so.

To his (mild) credit, Wray recognizes the problem, anyways. He notes that Krugman has argued that speculative distortion should lead to accumulations of large and growing inventories in the hands of speculators. He attempts to avoid confronting this implication by stating that Krugman’s argument presumes perfect competition, and that commodity markets are not perfectly competitive, therefore Krugman’s argument doesn’t hold.

It is Wray’s argument that doesn’t hold. Perfect competition is not the essential linchpin of the analysis. Even if there is some market power on the producer side of the market, sellers will respond to higher prices by increasing output. Similarly, consumers will respond by reducing consumption. If somebody–a speculator–injects additional demand for the real commodity into the market, and drives prices up, producers will increase output and consumers will reduce consumption. This is sustainable only if the speculators willing to pay the (putatively) artificially high price put their money where their mouths are, and hold inventories of the commodity. (Wray tries to finesse the analysis by stating that maybe large oil producers are keeping oil in the ground rather than producing it. Maybe. But that is something that cannot be laid at the feet of the speculators. Moreover, it is hard to reconcile with the movement of the market into backwardation.)

Wray makes some other basic economic errors. For instance, he notes: “Americans have responded to rising gasoline prices in the manner economists expect, with consumption falling sufficiently to offset China’s increased use of crude oil—yet crude prices barely responded.” Catch the freshman mistake? If the reduction of consumption is an equilibrium response to higher prices, you wouldn’t expect the drop in consumption to cause a fall in prices. The reduction in consumption is a movement along a demand curve, and absent any shift of the demand curve, holding all else equal, the price should not fall. Wray’s is essentially a yo yo theory of prices. Rising prices cause falling consumption cause falling prices cause rising consumption cause rising prices . . . Maybe Wray should get rich by inventing a perpetual motion machine.

In brief, there is nothing new here. Indeed, these papers–trumpeted to the skies by Senators Lieberman, Cantwell, and others–are just a repetition of the same blarney that’s been flying about for months now. Can we please get unstuck from stupid, and start having an intelligent debate on these issues, one that reflects at least a modicum of comprehension of basic economics? Alas, I seriously doubt it.

In one of my earliest SWP posts, Whither NYMEX?, I pondered the future of NYMEX. Somewhat later (and in an interview on CNBC) I predicted that NYMEX would wind up in the hands of the CME. That prediction has come to pass with yesterday’s vote by the NYMEX membership to accept the CME’s merger offer. The weeks leading up to the vote saw the chest-puffing bluffing that one can expect from canny experienced traders trying to extract the most from a trade as possible, but the CME management did not budge after raising its offer to the holders of trading rights, and in the end the trading rights members meekly accepted the CME bid.

This outcome was almost inevitable given the lack of any competing bid for NYMEX. This distinguished the NYMEX bid from the CME’s bid for the CBT, where ICE made the Chicago Boys sweat. The lack of a competing bid was in no way surprising, given (a) the contract between CME and NYMEX to trade the latter’s contracts on GLOBEX, and (b) the clearly superior synergies between CME and NYMEX as compared to NYMEX and anybody else. ICE was not a player in this game because of antitrust obstacles that would have been acute particularly in the hothouse environment surrounding energy prices and the criticism that the USDOJ has faced. NYSE-Euronext wasn’t a good fit at all, and wouldn’t have offered nearly the same economies in clearing. NYMEX was also not viable as a standalone in the long run, especially given its weak technological position, doubts about its management, and Byzantine internal politics (factors discussed in Whither NYMEX.) So, when push came to shove, the members had no better option than to accept the CME’s bid.

So, now the question becomes: Whither CME? The decline in the company’s stock price has been pretty stunning, but its fundamentals are still strong. It has, however, effectively completed one phase of its strategy–and of the industry’s evolution: the consolidation of the US futures trading industry on a first rate execution and clearing platform. It can expect continued growth in revenues from growing trading volumes, especially when the credit crisis runs its course. But that organic development is not going to be sufficient to generate the profit growth capitalized even in the company’s currently lower stock price. CME will need to develop a whole new product line. The most likely candidate is OTC clearing. The acquisition of NYMEX is a step in that direction given the New York exchange’s nice OTC energy clearing business. But the big prize is clearing of OTC financial derivatives, notably credit derivatives. That is an immense market, and cracking it faces numerous challenges.

Clearing works best with homogeneous products traded in transparent markets with accurate and reliable pricing. (I have a working paper that argues that traditional impediments to risk shifting–moral hazard and adverse selection–are most acute when products are customized and heterogeneous, require specialized valuation expertise, and when there is not reliable pricing information.) These conditions are not yet met in OTC credit derivatives.

Moreover, CME will face competition in this business. The big banks are not willing to give up this lucrative business without a fight, and even if the CDS market moves to centralized clearing, the big banks have already established a clearing entity in combination with The Clearing House Formerly Known as BOTCC to vie for this business.

CME’s management will spend some time on the integration of its new acquisition, but this should be a relatively straightforward process given that NYMEX contracts already trade on GLOBEX and that there is considerable overlap between clearing memberships on the two exchanges. Once that task is complete, Donahue’s and Duffy’s real work begins–to revolutionize the management of derivatives performance risk by integrating OTC and exchange clearing.

During his testimony before the House Ag Committee on 9 July, 2008, Rep. Bart Stupak (D-MI) asserted that current speculation in the oil markets is just like the Hunts in silver in 1980. The next day, a Republican representative (Bob Goodlatte, R-VA of Virginia, if memory serves) asked me whether the analogy was correct. (Unfortunately, hearing transcripts are not yet available.)

I responded no, they were not, and that indeed the contrast between the Hunt episode and the current oil market provides an excellent illustration of (a) why there is no evidence that speculation is distortion the energy markets, and (b) what kind of evidence you would see when such distortion occurs.

In stark contrast to oil speculators today, the Hunts accumulated huge–and I mean huge–quantities of physical silver. In September, 1979 the Hunts owned about 40mm ounces of silver in deliverable stocks, and COMEX and CBT deliverable stocks were approximately 105mm ounces. By March the Hunts owned approximately 100mm ounces of deliverable stocks, and total COMEX stocks had risen to about 130mm ounces. In addition, I have read that the Hunts also owned about 90mm ounces in Switzerland. In a nutshell, during their silver escapades, as prices were rising dramatically, the Hunts held large and rising amounts of physical silver, and deliverable silver stocks rose substantially (approximately 20 percent).

Moreover, there were manifest signs of distortions in the physical market. Massive amounts of silver coins were melted into bullion. So many coins were melted that the capacity to convert them was strained. As a result, the differential between the price of bullion and the price of coins swelled to unprecedented levels. (This differential represents the shadow price, and the marginal cost, of the conversion. The marginal cost increases with the amount of coins converted.) Large amounts of silver flowed out of India–and into the hands of the Hunts.

The prices of silver were clearly distorted in 1979-1980. These price distortions were reflected in (a) the flow of large stocks of silver into the Hunts’ hands, and (b) distortions in the physical market. This illustrates that if speculators drive up prices–if they are willing to pay more than anybody else for the commodity–they must end up holding the commodity, and that distortions in prices inevitably lead to distortions in the physical market.

None of these signs are present in today’s energy market, or other commodity markets, for that matter. Prices are indeed high, but speculators are not sitting atop large and growing stocks of the physical commodity. If they were, one could say, with Rep. Stupak, that we are seeing the second coming of the Hunts. Since they aren’t, we can’t. Indeed, as I testified in Congress, the differences between silver 1979-1980, and energy in 2007-2008 are very revealing. And what they reveal is that today one should look for other causes of high energy/commodity prices than excessive speculation.

The recent assault against commodity speculation could use a little historical perspective. In particular, history can provide some lessons regarding what happened during previous attempts to restrict–or ban–futures trading.

Example 1. Gold futures during the Civil War. Union fortunes were ebbing during the spring of 1864. In early-June, Grant had suffered a punishing defeat at Cold Harbor, suffering 7000 casualties in a period of an hour. In mid-June, he made a brilliant descent on Petersburg (a major transport hub south of Richmond), but his assaults on 15-17 June made only limited headway. In Georgia, Sherman was making only slow progress against Joseph Johnston, and was mired in the piney forests around Dallas and New Hope Church in late-May. West of the Mississippi, Banks’ Red River Campaign had ended in disaster in late-May, with the US Navy’s Riverine fleet barely escaping capture only through the ingenious efforts of Army engineer Joseph Baily.

Union military failure was reflected in a skyrocketing price of gold in greenbacks (i.e., a collapse of the paper dollar.) Data from The International Center for Finance shows that from the time of Grant’s crossing of the Rapidan on 4 May until 16 June, the value of the Greenback fell from $.557 gold to $.507 gold–a 9 percent drop.

Congress soon found a culprit–gold speculators. Congressmen lashed out at speculators on the New York Gold Exchange, and soon matched their words with deeds. On 17 June, 1864, Congress passed the Anti-Gold Futures Act of 1864. The Act prohibited the trading of gold futures, and for good measure, banned the trading of foreign currency contracts with more than 10 days to maturity. The Act also made it a crime to transact in gold bullion anywhere but the ordinary place of business of the buyer or seller, effectively putting the Gold Exchange out of business.

The exchange closed, but speculation didn’t. Instead, trading activity in spot gold moved to the offices of brokers. And the price of gold continued to plummet. From 17 June to 30 June, the price of greenbacks fell to $.4082–a 21 percent drop. Congress soon recognized the folly of its anti-speculation legislation, and in a commendable example of legislative humility, repealed the Anti-Gold Futures Act on 2 July, 1864.

What had driven down the price of greenbacks during the Act’s short life? In a word: Fundamentals. Bad news continued to flow from the war fronts, indicating a long war–and a continued need to run the printing press to finance it. Grant was definitively stopped in front of Petersburg, and suffered some punishing defeats at the Battle of the Weldon Railroad. Sherman suffered a bloody repulse at Kennesaw Mountain. A large Confederate force under Jubal Early was on its way north through the Shenandoah Valley, with nothing in its way to stop it.

The moral of the story: constraining speculation is easier said than done, and such constraints are too weak to overcome the effects of powerful fundamentals.

Example 2: The German Exchange Act of 1896. This bill implemented many restrictions intended to constrain speculation in agricultural commodities and stocks. The Act gave German state governments the authority to ban futures trading. In addition, in an interesting parallel to one feature of the Stop Excessive Energy Speculation Act, the German legislation empowered the state to appoint a board consisting of agriculturalists and grain processors to oversee the operation of grain exchanges. The Act also eliminated futures trading in the stocks of industrial and mining companies.

The attempt of the Prussian state government to appoint a board to oversee the exchange, with its implied threat of eliminating futures trading on the exchange altogether, led the members of the Berlin Exchange to decamp from their facilities to a theater across the street–evocatively named “The Fairy Palace”–where they continued to carry out their business, but without calling themselves an exchange. The outraged Agrarians railed against this attempted evasion, and pressured the Prussian authorities to announce to the Fairy Palace crowd that if they did not disperse, the police would be called to break up the gatherings of traders there.

According to contemporary accounts, such as an article by Henry Emery in the Political Science Quarterly, and by Ernst Loeb in the QJE the Acts did not have the desired results, and actually had detrimental effects. Although neither author presents any empirical evidence, according to their accounts, speculation did not decline, but shifted into securities not covered or into cash transactions. Market liquidity declined, and prices became more volatile. Transactions costs increased. In foodstuffs, the absence of a central location for price discovery led to more negotiations and haggling between buyers and sellers. In stocks, trade was driven from exchanges into the hands of big banks who internalized orders. Some trading activity was diverted to foreign markets. According to Emery, the passage of the Act and the reduction of trading activity on the exchange was accompanied by a dramatic increase in the commissions that banks earned (and this presumably does not include the effect of the profits that the banks made on the internalized order flow in the absence of competition from a liquid and transparent exchange.) According to Carl Parker, “Governmental Regulation of Speculation” (Annals of the American Academy of Political and Social Science, 1913), the elimination of futures, and the resulting increase in difficulties of short selling, led to more pronounced rallies followed by more pronounced crashes as prices returned to levels dictated by fundamentals.

In time, even the German government recognized that the law was ineffective at best, and pernicious at worst. A 1907 government report stated “[t]he dangers of speculation have increased, the power of the market to resist one-sided movements has weakened, and the possibilities of misusing inside information have enlarged.” The report further stated that the law “has proved injurious to the public, without accomplishing its original purpose.”As a result, in 1908 Germany repealed many of the features of the law. The continued outrage of agricultural interests led to the continuation of the ban on agricultural futures, which lasted until almost 100 years after its passage. Ag futures trading was allowed only in 1998. (Personal aside: after the repeal of the law, I worked on a feasibility study and contract design work for the first German ag futures exchange, the Warenterminborse, or WTB. The exchange continues to operate under the name Risk Management Exchange, or RMX.)

So, the bottom line is that previous efforts to ban futures trading, or sharply constrain it, have failed in their object. They have reduced market quality, increased transactions costs, and impaired competition–without actually reducing speculation or affecting prices in the way that the sponsors of the anti-speculation laws intended.

Will Congress take these lessons into account? Somehow I doubt that a consideration of the facts will overcome the temptation to engage in political pandering and demagoguery.