Streetwise Professor

The DOJ comment refers to “appropriate regulation” of a separate clearing entity, but never specifies just what that “appropriate regulation” would entail. In football, that’s called a punt. It reminds me of the old Steve Martin routine “How to Make a Million Dollars Without Paying Taxes.” First, make a million dollars . . .

The devil is in the details, and “appropriate regulation” doesn’t appear at the wave of a magic wand. Indeed, after the political sausage is ground, all too often we end up with inappropriate regulation. It takes a market structure to beat a market structure, and merely assuming an “appropriate” alternative doesn’t cut it. If DOJ is really serious, it would spell out a model market structure, and how to transition from the current structure to its proposed alternative so that the tradeoffs can be evaluated. Otherwise, we’re just rocking with Nirvana–the Nirvana Fallacy, that is.

The Antitrust Division of the US Department of Justice just lobbed a grenade at US futures exchanges, most notably the CME. In comments submitted to the US Treasury’s review of the Regulatory Structure Associated With Financial Institutions (try fitting that on a business card), the DOJ stated that it “believes that control exercised by futures exchanges over clearing services . . . has made it difficult for exchanges to enter and compete in the trading of financial futures contracts.” The DOJ also opined that

current rules and policies related to clearing futures contracts may be unnecessarily inhibiting competition among futures exchanges . . . the detriment of the economy and consumers. . . . The Department believes that significant benefits might be achieved if regulatory policy were changed so as to foster exchange competition by . . . ending exchange control of clearing (in conjunction with appropriate regulation to ensure that clearinghouses could not in turn exercise market power.

The grenade has caused casualties upon impact. Futures exchange stocks cratered today, with billions of dollars of market cap disappearing after the DOJ blast.

Unfortunately, the DOJ letter is an appalling combination of bad economics and a selective reading of history. It is also almost impossible to reconcile the letter with the DOJ’s decision to permit the CBT-CME merger. This raises questions about the motives underlying the comments.

The fundamental problem with the economic “analysis” in the comments, such as it is, is that the DOJ does not seriously analyze why futures exchanges typically vertically integrate clearing and execution. (And note this is not a uniquely American phenomenon. As I have documented in an academic paper on the subject, integration is the rule worldwide, and separation the clear exception.) The implicit story in the DOJ comment is that (a) execution is inherently competitive, (b) exchanges that control clearing impede competition in execution by withholding access to clearing, and (c) economies of scale in clearing make it impossible (or at least, extremely difficult) for an entrant to compete against the incumbent clearinghouse.

But, as I have pointed out ad nauseum before, if clearing is actually a natural monopoly (part (c) of the argument), why wouldn’t the incumbent clearer just extract the monopoly rent by charging a supercompetitive price for clearing, and not give a whit where execution takes place? Indeed, the DOJ comment makes this very point:

If exchanges did not control clearing, an appropriately regulated clearinghouse could treat contracts with identical terms from different exchanges as interchangeable, i.e., fungible. The incentives of such a clearinghouse would be to maximize its own profits, and thus likely would treat identical contracts as fungible. In a world of fungible financial futures contracts, multiple exchanges could simultaneously attract liquidity in the same of similar futures contract, facilitating sustained head-to-head competition.

But, this argument also implies that a profit maximizing exchange that offers both clearing and execution would also have an incentive to maximize its own profits by making contracts fungible. An exchange with a monopoly clearinghouse would be cutting off its nose to spite its face by tying execution and clearing if execution were indeed competitive. By so doing, it reduces the derived demand for its services–and hence its profits–by forcing traders to execute trades on a higher cost platform. Thus, the DOJ’s assertion that exchanges integrate into clearing to deter competition in execution doesn’t make sense. An integrated, profit maximizing clearer has no incentive to force traders to execute on its platform if execution is indeed competitive.

This immediately raises the question: then why does integration occur? If integration doesn’t make sense as a strategy to deter entry, it must have some other rationale. The most plausible rationale is that it somehow enhances efficiency, by economizing on transactions costs, or mitigating multiple supercompetitive markups, for example. The DOJ doesn’t even raise this possibility, let alone address it in a serious way. Its analysis of justifications for integration in section III.D is pathetically weak, and completely untethered to any serious analysis of the economics of vertical integration and vertical restrictions.

Now, one could argue that clearing is a natural monopoly, and hence it must be regulated to prevent the clearer from exercising market power. (This is implicit in the DOJ’s call for “appropriate regulation to ensure that clearinghouses could not in turn exercise market power.”) But if clearing is a monopoly, then there is no need for the incumbent, unregulated clearer to tie execution. Thus, the DOJ’s call for “ending exchange control of clearing” in “conjunction with” regulation of a clearing monopoly makes no sense. In this case, the “exchange control of clearing” is a red herring. The ability of a clearing monopoly, integrated or no, to charge supercompetitive prices, is the central issue. By linking these two issues, DOJ betrays economic ignorance/confusion.

Now, I have shown that if execution is not competitive due to network effects, an exchange with a clearinghouse may have an incentive to tie (i.e., not make its contracts fungible) to deter entry. But, this is not consistent with DOJ’s (implicit) assertion that execution is competitive. Moreover, I have also shown that if execution is not competitive, entry may be inefficient, and in this case a tie that deters entry may actually enhance welfare. Again, no serious analysis of these issues from the DOJ.

In brief, the DOJ opinion represents a return to a long-discredited antitrust law and economics view of vertical integration and vertical restrictions, a suspicious, hostile view that deems vertical restrictions and integration as anticompetitive, rather than efficiency enhancing.

Insofar as the history is concerned, DOJ examines several instances in which entrants failed to survive in competition with incumbent exchanges. DOJ asserts–but in no way proves–that these failures were due to exchange control of clearing. DOJ says “[e]fforts over the last decade by exchanges to enter the U.S. financial futures markets . . . all of which failed, show the effect of exchange-controlled clearing.” Er, no, they don’t. These failures could have also been due to the liquidity network effect in execution. Just because entry against integrated exchanges failed doesn’t imply that the entry would have succeeded if the incumbent hadn’t been integrated into clearing. DOJ does not seriously investigate the possibility that in these instances clearing was not the crucial barrier to entry, or that the network effect of liquidity in execution was sufficient to make entry fail.

One piece of DOJ’s historical analysis is extremely dubious. It attributes Euronext.Liffe’s failure to dent the CME’s hold on Eurodollars to CME’s adoption of a rule preventing the transfer of positions from CME to LIFFE. Importantly, this occurred after several large block trades that “amounted of a large scale transfer of open interest in Eurodollar contracts from CME to LCH[which was LIFFE’s clearer].” But note well; LIFFE offered clearing (via LCH), and apparently it was economical for some traders to use LCH clearing. Thus, CME clearing was not an “essential facility” that LIFFE needed to access to compete against CME on execution. Implicit in DOJ’s argument is the assumption that integrated entry is infeasible, and no entrant can succeed without access to an existing clearing facility. DOJ’s argument would actually be stronger if no open interest had moved, as this would suggest that there was no economical alternative to clearing via the CME. The fact that (a) LIFFE offered both execution and clearing (via contract with LCH), and (b) some market participants found it economical to use LCH clearing undercuts the DOJ argument that the incumbent exchange’s control of clearing deters entry.

DOJ also points to the history of clearing in equities to suggest that clearing is the crucial bottleneck that precludes competition in execution. The DOJ comment notes that the formation of a cross-exchange clearing platform occurred in the 1970s. What the DOJ does not tell the Treasury is that the NYSE nonetheless maintained a dominant position in the execution of its listed stocks until the last couple of years. NYSE market share was on the order of 80 percent throughout this period, and most of the off-exchange volume was of the “cream skimming” variety, rather than head-to-head competition among price discovery venues. Only with (a) the socialization of order flow through the imposition of RegNMS, and (b) the NYSE’s delay in embracing electronic trading has NYSE market share declined appreciably. Moreover, a lot of the off-exchange trading (in dark pools, particularly) is execution of uninformed orders. That is, contrary to the DOJ’s assertions, the case of the equity market shows that removal of exchange control of clearing is not sufficient to ensure rigorous competition in execution. This is consistent with the view that liquidity network effects make execution relatively uncompetitive–but if this is true, the DOJ’s prescription of disintegration of execution and clearing (perhaps combined with price regulation of clearing) makes no sense.

The options market is the strongest evidence for the DOJ view. Superficially, the fact that multiple exchanges compete in the options market is inconsistent with the network effects-driven “tipping” story. But I am not sure that this superficial contradiction would survive a more detailed analysis.

For one thing, as I have shown in my JLEO paper and several working papers, multiple trading venues can co-exist when there is “cream skimming” of uninformed order flow. There is payment for order flow in options markets, and this is often associated with cream skimming. The tipping story basically implies that price discovery is a natural monopoly, and other markets can free ride off of that price discovery.

There is considerable evidence that off-NYSE trading in listed stocks (block trades, NASD trades, etc.) prior to RegNMS was uninformed, and that these execution venues were cream skimming. I am aware of no such analysis of options trades. Thus, the options market case may not provide evidence of the simultaneous existence of multiple price discovery execution venues.

For another thing, aggregate statistics on options volume are uninformative. As an extreme example, if 100 percent of options on stock X are transacted on one exchange, and 100 percent of options on another are transacted on another, it would be misleading to say that this is evidence against tipping. I know the example is extreme, and not reflective of reality, but it would be more informative to see exchange market shares for individual equity options. And even if one finds some spreading of volume in a particular option across exchanges, it would be essential to know whether one of these exchanges is the locus of price discovery, and the others are satellite, cream skimming markets.

For yet another thing, as the DOJ acknowledges, “multiple listing was followed by regulatory changes that have furthered competition in options trading, included rules that have linked option markets.” This linkage is extremely important. Linkage can socialize order flow (this is what RegNMS has done), thereby preventing any single exchange from taking advantage of the liquidity network effect.

Thus, it may well be the linkages, rather than fungibility in clearing, that are truly important in facilitating competition in execution in options. This is the lesson from the equity market. If so, mere disintegration of clearing and execution will not be sufficient to generate similar outcomes in futures markets. As I said in an editorial over a year ago, the survival of multiple execution venues may require much more far-reaching structural changes, such as the creation of a central limit order book or other mechanism that effectively creates a cross-exchange liquidity pool–that is, requires the socialization of order flow, not just clearing.

In sum, the DOJ comment makes a very weak case for its assertion that a separation of clearing (with price regulation) and execution is the magic bullet that will dramatically improve the competitiveness of futures markets. Moreover, its own analysis implies that exchanges do NOT integrate to impede competition, which in turn implies that they do it for some other reasons–reasons that DOJ does not explore in any serious way. If exchanges do not control clearing to deter entry in execution, the DOJ’s conclusions do not follow. This in turn suggests that implementing the DOJ’s recommendations could well lead to efficiency losses (as integration economizes on transactions costs.)

I am not arguing that financial market structure in general, or futures market structure in particular, is efficient. Indeed, my academic work emphasizes that network effects in execution and clearing impede competition in the trading of financial instruments. If one agrees with this assessment, simple nostrums like separating clearing and execution are not going to mitigate these problems. Instead, far more reaching measures–such as forced linkage of execution venues (socialization of order flow) or the creation of a central open entry order book and regulation of clearing fees or clearing firm structure–are necessary. But as I have also noted, these measures pose their own difficulties.

So, the DOJ either goes too far, or not far enough. It certainly does not get it right. It is disappointing that decades after the Chicago critique of traditional antitrust analysis of vertical structure that DOJ repeats the analytical errors the Chicago economists pointed out so long ago. The shoddiness of the work, its inconsistency with the decision in the CBT-CME merger, and the timing of the release all raise questions about why DOJ did this. I have my suspicions, but they are just that.

One last thing. Oddly, in footnote 1, the DOJ states “[o]ur comments are directed solely at competitive issues raised by financial futures markets. Markets for commodities futures, such as energy futures markets, are outside the scope of this comment.” Huh? Why should commodities be any different? Does DOJ believe that commodities are different? (In which case, I might add, the CME purchase of a pure commodity exchange like NYMEX and maintaining an integrated clearinghouse would not be problem.) If it believes that they are the same, why explicitly disclaim any opinion regarding commodity markets? (Does this suggest a political calculation? I don’t know, but its difficult to divine a rational, economically grounded, intellectually rigorous explanation for this separate treatment of financial and commodity futures.)

The New York Times reports that the Treasury and the SEC are contemplating requiring banks to disclose publicly quotes and trades in derivatives, such as CDOs. Where have I heard that idea before? Oh yeah, I came up with it 5 years ago to address problems in the energy market.

Now, of course, I shouldn’t take entire credit for the idea, as Mike Prokopp at Amerex, Ed Bell, then of PA Consulting, and Bob Anderson at the CCRO, and some folks at Reuters were thinking along similar lines. But I think it is fair to say that I contributed as much, and perhaps more, to the development and evangelization of the concept as anybody.

In energy, the issue was that many traders falsely reported the prices at which they bought and sold natural gas to trade publications such as Gas Daily and Inside Ferc. The price reporting was purely on an “honor system,” and like everything, honor has its price–and that was a price many traders weren’t willing to pay. So the basic idea I developed was that of a “data hub.” In a nutshell, traders would report prices of actual transactions to a central repository, that would validate the submissions by matching buys against sells. The data would then be disseminated to the marketplace.

The concept is pretty straightforward, but in the energy space it attracted a lot of flak, some of which I am still picking out of my backside. Transparency is not everybody’s friend; traders feel that they give up valuable information by publicly disclosing their prices. Moreover, the price reporting incumbents–notably Platts–had a vested interest in maintaining the old system. FERC and CFTC said nice things about the idea, but the political pressure from some industry groups, individual energy firms, and Platts overwhelmed the arguments that an academic and a few industry mavericks put forth. As a result, neither regulatory agency was willing to mandate that firms report prices to a particular entity. Absent a mandate, the collective action problems of creating a viable data hub were daunting.

In May, 2004 the idea was all but dead. As a last gasp effort to revive it, my then assistant Jeff Graefe had the idea to organize a roundtable on the idea at UH. Bob Anderson, who had formed a non-profit company called Energy Data Hub (imagine that) was there, as were several representatives of energy firms. Bob was about to give up on the idea when Jim Allison from Conoco-Phillips gave the idea his strong endorsement, and suggested that the concept be extended.

The original concept behind the hub was to collect and disseminate data on simple energy products, like day ahead and month ahead gas. Allison said that it would be much more useful to collect and disseminate information on more complicated products, including longer dated swaps and options. This would help firms get better estimates of the values of their outstanding contracts, and hence allow them to manage risk and determine profitability much more effectively.

With Allison’s strong endorsement, Anderson plugged ahead with the Data Hub. It is now collecting data from several companies, and should go live later this year. Although I take pride in pioneering the concept, Bob deserves credit in persevering to make the concept a reality, and Jim deserves credit for the vision to see how the concept could be used to solve problems other than the false-reporting issue that had been the reason for its development.

It is ironic, in light of the NYT article, that at a lunch with Anderson before Christmas I mentioned that the hub concept could–and should–be extended beyond energy to deal with other opaque markets, such as credit derivatives. The idea is, as they say, scalable, and numerous segments of the derivatives marketplace could do with greater transparency.

I am not a big fan of government mandates, but theory and practical experience tell me that (a) a mandate is the only way this can be done quickly, and (b) a mandate is economically efficient. As I noted before, trading firms don’t like transparency. They operate on the motto “The One Eyed Man is King in the Land of the Blind.” A individual firm that sees some deal flow–but not all the deals–likely has something of an information advantage over other firms. If all prices are revealed to everybody, the informational playing field is level–and who can make any money when that happens? So many firms–especially the big hitters that see a big chunk of the deal flow–would rather have a relatively opaque market. Sure, they don’t know values as accurately as if all prices were disseminated publicly, but trading profitability only requires that you have better information than others. So the biggest, most influential firms have a vested interest in opposing greater transparency.

Moreover, there is a positive externality from disclosure of value information; it helps other firms manage their risk better and mark their books more accurately. Firm A doesn’t benefit if firm B can manage risk better. Though Firm A could manage risk and mark books better if it also received information from firms B, C, etc., no individual firm captures all the benefits of its disclosures. Moreover, investors in the stock of the trading firms (and investors in hedge funds trading in these opaque markets) would benefit from having more accurate valuation information. But firm A gets all the trading benefits of keeping the information to itself, but none of the benefit that disclosure confers on other firms who can use the information to manage risk and mark more accurately. Collectively firms would benefit from disclosure (as the trading part of it is close to a zero sum game but the risk management part is positive sum), but individual firms can’t capture the collective benefit through unilateral disclosure.

Thus, there is a collective action problem, similar to the common pool problem in the oil business. It is well known (as documented by Gary Libecap and Steve Wiggins) that operators of common pools typically do not resolve that problem efficiently. On a priori grounds I would predict that collective action problems would make it very difficult for individual firms to come to an efficient agreement regarding mutual disclosures of price information. Indeed, the resistance of the “front offices” (i.e., the traders) to the idea would likely overcome the influence of the “middle offices” (i.e., the risk managers) who would otherwise favor the concept. (Traders usually swing much more stick than the green eyeshade types.) My experience in the energy data hub was strongly consistent with this conjecture.

So, despite my usually libertarian/Chicago instincts, here is a situation where I believe a mandate to be warranted, and I support the Treasury/SEC initiative. It is clearly most needed in the credit derivatives market, and in the market for various structured products, but it is also defensible in other parts of the derivatives market as well.

Perhaps the SEC/Treasury action will also galvanize FERC and CFTC to revisit the issue in energy markets too. Although the Energy Data Hub lives, it is still fighting the collective action problem.

When the subprime stuff hit the fan, it was clear that the market could use better price information. It was equally clear that due to the conflicting interests and the collective action problem, market participants were unlikely to provide it absent a nudge from the feds. That nudge has come, and none too soon.

I was quoted in this article in the Chicago Tribune about the just announced competitor to the CME.

A couple of points. First, as I’ve pointed out in my academic research, an entrant exchange has a chance against an incumbent if it (or its owners) control enough order flow to generate sufficient liquidity to narrow the incumbent’s execution cost advantage. The owners of the CME’s new competitor do control a decent fraction of order flow in Treasuries and Eurodollars, so this exchange has a leg up as compared to earlier would-be competitors. Nonetheless, I am skeptical that this is sufficient to allow the upstart to prevail. It is a necessary condition, but not a sufficient one.

Indeed, previous attempts to compete in the US Treasury complex have failed miserably despite the direct involvement of large banks. BrokerTec Futures (BTEX) was formed in 2001 by a consortium of 14 big banks, investment banks, and brokerages (including some involved in the latest venture) . Although BrokerTec was very successful in trading cash Treasuries, it failed miserably in Treasury futures in competition with the CBOT, and the banks pulled the plug a couple of years later. BTEX was sold to Eurex US shortly before Eurex entered the US market. The major bank/owners of BTEX were given an equity stake in Eurex US, and they had incentives to direct additional order flow to Eurex US; Eurex would boost each bank’s equity stake based on how much revenue (and hence trading volume) that bank threw Eurex US’s way. That didn’t work either.

A couple of lessons: (1) Although big players do have a lot of order flow, they haven’t had enough to “tip” the Treasury futures market in their direction, and (2) the definition of insanity is doing the same thing repeatedly, and expecting a different outcome. Here we have essentially the same players implementing essentially the same business model based on the same economic theory (re control of order flow)–but we’re supposed to believe that the outcome will be different this time. If you think so.

Indeed, the CME is in a better position than CBOT was when Cantor and then BrokerTec and then Eurex made a run at the Treasuries. CBOT was still largely floor based when each of the electronic competitors entered. Thus, the entrants arguably had a technology differentiator that appealed to a large potential set of market participants (although Cantor’s setup was stupid–users couldn’t enter orders into the electronic system directly, but had to phone it in to a Cantor clerk who entered it. Gee, I wonder why that didn’t work?) Moreover, at the time its earlier competitors surfaced, CBOT was going through managerial turmoil and intense internecine conflict over strategic direction regarding the fate of the floor, and was not renowned for its managerial nimbleness and foresight; the political battling often hamstrung management. Furthermore, entrants were not at a disadvantage in attracting traders participating in other interest rate products, especially Eurodollars, and especially Treasury-Eurodollar spreaders. Spreaders, for instance, had to trade multiple platforms regardless of whether they traded the Treasury leg at the CBT or elsewhere.

In contrast, CME is fully electronic, with a robust and proven trading platform–so no technological differentiator. Moreover, CME management is very good, and CME is not beset by the political infighting that often paralyzed CBOT around the turn of the millennium. And perhaps most importantly, spreaders and others trading both Eurodollar futures and Treasuries can execute on a single platform–CME Globex. Somebody who wants to trade the Treasury leg on the CME’s new competitor still has to trade the Eurodollar leg on CME. If the entrant decides to list Eurodollar futures too in order to overcome this disadvantage, it will be faced with the task of building two liquidity pools and wresting two complexes from an incumbent. Won’t say it can’t be done. Will say it has never been done before.

Second, this is a case of back to the future–a return of exchanges to the customer-owner mutualized model. The question arises : who will benefit if this new mutual succeeds? Even if the CME is charging supercompetitive fees for its services, the entrant’s success does not mean that fee levels in the industry will become competitive. Given the tippiness of order flow, if the entrant succeeds it will likely gain a near monopoly position. In the event, the monopoly rents will just move from the CME to the new exchange–and its big bank owners.

So, this should be viewed as a battle over rents. The efficiency effects of this entry are likely to be negative because real resources will be expended in this contest in which either (a) the incumbent monopoly will survive, or (b) it will be replaced by a new monopoly. This rent dissipation is wasteful. Indeed, if the bank-backed exchange prevails, efficiency may suffer because this outcome could dampen competition in the OTC space where the CME is endeavoring to encroach on the big banks’ turf.

Tom Fowler of the Houston Chronicle quotes me in a blog post spurred by US Asst. Attorney Belinda Beek’s mentioning during jury selection in the manipulation trial of several former El Paso traders that onions were not covered by the Commodity Exchange Act. As I noted to Tom, onion futures were banned due to intense political pressure from onion farmers after several episodes in which the price of onion futures plummeted, at times falling below the price of the sacks in which they were shipped.

Interestingly, in 1972 similar events in the potato market led to the proposal of a bill to ban potato futures. This bill failed, however, in part because a USDA study of what happened in onions after futures trading was banned; the USDA study did not find any evidence that the ban had affected pricing patterns. In a 1963 article in the Journal of Farm Economics Roger Gray found that if anything, the ban increased volatility of onion prices.

The potato contract died a somewhat unnatural death a few years later due to several spectacular manipulation attempts, but this time Congress did not commit the murder. In one of these manipulations, in 1976, both a big long and a big short were trying to manipulate the contract simultaneously, with the short trying to ship huge quantities of potatoes from Idaho to Maine (the delivery point) and the long tied up most of the railroad cars on the Bangor & Aroostook Railroad (in which delivery had to be made). There was a large default against the futures contract. The default severely damaged NYMEX’s reputation. Here is a court case that provides some of the lurid details.

Ironically, the demises of the onion and potato contracts were perhaps the best things that happened to the CME and NYMEX, respectively. The loss of these contracts forced each exchange to innovate to find replacements. CME developed meat futures (including the legendary pork belly contract, which is now fading away but was once the hottest thing in town) to replace onions. NYMEX, under the leadership of Michael Marks, developed energy futures. (Which, funnily enough, a commenter on the Fowler post says should be banned. La plus ca change.) Necessity as the mother of invention, futures exchange edition.

The common feature of potatoes and onions is perishability. Perishability makes prices inherently volatile, and also can make some manipulative strategies possible. Indeed, short manipulations are likely to be more profitable for things like onions and potatoes than other products because dumping additional supplies on the market can depress prices sharply because the perishable good must be consumed almost immediately. This allows someone short futures to profit substantially.

In the frenzy over (nearly) $100 oil, everybody–be they politicians or spokesmen for supermajors or OPEC–are desperate to deflect blame. OPEC representatives make risible statements that an increase in OPEC output would not cause prices to fall. (Who knew?) Oil industry folks say that fundamentals can’t justify current prices. Politicians bloviate (well, more than usual), mutter darkly about manipulation, and propose various whacked-out policy nostrums. But all agree on one thing: Speculators Are to Blame. Like the Claude Rains character in Casablanca who orders his gendarmes to “round up the usual suspects” after Humphrey Bogart shoots the Gestapo agent in front of his eyes, whenever energy prices spike, the hue and cry goes up to round up the speculators.

Of late, Exhibit A in case against energy speculation is based on the CFTC’s Large Trader Reports. These reports show that long “non-commercial” positions have been increasing along with prices. “Aha!” go the anti-speculators: “See, those speculators are buying, and driving up prices. If we curtail ‘excess’ speculation, we’ll get oil prices back down.”

Err, not exactly. Leaving aside the myriad deficiencies in the large trader reports–they are a very imprecise measure of actual speculative and hedging activity because there is no reliable mapping between “non-commercial” and “speculation” or “commercial” and “hedging” (commercials speculate too, you see)–there is a serious conceptual problem here. Rather than relying on some abstract, academic analysis to try to make this point, I think this problem can be illustrated best with a contrast.

Believe it or not in this age of record nominal gold prices, but in the 1990s and early-2000s, many gold market participants claimed that gold producer hedging–forward sales of gold–was depressing gold prices. Now let’s work through this. If gold hedgers were net short, since derivative contracts are in zero net supply, that means that gold speculators were net long–just like the current situation in oil. And similarly, if oil speculators are net long today, that means that oil hedgers are net short. So riddle me this: how is it possible that a short hedging imbalance caused gold prices to be too low but is causing oil prices to be too high, and how is it possible that a long speculative imbalance is causing oil prices to be too high, but caused gold prices to be too low?

In other words, if I applied the gold bug theory about low gold prices (short hedging imbalance causes prices to be too low) I would conclude that current oil prices are too low, and if I applied the current theory about high oil prices (long speculation causes prices to be too high) I would conclude that gold prices in the 90s were too high. Does this mean that for prices to make Goldilocks happy (i.e., for prices to be “just right”), net hedging is zero and net speculation is zero? Put differently, the same theory can be used to reach the exact opposite conclusions about whether prices are too high or too low; I can use the exact same data on the composition of open interest to support either conclusion depending on my political/rhetorical/economic purposes. In other words, this “theory” provides no practical guidance whatsoever as to whether prices are higher or lower than they “should be.” It is, to be blunt, pure garbage.

The contrast between the gold and oil markets illustrates the pitfalls of overinterpreting accounting identities. Speculative and hedging positions have to add up to zero, and whether one number is positive and the other negative, or vice versa, is of no use in evaluating which is driving prices.

From a New York Times article on the fading away of floor trading in Chicago:

Equal access to the markets has made trading more challenging for pit traders. “We’re trading against machines” all over the world, said Jeffrey Levant, 53, who has been at the exchange for 29 years, and recently left the Nasdaq pit to learn electronic trading. “Sometimes it feels like we’re John Henry going up against the steam hammer.”

Well said. In the past I’ve compared floor traders to the Polish cavalry charging German tanks in 1939, but Mr. Levant’s metaphor is much more colorful and evocative. It is particularly evocative when one listens to “John Henry” by acoustic blues performer Furry Lewis: “I’m gonna die with this hammer in my hand.”

It is somewhat ironic to see how things have changed in a short decade. Even in late-1997 it was widely believed that the floor was inherently superior to the machine. Then, in early-1998, Eurex wrested the Bund contract from LIFFE, and the momentum changed. I had been an early advocate of electronic trading, and had taken some flack for that advocacy. Hence, it was somewhat gratifying to see my predictions borne out. Nonetheless, even an apostle of the steam hammer can feel for John Henry, and it is with mixed emotions as I see the floor and its vibrant culture fade away.

I was quoted on a Marketplace story on the energy market regulation changes I blogged about yesterday. Nice to get the last word.

The CFTC is supporting Congressional efforts led by Sen. Levin of MI to pass legislation that would allow it to impose position limits and obtain position information on energy derivatives traded on ICE (and presumably other electronic OTC trading platforms) in order to prevent energy price manipulation:

The CFTC is seeking mandatory daily reporting to the agency of large ICE trades, limits on the number of ICE energy contracts a single trader could control and exchange rules to force a trader to unwind large contract positions.

To recycle a line I’ve used before, they want to reduce manipulation in the worst way–and they’ve found it. Position limits and position reporting are inefficient ways to reduce the frequency of manipulation, as compared to readily available alternatives. There are so many defects in these remedies, it’s hard to know where to begin.

For one thing, position limits must be set based using very crude information about the market conditions that will prevail when the position limits are in effect. Sometimes the limits will be too large to constrain much manipulative behavior. Other times, the limits will be smaller than necessary to combat manipulation, and will be so small that they constrain the legitimate activities of market participants.

This last effect is very important. It is economically efficient for some traders to accumulate large speculative positions. These speculators absorb risk from hedgers. Position limits constrain speculators’ ability to take on risk, meaning that hedgers will find it costlier to transfer risk to speculators. They will hedge less as a result. That’s a real cost.

I have just completed a paper that shows that even if position limits constrain manipulation, they reduce overall welfare because of they interfere with the efficient allocation of risk. In essence, position limits throw out the baby with the bath. Sure, they constrain the rent seeking, manipulative activities of speculators, but they also constrain speculators’ efficiency enhancing risk bearing function too. In the standard mean-variance/Anderson-Danthine hedging/speculation equilibrium model of my paper, the latter effect outweighs the former, and position limits reduce welfare. Thus, even if they are successful in reducing manipulation, that doesn’t mean that they’re good public policy.

This possibility has been totally ignored in the debate, such as it is, over position limits in energy. This reflects a general ignorance of the socially beneficial effects of speculation, and indeed, the hostility to speculation that has dominated the Congressional and regulatory intellect for decades (stretching back into the 19th century.) Risk transfer is a primary function of derivatives markets, and position limits interfere with this primary function. This is a real cost, but one that is too often ignored.

Position reporting wins no prizes for efficiency either. Presumably the theory is that the ability to monitor positions gives regulators the ability to identify incipient manipulations, and intervene before things get out of hand. Now let’s deal with the reality.

The first reality is that how big is big–i.e., how big a position must be before it poses a manipulative threat–depends on variable market conditions, and how the trader acts. Just seeing that somebody holds a big position tells you absolutely bupkus. As a result, regulators will start to scrutinize big positions only when price distortions become manifest in the marketplace. Well, by the time this happens, a lot of the damage is already done. Maybe the regulators can keep things from getting worse, but the idea of preventing manipulation before it affects prices is a pipe dream. Even when armed with position information, regulators only become engaged when price distortions become apparent.

And even when they intervene, there is no guarantee that they will succeed. They can jawbone, but sometimes regulators can be fooled, persuaded–or intimidated–into inaction by manipulators. Think that doesn’t happen? Want to buy a bridge?

Regulators can also be wrong, and it is important to remember that when attempting to intervene during an alleged manipulation regulators necessarily have worse information than is available after things play out. The manipulative “end game” (as I call it in my ’93 JOB piece on manipulation) often provides the most powerful information on whether a manipulation in fact occurred. For one thing, the price movements post-manipulation–the “burying the corpse” effect–often provide the strongest evidence that prices were distorted. (After a corner ends, the manipulated price collapses relative to other prices as the excess deliveries are dumped on the market. These deliveries are the “corpse” of the corner, and disposing of them is referred to in the biz as “burying the corpse.”) (And to reiterate, Bill, I didn’t make up that phrase. P. D. Armour did. Sorry for the inside humor, folks, but I couldn’t resist–although I did restrain myself from making a really cutting remark.) Also, the alleged manipulator’s behavior–whether he takes deliveries at prices that appear uneconomic–provides the strongest evidence on his motives and intent.

Errors are important. Regulators can intervene and force liquidations of large positions when there is really no manipulation, or they can fail to intervene when a manipulation is actually in progress. Both kinds of errors are costly. Given the lack of crucial information before things play out, for a given probability of one type of error, the other type of error is higher when regulators try to intervene before the fact than afterwards. As I’ll discuss momentarily, civil (or even criminal) sanctions imposed after the fact can utilize better information, reduce the frequency of one or both kinds of error, and reduce the frequency and severity more efficiently than early intervention.

Reporting is wasteful for other reasons too. It is costly to collect this information, most of which will never be needed to detect or prevent a manipulation.

Moreover, traders can avoid position limits and reporting by moving their activities into the non-electronic OTC market, using voice brokers or just bilateral deals with other traders. To the extent that it is more efficient to execute transactions electronically on a platform like ICE, this displacement of trading activity is inefficient (though it is a boon to voice brokers.)

So what is better? Dropping the hammer on manipulators after the fact, that’s what. Law and Economics scholars (notably Steve Shavell) have identified conditions under which deterrence through the imposition of sanctions ex post is more efficient than ex ante prevention. Most importantly, deterrence is efficient (relative to prevention) when the offense is detected with high probability, and malfeasors are not judgment proof.

Both conditions characterize manipulation in derivatives markets. As Judge Frank Easterbrook once wrote, an undetected manipulation is an unsuccessful manipulation. A successful manipulation distorts prices–and everybody in the market can observe it. Moreover, most manipulators are well heeled, and can pay legal judgments levied against them.

By waiting to act until after a putative manipulation runs its course, regulatory or judicial authorities–or private plaintiffs harmed by the manipulation–can rely on the best information available on the price impact of the manipulation–including the “burying the corpse” effect–and on the alleged manipulator’s actions. Thus, there should be fewer errors (incorrect convictions, or incorrect acquittals) after the fact than when regulators attempt to intervene during a suspected manipulation.

Litigation is expensive, to be sure. But the expenditures can be targeted, and only incurred when the harm occurs. Position information need only be collected via discovery when the evidence of a manipulation is manifest, and from the likely culprits (who can be identified pretty easily, as there is a lot of information about who is doing what is floating around the markets, and some manipulative behavior is hard to miss, e.g., who ends up owning all the deliverable supply.) This is cheaper than collecting information from everybody (virtually all of whom are completely innocent of anything) all the time (when usually nothing amiss is happening).

So, in a nutshell, deterrence rules, and position limits/reporting are for fools. And guess which way Congress and the CFTC are moving? Draw your own inferences, people; do I have to draw a map?

Ironically, the news about the Levin bill and the CFTC advocacy thereof comes almost simultaneously with the announcement that BP has agreed to pay $300 million(!) (subscription required) to settle civil charges that it manipulated the propane market in 2004, and that four BP traders are facing criminal charges (ditto) arising out of the same incident. I have mixed feelings about the criminal aspect of this case, but the imposition on a hefty fine on BP is the way to go as a way to deter this sort of conduct going forward. Three hundred large large is some major change–especially considering that the alleged (and I guess now admitted) BP corner attempt was apparently unprofitable because the company ended up with a much bigger corpse to bury than it had anticipated. Surely any trader contemplating cornering, squeezing, or hugging a market in the future will think once, twice, and a few more times, before squeezing the next time. It should also be noted that all this activity took place in the OTC market, and that it did not take place on ICE, or to my knowledge, any electronic trading platform. Nonetheless, the manipulation was identified, the culprit fingered, and the hammer brought down. No need for watching everybody all the time, most of said watching effort being completely unnecessary because much of the time manipulation isn’t a serious worry.

For those of you with way too much time on your hands, I have a much expanded analysis of the deterrence vs. prevention debate in my book The Economics, Law, and Public Policy of Market Power Manipulation. (Shameless plug! Now up to #1,302,119 on Amazon! Only 3 copies left! Order soon!) I also presented some rigorous numerical analysis of the power of detection ex post vs. ex ante in the working paper version of what eventually turned into my 2004 ALER article on the Ferruzzi squeeze. I think that version is still posted on my UH web page.

One last comment. I find the obsession with energy market manipulation to be somewhat curious. The US government has manipulation problems much closer to home–the US Treasury securities market. Manipulation problems in this market became so chronic in the early-2000s that two high ranking Treasury officials raised the subject in public speeches, and the FRBNY called bond market heavyweights to a Come-to-Jesus meeting, where the assembled congregation was sternly warned to go away and sin (that is, manipulate) no more. Despite the importance of the Treasury markets, and their size, Congressional interest in this problem seems de minimus as compared to the constant hyperventilating over energy market manipulation. Presumably this has to do with the fact that energy prices affect pretty much everybody, whereas the Treasury markets (especially the repo market) are pretty much inside baseball; Congress has to be seen Doing Something about energy prices even though there is little if any connection between persistently high energy prices and the kinds of manipulation that are allegedly the targets of legislation, and even though (as discussed above) the legislation is an inefficient way to reduce those kinds of manipulation.

I was thinking of inserting an apposite Mark Twain quote here (you probably know the one I’m thinking of), but won’t gild the lily. Like Mom says, if you can’t say anything nice . . . I know I’ve broken that rule a lot already in this post, but I’ll follow it just this once.

Correction. I wrote that to my knowledge, none of BP’s propane transactions were consummated on an electronic system. I took another look at the CFTC’s civil complaint against BP, and noticed that market participants utilized an electronic trading platform called Chalkboard to trade propane. I don’t know the breakdown of volume between voice brokers and Chalkboard.

Crain’s Chicago Business reports that several analysts are touting a potential CME-NYMEX merger. Crain’s cautions that it has no indications that talks are underway, and both exchanges declined comment. Nonetheless, it is clear that the compelling economics of the transaction, which I have been pointing out since early-2006, are becoming widely understood.

Interestingly, NYMEX’s stock price has been relatively flat in recent months, while CME’s has appreciated dramatically to all time highs–up $40/share since early August, and rallying over $80/share since late September after a sell-off earlier in the month. The CME’s warchest is therefore bulging, and CME is more than able to swallow NYMEX. Antitrust considerations would most likely stymie CME’s nemesis in the CBT merger–ICE–in its pursuit of NYMEX. Thus, CME’s most likely competition would be NYSE/Euronext, and Thain is desperate to get into derivatives, but I still give CME the leg up due to the fact that NYMEX contracts already trade on CME’s Globex.

The article also suggests that CME is looking abroad–to exchanges like Brazil’s BM&F. Given CME’s financial heft and management, in my opinion the exchange can do both. So, my guess is that in early ’08 we’ll see CME make a bid for NYMEX, and perhaps BM&F as well. NYMEX is the prize, though, and I expect the CME to focus there first.