Streetwise Professor

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

But I’m still standing.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The biggest news of the last couple of days is the announcement of the BP-Rosneft agreement.  Under the agreement, the firms exchange stakes, and will undertake a joint venture (theoretically) to produce oil in Russia’s Arctic.

The BP move smacks of desperation.  The company reminds me of a gambler who has lost several big hands in a row, and figures that his luck just has to change.  The most recent big loss, of course, was in the Gulf of Mexico.  But it has also suffered major losses in Russia.  These include the effective expropriation of the Kovytka gas project; Gazprom refused to provide transportation from the field, the company was at risk of losing its license which required it to produce (which it couldn’t do because it couldn’t transport and sell), so it ceded the stake to Gazprom.  The other big loss involved BP’s current CEO, Robert Dudley, who was run out of Russia–literally–in a battle between BP and its Russian partners for control over the TNK-BP joint venture.

And of course other western majors have had bad experiences in Russia.  Shell over Sakhalin II.  Exxon over Sakhalin I.  This is why despite the fact that there is oil in Russia, other majors are not rushing out to do deals there even though they, like BP, are intent on finding new reserves.  As an example, Chevron Conoco-Phillips just sold its stake in Lukoil.

But BP has had its successes in Russia.

Just kidding.

It would be one thing if BP had proven its ability to navigate Russia’s treacherous energy politics, but it hasn’t.  Indeed, it has been very clumsy.  It was outmaneuvered continually in the TNK-BP saga. Its attempts to rescue its Kovytka stake were tragicomic.  They approached Igor Sechin–former intelligence operative, deputy prime minister, chairman of Rosneft, thug, and head of a Rosneft-centered clan that was a mortal rival of the Gazprom-centered clan–for help in dealing with Gazprom.  This was about as bright as approaching the Tagliattas to intermediate with the Corleones.

In one sense, you have to cut the company some slack for its past experiences: they are not alone.  No supermajor has had anything but headaches–and worse.  All the advantages are with the Russian state.  They have many levers that they can pull.  Everything from environmental and licensing rules to taxes to guns.

But that means that it is hard to cut the company slack about its current decision.  How could it possibly think that this time it will be different?

The nature of the oil business makes this problem particularly acute, and the risks of opportunism are particularly acute in the BP-Rosneft JV.  Rosneft needs technology to exploit the offshore opportunities in the Arctic.  BP has the technology and expertise.  BP understands that its ability to utilize that expertise in other areas, most notably the US  Gulf, are doubtful at best as a result of the Horizon disaster.  So, in some sense, there is economic sense to the deal, in that each party has something the other wants and needs.

But deals have to be enforceable, and here the problem is one of asynchronous performance that creates extreme hazards in enforcing any deal.  BP has to commit its technology and expertise and capital at the front end.  It does so in the expectation that when the oil flows, it will profit accordingly.  But once it has sunk its capital and technology into the frozen Russian wastes–once it has incurred massive costs–its bargaining position vis a vis Rosneft and the Russian state declines dramatically.  The Russian state can then start playing its tricks to squeeze BP.

And it almost surely will.   It is really almost impossible to fathom how BP believes that it can avoid this problem.  Asynchronous performance is inherent in the proposed JV.  Russia has a demonstrated track record of acting opportunistically, especially in the energy sector.  Reputation has clearly not kept Russia from acting opportunistically in the past.  There are no legal protections to speak of: indeed, in Russia, the legal system is the sword of the state, rather than a shield for private capital.  This means that BP will run extreme legal and political risks in attempting to collect on its commitment of capital and technology.

When thinking about this deal, remember one of the sources of dispute between TNK and BP: the former –the Russian partners–wanted to invest more outside of Russia.  That’s pretty telling, if Russia is where the best oil prospects are–physically, anyways.

Maybe BP knows something that isn’t immediately apparent that has convinced it that this time it will be different.  But it almost never is.

Hope springs eternal.  But to me, the more appropriate aphorism is: fools rush in where angels fear to tread.

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

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

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

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

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

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

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

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

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

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

Bart Chilton has come out in support of a position “point” plan that would permit the CFTC to monitor trader positions, investigate positions larger than pre-set “points,” and vote to require traders to reduce any such positions.  As a result, it appears that this interim plan will go forward.

In some respects, this is better than hard limits, but many issues remain.  The proposal gives the Commission considerable discretion, and discretion can be misused and abused.

Here are several open questions.

First, what conditions would permit the ordering of a position reduction?  Must there be some showing of a market disruption?  In the language of the CEA, must the Commission show that the position in question represents “excessive” speculation?  How would that be defined, and what criteria would be used to evaluate whether it has occurred?  Must the Commission show that the position has caused “unwarranted” price fluctuations?  Or must the Commission merely show that the position has the potential to cause such unwarranted flucutations?  (“Bart doesn’t like it” shouldn’t be sufficient to justify a required reduction.)  If not, what is the statutory basis for the authority?

Second, what evidentiary burden must the CFTC meet to support any order to reduce a position?  That is, what evidence must the CFTC produce to support a finding that the position has caused a disruption/unwarranted price fluctuation (or has the potential to do so)?

Third, what recourse does the affected trader have to an order to reduce his position?  Can he appeal the decision?  To whom?  Can the trader get injunctive relief?

With respect to this third question, there’s an interesting case from 1979:

On Thursday, March 15, 1979, the Commission, pursuant to this section, issued an order to the Board of Trade of the City of Chicago (Board of Trade) to suspend all trading in the March 1979 Wheat Futures Contract (Contract) for the following day, Friday, March 16, 1979. The order stated that the Commission had reason to believe that an emergency within the meaning of Section 8a(9) of the Act existed with respect to the Contract in that significant transportation and warehouse facility shortages had caused a major market disturbance which prevented the market from accurately reflecting the forces of supply and demand. The order additionally specified that the Commission had reason to believe that there existed a threatened manipulation or corner in wheat as a consequence of this market disturbance and as a result of the combined long open positions maintained in the Contract by a small number of speculative traders.

. . . .

The Board of Trade complied with the Commission’s order, and all trade in the Contract was suspended on Friday, March 16. Throughout that day Board of Trade officials and the Commission communicated with each other concerning further trading in the Contract. On that Friday afternoon the President of the Board of Trade advised the Commission that under its own rules it had declared an emergency in the Contract and that trading would be limited to “liquidation only (except new sales for delivery only).”2 In response to the Commission’s inquiry concerning what reasons the Board of Trade intended to announce for issuing the order, the President of the Board of Trade stated that the true reason was the shortened trading period remaining due to the one day suspension of trading ordered by the Commission.3 After the Commission notified the Board of Trade President that such a reason was unacceptable, the Board of Trade issued its order which stated that “various factors” led to the conclusion that trading in the Contract should be limited to liquidation only.

That same evening the Commission issued a supplemental order. The supplemental order recited that the Commission continued to believe that an emergency existed with respect to the Contract, and that further action was appropriate. The Commission ordered the Board of Trade to:

(1) immediately terminate all trading in the Contract on March 19, 20, and 21, 1979, the three remaining trading days in the Contract;

(2) permit deliveries of wheat to be made in fulfillment of current open positions in the Contract through the last day permitted for delivery under the rules of the Chicago Board of Trade at the settlement price for the Contract in effect at the close of trading in the Contract on March 15, 1979; and

(3) settle all positions in the Contract remaining open as of the close of business on March 30, 1979, at the settlement price for the Contract in effect at the close of trading in the Contract on March 15, 1979.” (App. 5a)

On the next day, Saturday, March 17, the Board of Trade instituted this action in the district court seeking review of the Commission’s March 16 supplemental order. The complaint asserted that the Commission’s order was arbitrary, capricious, an abuse of discretion, not in accordance with law, and in excess of the Commission’s statutory authority because no emergency existed within the meaning of Section 8a(9) of the Act. The Board of Trade’s complaint sought an injunction restraining the Commission from enforcing its March 16 supplemental orde

Could a trader ordered to reduce a position initiate a similar action?

In my opinion, there is a legitimate reason for emergency authority (although I have argued frequently that ex post deterrence is superior to a market intervention) in cases of manipulation.  Given the inherent vagaries of the idea of “excessive speculation,” however, I have serious concerns about giving the Commission discretion to intervene selectively in order to force individual traders to reduce positions when manipulation is not suspected.  Any such authority should be constrained.  The Commission should be required to set out a coherent rationale for any such intervention; provide evidence that but for such intervention the existence of said position would cause prices to diverge substantially from the competitive level justified by fundamentals; offer the target of such action the opportunity to present contrary evidence; and permit review by a court.

Absent such protections, the market would be at risk to arbitrary actions based on flaky theories that have not been subjected to serious empirical test.  This would create an unnecessary regulatory risk.  Moreover, political economy factors could further distort the exercise of this discretion, as some traders (or other interested parties) may attempt to influence the Commission to take action against market rivals, or to bail out traders caught on the wrong side of the market.  Given the political and popular frenzy that sometimes accompanies big price movements, such perverse outcomes are well within the realm of possibility.  Indeed, I argued in my 1995 JLE piece on self-regulation that fear of such opportunistic intervention was a major reason why exchanges in the past failed to pass rules permitting the exchange to force traders to liquidate or take other actions that would potentially influence market prices.  I think these exchanges were on to something.  The CFTC should ponder that.

In October, 2007, I wrote a post titled “Cocaine Blues” in which I noted the association between oil prices, and Soviet/Russian aggressiveness/obstreperousness/cussedness/hey-ma-look-at-me-top-of-the-worldness.

Anne Applebaum just noticed the connection:

Why the change of tone? Why now? Many complex theories have been hatched to explain it. This being Russia, none can be proved. But perhaps the explanation is very simple: Oil is once again above $90 a barrel – and the price is rising. And if that’s the reason, it’s nothing new. In fact, if one were to plot the rise and fall of Soviet and Russian foreign and domestic reforms over the past 40 years on a graph, it would match the fall and rise of the international oil price (for which domestic crude oil prices are a reasonable proxy) with astonishing precision.

To see what I mean, begin at the beginning: In the 1970s, oil prices began to rise significantly, along with the then-Soviet Union’s resistance to change. The previous decade (with oil prices at $2 or $3 a barrel, not adjusted for inflation) had been one of flux and experimentation. But after OPEC pushed prices up in the 1970s, oil revenue poured in – and the Soviet Union entered a period of internal “stagnation” and external aggression. Soviet leader Leonid Brezhnev invested heavily in the military, halted internal reforms and in 1979 (when oil was at $25 a barrel) – invaded Afghanistan.

Brezhnev was eventually followed by Yuri Andropov, who had the good fortune to run the Soviet Union when oil prices were still high (at his death, in 1984, they averaged $28 a barrel). Andropov could thus afford both an internal crackdown on dissidents and a continued tense relationship with the West. But Andropov was followed by Mikhail Gorbachev, who took over just as prices plunged. In 1986 (with oil down to $14 a barrel), he launched his reform programs, perestroika and glasnost. By 1989 (when oil was still only at $18) he allowed the Berlin Wall to fall, freed Central Europe and ended the Cold War.

Prices fluctuated, but they did not really rise again in the 1990s (plunging as low as $11 in 1998), the years when Boris Yeltsin was still trying to be best friends with Bill Clinton, the Russian media were relatively free and there was still talk, at least, of major economic reforms. But in 1999 (when oil prices rose to $16 a barrel), Yeltsin’s prime minister, Vladimir Putin, launched the second Chechen war, the West bombed Belgrade, and the mood in Russia turned distinctly anti-Western once again.

The fortunate Putin took over as president in 2000, at the start of a long and seemingly inexorable rise in oil prices. Indeed, Gorbachev’s calls for internal reform were long forgotten by 2003 (when oil prices were creeping up to $27 a barrel). The days when Yeltsin pushed for Russia to join Western institutions were a distant memory by 2008, when Russia invaded Georgia (and oil was at $91 a barrel).

The new Russian president, Dmitry Medvedev, did try to sound nicer in 2009 (when oil prices averaged about $53 a barrel), leaving Putin, now the prime minister again, grumbling in the background. Medvedev locked a draconian treason law, invited democracy activists to the Kremlin, denounced the Belarusan dictator and even seemed to some to have liberalized Russian television just a bit.

But now it is 2011, Putin is very much in the foreground, and Khodorkovsky has just been sentenced by a kangaroo court. As I write these words, oil is at $92.25 a barrel.

Is this analysis too simplistic? Sure it is. But I haven’t yet heard a better explanation.

That’s because there isn’t one.

And as Sergei Guriev and Aleh Tsyvinski note in their “Challenges Facing the Russian Economy after the Crisis” (in the volume Russia After the Global Economic Crisis, Aslund, Guriev, and Kuchins (eds.)), this is a big problem for Russia’s future:

Russia’s internal problems relate to the “resource curse.”  If oil prices remain high, Russia will probably delay much-needed economic reforms.

. . . .

But in Russia it is especially problematic [to improve economic and political institutions] as the ruling elite is not interested in building such institutions.  The “resource curse” provides and explanation.

Guriev and Tsyvinski argue that higher oil prices are antithetical to the political reforms that Russia requires to become a truly modern, innovative, entrepreneurial economy and more humane polity.  To which I would add they are also antithetical to the development of a more neighborly, less revisionist Russian foreign policy.

There’s another interesting implication of the rising oil price that hasn’t drawn attention, at least that I’ve seen.  In particular, it will intensify conflict between Gazprom and its customers.  Gazprom has historically sold gas under contracts with prices tied to the price of oil.  But oil and gas prices have diverged in recent years (for a variety of fundamentals-based reasons).  As a result, Gazprom’s big European customers want to change the contract terms and pricing, but Gazprom does not–and that’s an understatement.  The increase in oil prices has increased the divergence, putting Gazprom’s gas prices even more out of line with cash market values.  Which will only crank up the tension between Gazprom and its customers.  And since there is nothing that happens to Gazprom that doesn’t have a political angle, this will result in some political tensions as well.  (EG, how will BFFs Berlusconi and Putin deal with the issue?)

In a nutshell: higher oil prices will stymie domestic reform in Russia and fuel external tensions.  A fun time will be had by all, because Putin et al can’t lay off that whiskey, and let that cocaine be.

What are positions limits supposed to do, exactly, and how? Here I want to focus on all month limits, not spot month limits.  Spot month limits can constrain market power manipulations.  I think there are better ways to do that, but at least there is a reasonable goal, and a reasonable connection between means and objectives.  Can the same be said for all month limits?  I am extremely skeptical, especially limits of the kind currently under consideration by the CFTC.

Here’s what the CFTC website says:

To protect futures markets from excessive speculation that can cause unreasonable or unwarranted price fluctuations, the Commodity Exchange Act (CEA) authorizes the Commission to impose limits on the size of speculative positions in futures markets.

I’ll take as given the theoretical correctness and empirical relevance of the highly dubious but positive assertion that “excessive speculation that can cause unreasonable or unwarranted price fluctuations,” and focus on the ability of position limits to address this problem.  I’ll focus particularly on the kind of position limits the CFTC is currently considering, which set limits as a fraction of open interest.

It’s first important to note that all limits that have been in force and have been proposed since 1936 have or would have limited the permissible size of the position any individual entity can hold, not the size of speculative positions in aggregate in futures markets.  That’s problematic when one considers several of the most widely cited examples of speculative bubbles in history.  (Again, not endorsing that any or all of these are truly speculative bubbles.  Just seeing if, under the assumption that they were, speculative position limits of the kind implemented and mooted in futures markets would have had the slightest impact.)

A list of such speculative bubbles might include tulips in 17th century Holland, the Mississippi Bubble in 1719,  stocks in the 1920s, the internet boom, and US real estate in the 2000s.  In historical recountings of these episodes, each was characterized by widespread participation by small traders, e.g., housewives speculating on RCA in the 1920s, or individuals putting their 401(k)s in internet high-fliers in the 1990s.  If they were manias, they were popular–or populist–ones.

Limiting the size of the position that any individual could have held would not have constrained seriously the overall amount of speculation in these episodes, because the aggregate speculation was driven by a large number of small positions.  When speculation is excessive because of an excessive number of small or medium-sized deluded traders plunge in the market, and predominately on the same side, limiting the size of any individual position will not constrain this form of excess.

In modern derivatives markets, much speculation takes place through funds or ETFs that aggregate the monies of large numbers of individual speculators into large pools.  If a popular speculative mania leads to an influx of money into these pools, and if there are sufficient economies of scale in managing these pools, then limits on the size of individual positions under the control of one entity could effectively tax speculation, although in a very indirect way.  If the constraint is binding on these pools, it would mean that they are not able to exploit fully their economies of scale.  This would mean that they incur higher costs than in the absence of the constraint.  This would raise the cost of speculation by small investors, which would tend to reduce the amount of speculation they undertake.  How much would depend on (a) the difference between the cost of operating a pool at efficient scale, and the (higher) cost of operating at a scale imposed by the limit, and (b) the elasticity of speculation with respect to transactions costs.

I don’t know for certain what (a) and (b) are.  (I do know that I haven’t seen anyone even point these out to be relevant factors in evaluating position limits.)  My intuition is that they are small, meaning that speculative limits would not appreciably constrain the mass speculative frenzy species of excessive speculation (if it indeed exists or is empirically important).

Moreover, it is not obvious that position limits of the type currently under consideration by the CFTC would even uniformly achieve this objective.  The currently contemplated limits would set maximum position size as a percentage of open interest.  So permissible individual position sizes in big markets (e.g., crude oil) would therefore be larger than permissible individual position sizes in smaller markets (e.g., wheat).  But scale economies relate to absolute size, not percentages of total market size.  And as Adam Smith put it, economies of scale are limited by the extent of the market. This means that the difference between cost at efficient scale and cost at aggregate outputs that differ from integer multiples of the efficient firm scale is declining with market size.  Thus, the kind of constraint under consideration would have a much smaller effect on the amount of speculation in big markets than in small markets, regardless of the elasticity of speculation with respect to transaction cost.  (The analysis is trickier when there is considerable heterogeneity among the cost curves of different pool operators.  Economies of scope–operating pools in different markets–are also relevant.  Index investing raises additional complications.)

This all means that speculative position limits are not well suited to addressing the popular speculative wave species of excessive speculation, especially in large markets (like the energy markets).  This is especially true of position limits based on percentages of open interest.

Given that many of the conventional and political attacks on commodity speculation in the 2000s were–and continue to be–based on variations on the popular mania explanation, imposition of speculative limits will leave their supporters disappointed, for two reasons.  First, because these attacks are dubious theoretically and empirically.  Second, because even if such speculative waves sometimes cause unwarranted price fluctuations, limits on the positions any individual entity can hold will have little, if any effect, on the size, strength, or price impact of these waves.

This means that any defense of position limits must be predicated on a belief that a position, or a handful of large positions, that are large relative to the overall market, can cause unwarranted price fluctuations.

There are examples of this historically, of course.  The Hunts come to mind immediately.

Putting aside manipulation for a moment (and it is hard to see what type of manipulation all month limits would stop), when one trader takes a disproportionately large position, it means that he has a far different view of the future course of prices than other traders.  He’s taking all the action (or a disproportionately large amount of the action) on one side of the market because at the current price, his view on where prices are going is the opposite of consensus opinion (or perhaps because there’s a big imbalance among hedgers).  This is contrarian speculation.  If the contrarian speculator is right–he makes a lot of money.  If he’s wrong–he loses a lot of money.

One justification for constraining this type of trading is a belief that such traders are more likely to be wrong than right.  They are unduly confident in their own abilities to forecast prices, or unduly convinced of the superiority of their information.  Their trading on these false beliefs does drive prices away from where they should be, and when reality intrudes, prices snap back.  Those movements could be characterized as unreasonable or unwarranted price fluctuations.

This is a rather peculiar theory because it presumes a positive correlation between the irrationality of the investor, and the amount of money he has to invest.  How did the dumb become so rich?  Not that it is impossible, just that you’d expect the correlation to go in the other direction (albeit smaller than one in absolute value).

The market is, of course, a stern disciplinarian that punishes such irrational plungers; fools and their money are soon parted.  The Hunts, for example, were poster children for the old joke: “Want to make a small fortune trading commodities?  Start with a large fortune.”  Ditto Amaranth.  Given the potential costs of position limits in constraining legitimate speculation, is it really necessary for the government to try to prevent what the market ruthlessly helps to deter?

It should also be noted that there is a tension between this justification for position limits and the anti-speculative wave justification.  Contrarians by definition take views at odds with the conventional wisdom.  If the conventional wisdom is irrational and not based on fundamentals–as the popular mania critique of speculation believes–we want contrarians to lean against the wind.  Since they are by definition at odds with the views of most others, they will take positions that are disproportionately large on one side of the market. This is the theme of The Big Short, which describes how a handful of traders bet against the real estate bubble.  If such bubbles exist, we want people to lean against it.

Position limits, and those based on concentration in particular, will constrain just that kind of contrarian trading.  So if you worry about bubbles driven by mass speculation, (a) position limits will do little to constrain it, and (b) will make it harder for those not suffering from the popular delusion to trade in ways that limits the price distortions resulting from it. This is a perverse, unintended consequence of limits on large trader positions.

If big speculators are right on average, or right more than they are wrong, limits that constrain their trading will not reduce deviations between actual prices and what prices “should” be, and could in fact increase the frequency and magnitude of these disparities.  So this justification for position limits depends crucially on a view of the correctness of big speculators.  This is something everybody has a speculative opinion on, ironically–but little or no evidence to back it up.

Another justification for limiting the size of an individual trader is that if he is wrong, the failure that results when reality intrudes could have knock-on effects.  The failure of the Hunts, for instance, did have some systemic consequences (as I wrote about some months ago).

But position limits are ill-adapted to addressing this kind of problem.  The real problem is the failure of a really big, leveraged player.  Some players are big, but not leveraged.  If they lose, they have the wherewithal to make good their losses, limiting any systemic consequences resulting from knock-on failures.  If prices move against a big ETF (like USO, for instance), it’s painful for the fund holders, but their positions are effectively fully collateralized, so their losses do not create counterparty default losses that could put others into distress.  Position limits constrain leveraged and unleveraged players alike. (It would be interesting to understand whether the imposition of limits could actually affect the relative importance of leveraged players in the market.  If so, limits could have unintended, adverse consequences.)

Relatedly, with respect to this problem, the metric of big is not big relative to the size of the specific market in which the speculator participates.  It is big relative to the broader financial system.

Consider a couple of polar cases.  For a small market, let’s say Minneapolis wheat, someone could accumulate a position that is huge relative to open interest, without accumulating position that is large relative to the financial system in any way.  During the peak of the price spikes in 2008, the maximum value of the open interest in July Minneapolis wheat was about $650 million.  In the scheme of things, this is chicken feed, even if one person had held the entire position, let alone 10 or 12.5 percent.

Now consider a big market, like crude oil.  At the peak in July, 2008, the value of NYMEX open interest was on the order of $200 billion–nearly 3 orders of magnitude bigger than for MW.  Somebody with 12.5 percent of this market (the upper bound under previous CFTC proposals) would have had a notional position value of about $25 billion–that’s serious money, which, if the position holder is leveraged, could lead to some knock-on problems if it went south. (Of course, $25 billion is an upper bound on the loss a long could suffer.  For both longs and shorts, the uncollateralized credit exposure is far smaller.  Perhaps sufficiently small that even such a large position is not systemically risky even if held by a leveraged player.)

Note that under the new proposals, where OTC markets are included, the disparity would become even more extreme.  The OTC positions tied to CL are large, absolutely and relative to the NYMEX open interest, as compared to OTC positions tied to MW absolutely and relative to MGE open interest.  (How much larger, nobody really knows at present.  That’s one reason why some commissioners are reluctant to act until they know more about the size of the OTC market.)

So under this theory of the systemic risk associated from the failure of a big speculator, you might conclude that a limit would be sensible for crude but not for Minneapolis wheat.   But the commodity position limits will be imposed on markets of all sizes.

In this regard, it is interesting to note that press reports state that the limits the CFTC is considering would hit far more agricultural traders than energy and metals traders.  Given that the latter markets are a lot bigger than the former, and hence would pose a far greater systemic risk, this means that the proposed limits are very poorly adapted to addressing any putative systemic risk posed by “large” speculators.

One last thing.  In October, I had a discussion (disclosed on the CFTC website) with the CFTC position limits team.  I basically argued that in designing such limits, it was imperative that the limits be designed based on a diagnosis of the problem to be solved.  This led to a discussion of potential problems associated with large positions.  A lot of the scenarios that were discussed revolved around how traders with big positions might exploit microstructural frictions to make money.

Yeah, maybe.  But I am skeptical that somebody is going to accumulate a huge position, with all of the capital required and risk entailed, to play liquidity games for ticks.  Moreover, many of the big players that some critics of speculation are obsessed with, e.g., the “massive passives” (ETFs and index funds) that keep Bart Chilton up nights, most certainly do not play these games.  They pretty much trade in a mechanical fashion, rolling on a schedule, and investing and liquidating based on customer money inflows and outflows.   So again, there seems to be a huge disconnect between  the paranoia about massive passives, and the types of behavior that some at the CFTC look to prevent using position limits.

There’s a common pattern to all this.  Come up with a scenario in which speculation distorts prices.  Then evaluate how position limits of the type currently under consideration would operate under this scenario.  And then conclude that these position limits would either not address the purported problem, or could actually be counterproductive and make the purported problem worse.

Given that speculative limits also interfere with the legitimate uses of derivatives markets, the very real possibility that they have virtually no offsetting benefit makes this a very bad policy choice.

Supporters of a specific position limit proposal should be required to provide a reasonable justification for that specific proposal.  This justification should first spell out in detail exactly a scenario or scenarios under which speculation distorts prices.  It should then show how–exactly–their proposed limit will reduce the likelihood of these scenarios.

I’ve gone through several alternatives above, and argued that there is a complete mismatch between the diagnosis and the prescription; position limits appear to me to be the financial equivalent of leeches or faith healing.  But maybe my imagination is unduly limited.  Maybe there are other stories/scenarios that I haven’t considered.  I’d be glad to entertain them–but I would also have to be convinced how a specific position limit proposal would improve market performance under these scenarios.

Of course, I also believe that those advancing these scenarios should provide rigorous theoretical justifications and empirical evidence to demonstrate that their scenarios are real possibilities.  But I’m pretty confident that supporters of limits will be unable to meet even the weaker burden of showing how position limits cure what they identify as ailing the market, no matter how implausible, not to say crack-brained, that diagnosis is.  And until someone proves otherwise, position limits will remain a solution in search of a problem.

* My daughter Renee gave a paper on the political economy of regulation of speculation, focusing on position limits, at the Instituto Bruno Leoni Mises Seminar 2010 in Sestre Levanti, Italy last October.  Her paper compared the drive for position limits in the 1930s to that in the late-2000s.  The audio of her presentation is available online.  Her paper has been accepted for publication in the Journal of Economic Affairs.

A busy day at the CFTC today.  One big rule moved forward, another not.

The rule that moved forward implements the Frank-n-Dodd requirement that swaps be traded on “Swap Execution Facilities” or SEFs.  The proposed rule was released on a 4-1 vote, with Commissioner Jill Sommers the lone nay.

Specifically, the rule specifies:

* platforms that provide for a centralized limit order book available to all participants and/or;

* platforms based on transparent request for quote systems that provide requests for quotes that are visible to all participants on platform, allow liquidity providers to post bids and offers and provide time priority for market participants who originated a request for quote.

* Trading platforms are allowed to offer three tiers of transactions:

* Tier 1 transactions are not block trades and exhibit material transaction volume.

* Tier 2 transactions are not block trades and do not exhibit material transaction volume.

* Tier 3 transactions are not subject to clearing and execution requirements, are block trades or are illiquid or bespoke. These swaps could be executed through various methods including voice and limited request for quote systems.

I’m with Sommers on this one. The underlying presumption of the CLOB-or-Public RFQ is that the more pre-trade transparency and anonymous trading, the better for customers, and that lack of transparency is a means of enhancing dealer/market maker market power and profit.

This is not true as a general matter.  As has been seen from time immemorial in securities markets, many customers prefer to trade away from centralized markets as this reduces their trading costs.  It is possible that this “fragmentation” harms other market users more than it helps those that choose not to patronize the centralized, transparent, anonymous market.  That is a common argument, but it is not generally true.  That argument is premised on the (usually) implicit assumption that the CLOB market is perfectly competitive with free entry–which may well not be true, and in fact has been untrue in many markets.

Moreover, for many products, derivatives end-users have had the choice between trading on centralized markets (with clearing and the associated credit arrangements) and trading in decentralized dealing markets (without clearing).  Indeed, the latter combination has grown absolutely and relative to the former.  Although it is difficult to determine the contribution of each element of the transaction and post-trade bundle to traders’ decisions on where to trade, this fact raises serious doubts about the assertion that forcing trades onto centralized platforms will be overwhelmingly beneficial to derivatives end-users.

The rule that didn’t move forward, somewhat surprisingly, was that on position limits.  CFTC Chairman Gensler had already delayed voting on the proposed rule once, and did it again today.  He said that “I think it’s just appropriate to let this one ripen a bit more.”

Uhm, Gary.  It’s pretty ripe already.  As in rotten.

The new position limit proposal is less bad than the one from January.  It no longer has the silly crowd out provision, or the equally silly limited risk management exemption.  The crowd out provision essentially forced market participants to choose between being hedgers, market makers, or speculators.  That micromanagement of firm business models in contravention of the potential for synergies across these functions was an unnecessary constraint on market participants.

On the other hand, the new rule has a very restrictive definition of bona fide hedger.

Although some of the worst elements have been stripped away, the underlying problem with spec limits generally remains.  No one has yet to provide credible evidence showing that speculation has distorted prices in recent years, or even provided a credible theory to demonstrate how this can happen (other than in corners or squeezes, which are better deterred in other ways).

Although it is not quite clear as to why the rule has not garnered majority support in the Commission, anti-speculation crusader Bart Chilton indicated that he did not support the rule as written.  This is likely due in part that he was a big fan of the crowding out provision.  In his remarks after the meeting he also indicated that the two-step approach in the proposal, which would have delayed full-blown implementation of limits until the Commission had the ability to collect data from the swaps market so it would be able to base its choice of  limits on, you know, actual data.  In other words, Chilton is playing Jacobin on this issue.  Republican commissioners have expressed reservations about proceeding without such information.

Apparently, however, Gensler threw a sop to Chilton, by instructing staff to identify position levels that would trigger a Commission review that could result in an order for large traders to reduce their positions.

Position limits have proved to be an extremely contentious issue.  SEFs are very controversial as well.  Both represent attempts by the CFTC–acting at Congressional direction–to transform the ways of executing transactions, and the quantities of transactions, that consenting adults have freely chosen.  That inevitably generates opposition.  There can be justifications for doing this.  Unfortunately, neither Congress nor the CFTC have provided even remotely plausible ones.

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

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

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

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

. . . .

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

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

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

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

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

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

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

. . . .

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Vladimir Putin was in fine form  in a speech in Berlin the other day, shrieking hysterically about the savage Europeans and their thieving energy policies:

Russian Prime Minister Vladimir Putin on Friday lashed out at European Union laws aimed at liberalising the continent’s energy market, saying they hinder investment and amount to uncivilised “robbery”.

Putin, speaking to an investor forum before talks with German Chancellor Angela Merkel, said the EU should consult Russia when drafting such important legislation.

“Our companies, together with German partners, legally acquired distribution assets in Lithuania. Now they are being thrown out there with reference to the Third Energy Package. What is this? What is this robbery?” Putin said.

“We often hear from our partners both in Europe and North America: ‘If you want to be members of a global family of civilised nations, you should behave in a civilised way.’ What is this then? Have our colleagues forgotten the basic principles?”

Nothing like sticking Putin’s beloved Gazprom to make him squeal like a piggy.

No doubt Putin believes that mandated unbundling of distribution pursuant to EU legislation, duly passed, is analogous to the expropriation of Yukos or Sakhalin II. Check that.  He actually thinks the latter were righteous and just: if you really want to hear him lose it, just say “Khodorkovsky.”   It’s unbundling that’s the crime.

Unbundling is a widely employed method to enhance competition in network industries.  It can work well, or it can work badly at enhancing competition.  But maybe that’s exactly what has Putin steamed: he’s not too big on promoting competition in the energy sector.

Moreover, it is not undertaken to expropriate property from one party to line the pockets of the state, or some individuals or firms favored by the state.  Moreover, the EU directive is meant to be applied uniformly across all companies, not selectively against individual companies who have fallen into disfavor, or who have something somebody else wants. Note that a German company, E.ON Ruhrgas, is also affected by the unbundling in Lithuania that vexes Putin, so it is not a measure directed at Russia or a Russian company alone.

In brief, Putin’s idea of “civilized” and the Anglo-Euro-American idea of civilized when it comes to property and regulation are quite different. There is a failure to communicate, and the failure is largely cultural.

I especially liked Putin’s assertion that the EU should “consult” with Russia when drafting its legislation.  Uhm, somehow I’m thinking that that’s just another Russian one way street.  Putin would shriek even louder if the Euros were to demand a voice in shaping Russian law, such as it is.  (Indeed, he has–as has Medvedev–told other nations to butt out when they expressed criticism of Russian legislation or legislative proposals.) Indeed, few things get him more incensed than any action by foreigners that he perceives slights Russia, treats it as an inferior to be instructed, or threatens to put Russia “on its knees.”

Lord knows that Merkel has her hands full, with the accelerating implosion of the Eurozone.  But I wonder just how much of Putin she’s going to take: she’s taken quite a bit already.  I also know that German business pushes her to deal with Russia to advance its interests, but Merkel has to know that there is a huge imbalance of economic power between Germany and Russia–and it don’t favor Russia.  So I imagine there will come a day when she slaps Putin down.

If, that is, she’s still in power to do it.  The meltdown in Europe puts her between the importuning PIIGS (and now maybe Belgium too) demanding German money to save the Euro and the EU and a German public that resists bailing out its spendthrift neighbors.  She may well be turned to powder between these political grindstones, leaving some other German chancellor to put up with Putin’s tantrums.