Streetwise Professor

September 20, 2019

The Simple (and Very Old) Economics of the Stock Market Data Pricing Controversy

Filed under: Economics,Exchanges,Regulation — cpirrong @ 4:20 pm

The most contentious battle in American securities markets right now is being waged over exchange pricing of data, in particular over proprietary order book feeds. The battle pits the exchanges against market users (e.g., HFT firms, institutional traders) with the latter claiming that the prices charged by the former border on the extortionate.

The critics actually have a very good point. The economics of the situation imply that the prices the competing exchanges charge are ABOVE the price a monopoly would charge.

No. Really.

So how could competing firms charge a supra-monopoly, let alone supra-competitive, price? The answer to this question is something pointed out by the first true mathematical economist, Augustin Cournot, in his Principes Mathematique, published in 1838. In that book, Cournot laid out “the problem of complements.” Cournot showed that imperfectly competitive firms overprice complementary goods. (Cournot’s example involved zinc and copper in the production of brass. They are complements used in fixed proportion.)

The basic issue is that when goods are complements, if firm A raises its price firm B that produces a complement to A’s good cannot steal sales from A by cutting its price (as would be the case of A’s and B’s goods were substitutes). This reduces the incentive to cut price, and actually provides an incentive to increase prices in order to get a bigger piece of the surplus that is generated when the consumer buys both goods.

This situation fits the stock market case perfectly. Execution services on US exchanges (e.g., NYSE, BATS) are substitutes, but data services are complements.

Consider an HFT firm. One source of profits for this firm is to exploit price discrepancies across exchanges. This requires having near immediate and simultaneous access to prices across all exchanges. Or consider a buyside firm that is trying to minimize execution costs by a clever order routing strategy. Optimizing the allocation of orders across exchanges requires knowing the order book on all the exchanges.

In other words, there are many market participants who have to collect the entire set (of exchange data). This makes the data provided by competing exchanges complements, which by the Cournot logic, forces prices above the competitive level, and indeed, above the monopoly level.

Furthermore, the problem becomes worse, the larger number of exchanges. This is a situation in which lower concentration leads to less competitive outcomes. (Robin Hansen made a similar point recently.)

This is yet another example of the only law that is never repealed: the law of unintended consequences. The intent of RegNMS was to increase competition in the execution of stock trades, and it has done a marvelous job of that. However, the unintended effect of this “fragmentation” (i.e., the increase in the number of execution venues and decline in concentration across exchanges) has been to create and exacerbate a complements problem in data.

A couple of final points. Perhaps one could make a second-best argument here: low execution fees and high data fees may be a good way of covering the fixed costs of operating exchanges (a la Ramsey pricing). Perhaps, but unproven.

What is the right regulatory response? Not clear. I addressed similar conundrums in my 2002 Market Macrostructure article. Natural monopoly-style/pricing regulation could mitigate the overpricing problem, but entails its own costs (e.g., undermining incentives to innovate). The issue is particularly challenging here because efficiency-enhancing competition on one dimension (execution) leads to inefficient problems-of-complements competition on another (data).

As I argued in Market Macrostructure, it really comes down to an issue of property rights. Should exchanges have exclusive ownership of their data? Should this ownership be attenuated in some way, such as limitation on prices, or a required pooling of data that would be sold by a monopolist, with revenues shared by the exchanges? Here is a case where a monopoly would actually improve outcomes.

Maybe that is the way to split the baby, politically. Exchanges would get rents, but efficiency would be improved. Not a first-best solution, but maybe a second best one, and one that could represent a Coasean bargain between exchanges and their customers. And perhaps the regulator–the SEC–could help facilitate and coordinate that deal.

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September 17, 2019

Funding Market Tremors: Today May Not Have Been “The Big One,” But It Was Bad Enough

The primary reason for my deep skepticism about the wisdom of clearing mandates was liquidity risk. As I said repeatedly, in order to reduce counterparty risk, clearing necessarily increased liquidity risk through the variation margining mechanism. Further, it was–and is–my opinion that liquidity risk is a far graver systemic concern that counterparty risk.

A major liquidity event has occurred in the last couple of days: rates in the repurchase market–the major source of short term funding for vast amounts of trading activity–shot up to levels (around 5 percent) nearly double the Fed’s target ceiling for that rate. Some trades took place at far higher rates than that (e.g., 9.25 percent).

Market participants have advanced several explanations, including big cash demands due to corporate tax payments coming due. Izabella Kaminska at FTAlphavile offered this provocative alternative, which resonates with my clearing story: the large price movements in oil and fixed income markets in the aftermath of the attack on the Saudi resulted in large margin calls in futures and cleared OTC markets that increased stresses on the funding markets.

To which one might say: I sure as hell hope that’s not it, because although there was a lot of price action yesterday, it wasn’t The Big One. (The fact that Fred Sanford’s palpitations occurred because he couldn’t get his hands on cash makes that bit particularly apropos!)

I did some quick back-of-the-envelope calculations. WTI and Brent variation margin flows (futures and options) were on the order of $35 billion. Treasuries on CME maybe $10 billion. S&P futures, about $1 billion. About $2 billion on Eurodollar futures.

The Eurodollar numbers can help give a rough idea of margin flows on cleared interest rate swaps. Eurodollar futures open interest is about $12 trillion. Cleared OTC notional volume (not just USD, but all IRS) is around $80 trillion. But $1mm in notional of a 5 year swap is equivalent to 20 Eurodollar futures with notional amount of $20 trillion. So, as a rough estimate, variation margin flows in the cleared IRS market are on the order of 100x for Eurodollars. That represents a non-trivial $200 billion.

Yes, there are potentials for offsets, so these numbers are not additive. For example, a firm might have offsetting positions in EDF and cleared IRS. Or be short oil and long Treasuries. But variation margin flows on the order of $300 billion are not unrealistic. And since market moves were relatively large yesterday, that represents an increment over the typical day.

So we are talking real money, which could certainly contribute to an increased demand for liquidity. But again, yesterday was not remotely a truly epic day that one could readily imagine happening.

A couple of points deserve emphasis. The first is that perhaps it was coincidence or bad luck, but the big variation margin flows coincided with other sources of increased demand for liquidity. But hey, stuff happens, and sometimes stuff happens all at once. The system has to be able to withstand such simultaneous stuff.

The second is related, and very concerning. The spikes in rates observed periodically in the repo market (not just here, but notoriously in China) suggest that this market can go non-linear. Thus, even if the increased funding needs caused by the post Abqaiq fallout wasn’t The Big One, in a non-linear market, even modest increases in funding needs can have huge impacts on funding costs.

This highlights another concern: inter-market feedback. A shock in one market (e.g., crude) puts stress on the funding market that leads to spikes in repo rates. But these spikes can feedback into prices in other markets. For example, if the inability to fund positions causes fire sales that cause big price moves that cause big variation margin flows which put further stress on the funding markets.

Yeah. This is what I was talking about.

Today’s events nicely illustrate another concern I raised years ago. Clearing/margining make markets more tightly coupled: the need to meet margin calls within hours increases the potential stress on the funding markets. As I tell my classes, unlike in the pre-Frankendodd days, there is no “fuck you” option when your counterparty calls for margin. You don’t pay, you are in default.

This tight coupling makes the market more vulnerable to operational failings. On Black Monday, 1987, for example, the FedWire went down a couple of times and this contributed to the chaos and the potential for catastrophic failure.

And guess what? There was a (Fed-related!) operational problem today. The NY Fed announced that it would hold a repo operation to supply $75 billion of liquidity . . . then had to cancel it due to “technical difficulties.”

I hate it when that happens! But that’s exactly the point: It happens. And the corollary is: when it happens, it happens at the worst time.

The WSJ article also contains other sobering information. Specifically, post-crisis regulatory “reforms” have made the funding markets more rigid/less-flexible and supple. This would tend to exacerbate non-linearities in the market.

We’re from the government and we’re here to help you! The law of unintended (but predictable) consequences strikes again.

Hopefully things will normalize quickly. But the events of the last two days should be a serious wake-up call. The funding markets going non-linear is the biggest systemic risk. By far. And to the extent that regulatory changes–such as mandated clearing–have increased the potential for demand surges in those markets, and have reduced the ability of those markets to respond to those surges, in their attempt to reduce systemic risks, they have increased them.

I have often been asked what would cause the next financial crisis. My answer has always been: the regulations intended to prevent a recurrence of the last one. Today may be a case in point.

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September 14, 2019

Bakkt in the (Crypto) Saddle

ICE is on the verge of launching Bitcoin futures. The official start date is 23 September.

The ICE contract is distinctive in a couple of ways.

First, it is a delivery settled contract. Indeed, this feature is what made the ICE product so long in coming. The exchange had to set up a depository, the Bakkt Warehouse. This required careful infrastructure design and jumping through regulatory hoops to establish the Bakkt Trust Company, and get approval from the NY Department of Financial Services.

Second, the structure of the contracts offered is similar to that of the London Metal Exchange. There are daily contracts extending 70 days into the future, as well as more conventional monthly contracts. (LME offers daily contracts going out three months, then 3-, 15-, and 27-month contracts). The daily contracts settle two days after expiration, again similar to LME.

The whole initiative is quite fascinating, as it represents a dual competitive strategy: Bakkt is simultaneously competing in the futures space (against CME in particular), and against spot crypto exchanges.

What are its prospects? I would have to say that Bakkt is a better mousetrap.

It certainly offers many advantages as a spot platform over the plethora of existing Bitcoin/crypto exchanges. These advantages include ICE’s reputation, the creation of a warehouse with substantial capital backing, and regulatory protections. Here is a case in which regulation can be a feature, not a bug.

Furthermore, for decades–over a quarter-century, in fact–I have argued that physical delivery is a far superior mechanism for price discovery and ensuring convergence than cash settlement. The myriad issues that were uncovered in natural gas when rocks were overturned in the post-Enron era, the chronic controversies over Platts windows, and the IBORs have demonstrated the frailty, and vulnerability to manipulation of cash settlement mechanisms.

Crypto is somewhat different–or at least, has the potential to be–because the CME’s cash settlement mechanism is based off prices determined on several BTC exchanges, in much the same way as the S&P500 settlement mechanism is based on prices determined at centralized auction markets.

But the crypto exchanges are not the NYSE or Nasdaq. They are a rather dodgy lot, and there is some evidence of manipulation and inflated volumes on these exchanges.

It’s also something of a puzzle that so many crypto exchanges survive. The centripetal forces of liquidity tend to cause trading in a particular instrument to gravitate to a single platform. The fact that this hasn’t happened in crypto is anomalous, and suggests that normal economic forces are not operating in this market. This raises some concerns.

Bakkt potentially represents a double-barrel threat to CME. Not only is it competing in futures, if it attracts a considerable amount of spot trading activity (due to a superior trading, clearing, settlement and custodial platform, reputational capital, and regulatory safeguards) this will undermine the reliability of CME’s cash settlement mechanism by attracting volume away from the markets CME uses to determine final settlement prices. This could make these market prices less reliable, and more subject to manipulation. Indeed, some–and maybe all–of these exchanges could disappear if ICE’s cash market dominates. CME would be up a creek then.

That said, one of the lessons of inter-exchange competition is that the best mousetrap doesn’t always win. In particular, CME has already established liquidity in the futures market, and as even as formidable competitor as Eurex found out in Treasuries in the early-oughties, it is difficult to induce a shift of liquidity to a competitor.

There are differences between crypto and other more traditional financial products (cash and derivatives) that may make that liquidity-based first mover advantage less decisive. For one thing, as I noted earlier, heretofore cash crypto has proved an exception to the winner-takes-all rule. Maybe the same will hold true for crypto futures: since I don’t understand why cash has been an exception to the rule, I’d be reluctant to say that futures won’t be (although CBOE’s exit suggests it might). For another, the complementarity between cash and futures in this case (which ICE is cleverly exploiting in its LME-like contract structure) could prove decisive. If ICE can get traction in the fragmented cash market, that would bode well for its prospects in futures.

Entry into a derivatives or cash market in competition with an incumbent is always a highly leveraged bet. Odds are that you fail, but if you win it can prove enormously lucrative. That’s essentially the bet that ICE is taking in BTC.

The ICE/Bakkt initiative will prove to be a fascinating case study in inter-exchange competition. Crypto is sufficiently distinctive, and the double-barrel ICE initiative sufficiently innovative, that the traditional betting form (go with the incumbent) could well fail. I will watch with interest.

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August 4, 2019

Pork Wednesday: A Tale of Gilded Age LaSalle Street, With a Heavy Dose of Irony

Filed under: Commodities,Derivatives,Economics,Exchanges — cpirrong @ 7:05 pm

On Friday, someone tweeted a picture of the front page of the Chicago Tribune from 126 years prior–2 August, 1893. It depicts the trading floor of the Chicago Board of Trade when a pork corner collapsed:

Actually, two corners collapsed on that day: the one in pork, and another in lard. The “provisions” markets (as the futures in pork and its products were called) had been successfully cornered repeatedly in the year running up to August, but the corners failed in August because the Panic of 1893 (which began in May of that year) weakened demand and made it impossible to sustain prices. From 31 July to 2 August, the price of pork futures fell from $19.25/barrel to $10.50, and lard fell from 9 cents/lb. to 5.9 cents/lb. The pork price fell $9 in 30 minutes.

The night prior to the collapse, the cornerers (notably John Cudahy, of the Cudahy family of meat packers) tried to hammer out an agreement with their bankers to secure financing to fund the deal, but Cudahy’s brother Michael (who ran the family packing establishment) refused to sign. Lacking the ability to fund their positions, the cornerers had to sell, and prices collapsed. (A la Silver Thursday when the Hunt Brothers ran out of money and had to sell. So perhaps this event should be called Pork Wednesday.)

I have spent a good deal of my professional career studying manipulation, so I find these things of academic interest. They are also fascinating from a historical perspective. Not only was this front page news in Chicago, it was front page news around the country: this paper from Omaha is just one example. This is not surprising, given the importance of agriculture in the economy at the time. Agriculture was the biggest industry and employer in the country, and food represented the largest share of consumption, so the vicissitudes of trading on the CBOT and the New York Cotton Exchange were of deep interest to most Americans. Events like those of 2 August, 1893 were a major impetus behind efforts to regulate (or ban) futures trading. These efforts failed until the post-WWI agricultural depression.

And look how big the pork pit was! It would give the 1990s-era T-bond and T-note pits a run for their money.

Further, the ag futures markets were of such economic importance at the time that they created systemic risks. The collapse of the pork and lard corner, occurring in particular as it did when banks were under suspicion due to the Panic, and when there was no deposit insurance or lender of last resort, caused runs on several banks in Chicago due to fears that they had extended credit to the cornerers or one of the four brokerage firms that failed due to the collapse, and hence were insolvent. Two prominent private banks run by Jews failed. The owner of one, Herman Scheffner, committed suicide by drowning himself in Lake Michigan. The owner of the other, Lazarus Silverman, had staved off a run at the onset of the Panic in May, but could not secure funding in New York in August, and suspended payments on 3 August. The failure of these banks, and the heavy withdrawals at others, contributed to a decline in economic activity in Chicago and the Midwest and exacerbated the prolonged depression that gripped the country from 1893 to 1897.

Lazarus Silverman’s story is of particular interest to me, in part due to a family connection (by marriage) and in part due to the compelling nature of the story itself. Silverman had immigrated from Bavaria before the Civil War, and started a business as a bank note broker which developed into one of the premier private banks in Chicago. His bank on Dearborn Street was quite the edifice:

He advised Senator John Sherman on monetary questions, and was a major financier of the development of iron ore in the Mesabi Range. An early investor in Chicago real estate, he was one of the giants of the Chicago financial community during the Gilded Age.

Although his assets exceeded the liabilities of the failed bank, it could not avoid bankruptcy. Nonetheless, due to his great stature and respect in the community, he was basically allowed to serve as his own bankruptcy trustee. Even though the bank’s debts were discharged in bankruptcy and he was therefore under no legal obligation to do so, he spent the remainder of his life repaying its unsecured creditors. After the failure, he conducted his real estate business out a building he had commissioned and whichA now houses the Standard Club.

I have often wondered if Silverman ever pondered the irony that he, a devout Jew who would not conduct business on Saturday (despite the fact that was a working day back then), whose business had survived the Civil War, the Chicago Fire, and the Panic of 1873, was brought low by the collapse of a corner in pork and lard.

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July 7, 2019

Spot Month Limits: Necessary, But Not Sufficient, to Prevent Market Power Manipulation

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — cpirrong @ 6:50 pm

In my recent post on position limits, I suggested that at most spot month limits are justified as a means of constraining market power manipulation. It is important to note, however, that setting spot month limits at levels that approximate stocks in deliverable position may not be sufficient to prevent the exercise of market power during the delivery period, with the resultant deleterious effects on prices.

The basic motivation for position limits equal to stocks is predicated on a model of manipulation that makes particular assumptions about market participants’ beliefs. I pointed out the importance of this assumption in my 1993 Journal of Business article on market power manipulation. In one model of that paper, I assume that market participants believe that a large long who takes delivery will resell what is delivered, and will not consume it. In the other model, market participants believe that the large long will consume (or otherwise withhold from the market) some fraction of what shorts deliver to him.

Under the first set of beliefs, it is indeed a necessary condition for profitable manipulation that a long’s position exceed inventories in deliverable position. It is this kind of manipulation that spot month limits pegged to inventories can prevent.

However, under the second set of beliefs, a large long with a position smaller than inventories in deliverable position can exercise market power and inflate prices. Spot month limits based on inventories cannot prevent this type of manipulation.

I recently completed a paper that incorporates this insight into a standard signalling model. In the model, there are two kinds of longs: (a) “strong stoppers,” who have a real demand for the deliverable commodity, place a higher value on it than others, and who will consume at least some of what is delivered to them, and (b) manipulators, who have no real demand for the deliverable and who will resell what is delivered. Shorts do not know which type is standing for delivery.

In the model, a long submits an offer to sell his futures position at a specified price prior to expiration. The strong stopper submits an offer above the price that would prevail in the absence of a strong stopper (reflecting his high valuation of the commodity). I show that under different out-of-equilibrium beliefs there is a pooling equilibrium in with the manipulator mimics a strong stopper, and submits a high offer price at which he is willing to liquidate.

In the pooling equilibrium, the shorts deliver a quantity that exceeds the quantity that they would deliver if they knew the long was a strong stopper: this reflects the fact that they realize that the manipulator will resell what is delivered, and the shorts can repurchase it at a depressed price. However, in this equilibrium the manipulator sells some of his futures position at a supercompetitive price, and earns a supercompetitive profit even though he has to “bury the corpse” of a manipulation.

Crucially, the manipulation can succeed even if the long’s position is smaller than inventories, as long as the flow supply curve is upward sloping at such quantities. The flow supply curve can be upward sloping merely due to the theory of storage: an anticipated depletion of stocks increases the value of the remaining inventory. Therefore, if shorts anticipate a positive probability that a long will consume what is delivered, the theory of storage implies that the supply of deliveries is an increasing function of the futures price at expiration.

Thus, a futures position in excess of inventories in deliverable position may be a sufficient condition to exercise market power, but it is not a necessary one. If shorts are uncertain about a long’s motive for taking delivery, and some longs are strong stoppers who will consume what is delivered and thereby deplete inventories, manipulators can mimic strong stoppers and extract a supercompetitive price even with a position smaller than inventories.

One implication of this analysis is that reliance on spot month position limits is not sufficient to prevent market power manipulations. Additional measures, what I have called “ex post deterrence” since my 1996 Washington and Lee Law Review article, are also necessary. In my earlier work I argued that they are necessary because it was unlikely that position limits could adjust to reflect inevitable changes in inventories. This new paper shows that even if they could so adjust limits, they would be inadequate. Market power manipulation facilitated by fraud (i.e., falsely pretending to have a real demand for the commodity) can occur even if position limits prevent a long from obtaining a position during the delivery period that exceeds stocks in deliverable position.

This analysis also implies that equating “deliverable supply” with “inventory in deliverable position” is wrong. The supply available at the competitive price may be smaller than inventories–and indeed, far smaller than inventories–when shorts do not know the “type” of long standing for delivery.

The traditional model of deliverable supply is predicated on a view of manipulation shaped by the big corners of history, in which there was little doubt about the motivations of a large long. But as the court in the Cargill case noted, “[t]he methods and techniques of manipulation are limited only by the ingenuity of man.” Exploiting shorts’ ignorance about his motive for taking delivery, a long can ingeniously exercise market power even with a position smaller than deliverable supply.

This is a possibility that is only dimly recognized in the existing regulatory structure in the US. Most importantly, it implies that a reliance on preventative measures like position limits alone is inadequate to reduce efficiently the frequency and severity of market power manipulation. Ex post measures are required as well.

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June 13, 2019

Debunking A Valiant–But Failed–Defense of Frankendodd

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — cpirrong @ 7:40 pm

I have known CFTC Commissioner Dan Berkovitz for almost 20 years, when he was a senior staffer on the Senate Permanent Subcommittee on Investigations, and he reached out to me for guidance on market manipulation issues. I think it’s fair to say that we disagree on most important issues. He supports many regulations I strongly oppose, but despite that our relationship has been cordial and mutually respectful.

Dan’s recent speech at the FIA Commodities Symposium in Houston focuses on issues that we happen to disagree on, and needless to say, I am unpersuaded. Indeed, I think his remarks demonstrate quite clearly the fundamental intellectual failings with the regulatory measures he favors.

He focuses on two issues: competition in OTC derivatives, and speculative position limits. With respect to OTC derivatives, he says

There are now 105 swap dealers and 23 swap execution facilities registered with the Commission. Almost 89% of interest rate swaps and 96% of broad index credit default swaps are cleared through a central clearinghouse. Nearly 98% of all swap transactions involve at least one registered swap dealer. The CFTC’s swap trading rules have led to more competition, more electronic trading, better price transparency, and lower spreads for swaps traded on regulated platforms

But then he contradicts himself on competition:

Despite this progress, we have seen an increase in concentration in the trading and clearing of swaps among the bank swap dealers.  [Emphasis added.] Although we have more competition in the swaps market since the passage of Dodd-Frank, in the form of tighter bid-ask spreads and lower transaction costs, we have fewer competitors.  [Which makes me question whether the tighter spreads are the result of more competition, or other factors.] High levels of concentration present systemic risks and provide fewer choices for end-users.  [But wasn’t the point of DFA to reduce systemic risk by reducing concentration? GiGi sure said so.] One of the purposes of the Commodity Exchange Act (“Act” or “CEA”) is to promote fair competition.  The Commission therefore has an obligation to address this issue.

How concentrated are our derivative markets?  For swaps trading, five registered bank swap dealers are party to 70% of all swaps and 80% of the total notional amount traded. And for clearing services, the five largest FCMs—all affiliated with large banks—clear about 80% of cleared swaps.[  The eight largest firms clear 96% of cleared swaps.  I am concerned about what could happen if one of those providers fails.  I am also concerned about the impact on the price of derivatives for end users.

Even prior to Frankendodd, I predicted that the regulations would lead to greater concentration, precisely because regulatory burdens create fixed costs, which favor scale. The concentration among FCMs is particularly worrisome from a systemic risk perspective, and has been exacerbated by the way clearing regulations have been implemented. Not all of these are the CFTC’s fault: it has attempted to push back on the Fed’s implementation of the liquidity ratio, which creates unnecessary capital charges associated with segregated margins. Dan alludes to that issue thus: “We must find ways to increase bank capital standards without discouraging the availability of clearing and other risk-management tools available to end users.” But the basic conclusion remains: measures intended to reduce concentration in order to reduce systemic risk have not achieved that objective, and have in fact likely increased concentration.

The biggest weakness in Dan’s speech is his valiant, but tellingly and painfully strained, justification for position limits.

The CFTC has a long history with speculative position limits, and their benefits to the market are well established.  Section 3 of the Act identifies risk management and price discovery as fundamental purposes of U.S. derivatives markets. Meaningful position limits coupled with appropriate hedge exemptions are crucial to advancing those purposes.  Position limits help prevent corners, squeezes, and other forms of manipulation.  They prevent distortions in the prices of many major commodities in interstate commerce—ranging, for example, from wheat to gold to coffee to oil.  The Hunt brothers’ attempts to corner the silver market, the Ferruzzi squeeze of the soybean market, and the Amaranth hedge fund’s excessively large positions in the natural gas futures and swaps markets are clear examples of why position limits are needed to prevent the price distortions and real-world impacts that can result from excessive speculation.  Episodes such as these validate Congress’ and the CFTC’s long-held view that position limits are “necessary as a prophylactic measure” to deter sudden or unreasonable price fluctuations and preserve the integrity of price discovery and risk mitigation on U.S. derivatives markets.

Insofar as prevention of market power manipulations (squeezes and corners) are concerned, this can be achieved through spot month limits and does not require restrictions on the positions held prior to the delivery month, and across all months, as the Commission’s previous proposals would impose. Meaning that the proposed regulations are over-inclusive and an unduly restrictive means of achieving their stated objective.

Further, insofar as the examples are concerned, they provide no support for the types of expansive limits that have been proposed. None.

As I’ve said repeatedly about the Hunt episode (the CFTC’s favorite go-to example): when do we get to the Trojan War? That episode is ancient history, and is more the exception that proves the rule than a warning of a clear and present danger. I have said this repeatedly only because the CFTC brings up the example repeatedly. If they stop, I will!

Ferruzzi is interesting, because Ferruzzi cornered a market with position limits, from which the company had an exemption. Indeed, it was the CFTC’s and CBOT’s revocation of Ferruzzi’s hedge exemption during the spot month that broke the company’s corner (and launched my academic career in commodities!–thanks to all!) I can think of other examples in which long hedgers with exemptions executed market power manipulations, and indeed, long hedgers with exemptions are the most dangerous manipulators. Meaning that position limits on speculators are beside the point when it comes to addressing market power manipulation.

With regards to Amaranth, Dan states

The Amaranth episode provides another clear example of how large speculative positions can distort market prices.  At one point, Amaranth held 100,000 natural gas contracts, or approximately 5% of all natural gas used in the U.S. in a year. “Amaranth accumulated such large positions and traded such large volumes of natural gas futures that it distorted market prices, widened the spreads, and increased price volatility.”

The quotations are to a Senate Permanent Subcommittee report (which Dan was an author) . I can say definitively that the analysis underlying those conclusions is completely unpersuasive, and would fail to pass muster in any manipulation litigation. The analysis lacks statistical rigor, and demonstrates neither “artificial” prices or that Amaranth caused these artificial prices (intentionally or otherwise).

Indeed, the CFTC did not pursue Amaranth for distorting natural gas prices through its immense OTC derivatives positions (the 100,000 contracts Dan refers to) outside the delivery month. Instead, it (and FERC) went after the fund and its head trader Brian Hunter for three “bang the close” manipulations in 2006. (Full disclosure: I was an expert for plaintiffs on those manipulations in a private lawsuit.) Position limit regulations would not have prevented those manipulations.

Indeed, other manipulation cases the CFTC has pursued, including bang the settle type cases against Optiver and Parnon and Moore Capital (which I was also an expert in in related private litigation) also would not have been impacted by position limits. That is, limits would not have prevented them. In another recent CFTC case (just settled, and again, I am an expert in related private litigation), the party accused by the CFTC (Kraft) was a long hedger with a hedge exemption.

In brief, neither Dan nor anyone else has presented an example of a post-Trojan War alleged manipulation that position limits would have prevented.

So what’s the point? Can position limits reduce the risk of distortion arising from something non-manipulative?

Dan has an answer, and the answer is “no!” (though he says “record before us demonstrates that the answer is ‘yes.'”)

What speculative position limits are intended to do is to prevent a single market participant from moving markets away from fundamentals of supply and demand through the accumulation of large speculative positions.  [Emphasis added.] In this regard, it’s important to note that speculative position limits focus on the positions held by a single trader or trading entity, not on the overall level of speculation in a market.  The Commission’s task in setting speculative position limits is not to determine how the collective level of speculation in a market might affect prices.  [Emphasis added.] Nor is it to try to determine the “correct” level of speculation that should be permitted in a market.  Instead, the Commission must focus on the single speculator and the impact of large speculative positions on the market.

But this demolishes the argument for limits that was made with increasing intensity around 2006, and peaking (along with oil prices) in mid-2008. Those advocating position limits then could point to no single large trader that was distorting prices. Instead, they blamed (to use Dan’s phrase) “the collective level of speculation” to justify limits–which is exactly what Dan (rightly) says the limits won’t and can’t constrain. Meaning that the CFTC’s proposed limits represent a bait-and-switch: by a limit supporting CFTC commissioner’s own admission, the proposed limits won’t address the supposed ill that led Congress to legislate them in the first place.

To summarize: Position limits outside the spot month are unnecessary to prevent market power manipulations (and other deterrent measures can enhance spot month limits); position limits won’t prevent other kinds of manipulation (e.g., bang the settlement); there are no examples in decades of distortions that position limits of the type proposed might have mitigated; the examples that have been proposed are wrong; the most likely market power manipulators (long hedgers) would be exempted from limits; limits would not have prevented the specific manipulations the CFTC has alleged in recent years; and the limits the CFTC has proposed would not touch the kinds of allegedly multi-trader “collective” excess speculation that caused Congress to mandate position limits in the first place.

Other than that, the case for position limits is rock solid!

Dan Berkovitz manfully attempts justify limits but achieves just the opposite. The arguments and evidence he brings to bear demonstrate how bankrupt the case for limits truly is.

Given that limits will involve substantial compliance costs, and bring no benefits, the song remains the same: position limits are all pain, no gain.

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April 8, 2019

CDS: A Parable About How Smart Contracts Can Be Pretty Dumb

Filed under: Blockchain,Derivatives,Economics,Exchanges,Regulation,Russia — cpirrong @ 7:04 pm

In my derivatives classes, here and abroad, I always start out by saying that another phrase for “derivative” is contingent claim. Derivatives have payoffs that are contingent on something. For most contracts–a garden variety futures or option, for example–the contingency is a price. The payoff on WTI futures is contingent on the price of WTI at contract expiration. Other contracts have contingencies related to events. A weather derivative, for instance, which pays off based on heating or cooling degree days, or snowfall, or some other weather variable. Or a contract that has a payoff contingent on an official government statistic, like natural gas or crude inventories.

Credit default swaps–CDS–are a hybrid. They have payoffs that are contingent on both an event (e.g., bankruptcy) and a price (the price of defaulted debt). Both contingencies have proved very problematic in practice, which is one reason why CDS have long been in such disrepute.

The price contingency has proved problematic in part for the same reason that CDS exist. If there were liquid, transparent markets for corporate debt, who would need CDS?: just short the debt if you want to short the credit (and hedge out the non-credit related interest rate risk). CDS were a way to trade credit without trading the (illiquid) underlying debt. But that means that determining the price of defaulted debt, and hence the payoff to a CDS, is not trivial.

To determine a price, market participants resorted to auctions. But the auctions were potentially prone to manipulation, a problem exacerbated by the illiquidity of bonds and the fact that many of them were locked up in portfolios: deliverable supply is therefore likely to be limited, exacerbating the manipulation problem.

ISDA, the industry organization that largely governs OTC derivatives, introduced some reforms to the auction process to mitigate these problems. But I emphasize “mitigate” is not the same as “solve.”

The event issue has been a bane of the CDS markets since their birth. For instance, the collapse of Russian bond prices and the devaluation of the Ruble in 1998 didn’t trigger CDS payments, because the technical default terms weren’t met. More recently, the big issue has been engineering technical defaults (e.g., “failure to pay events”) to trigger payoffs on CDS, even though the name is not in financial distress and is able to service its debt.

ISDA has again stepped in, and implemented some changes:

Specifically, International Swaps and Derivatives Association is proposing that failing to make a bond payment wouldn’t trigger a CDS payout if the reason for default wasn’t tied to some kind of financial stress. The plan earned initial backing from titans including Goldman Sachs Group Inc.JPMorgan Chase & Co.Apollo Global Management and Ares Management Corp.

“There must be a causal link between the non-payment and the deterioration in the creditworthiness or financial condition of the reference entity,” ISDA said in its document.

Well that sure clears things up, doesn’t it?

ISDA has been criticized because it has addressed just one problem, and left other potential ways of manipulating events unaddressed. But this just points out an inherent challenge in CDS. In the case Cargill v. Hardin, the 7th Circuit stated that “the techniques of manipulation are limited only by the ingenuity of man.” And that goes triple for CDS. Ingenious traders with ingenious lawyers will find new techniques to manipulate CDS, because of the inherently imprecise and varied nature of “credit events.”

CDS should be a cautionary tale for something else that has been the subject of much fascination–so called “smart contracts.” The CDS experience shows that many contracts are inherently incomplete. That is, it is impossible in advance to specify all the relevant contingencies, or do so with sufficient specificity and precision to make the contracts self-executing and free from ambiguity and interpretation.

Take the “must be a causal link between the non-payment and the deterioration in the creditworthiness or financial condition of the reference entity” language. Every one of those words is subject to interpretation, and most of the interpretations will be highly contingent on the specific factual circumstances, which are likely unique to every reference entity and every potential default.

This is not a process that can be automated, on a blockchain, or anywhere else. Such contracts require a governance structure and governance mechanisms that can interpret the contractual terms in light of the factual circumstances. Sometimes those can be provided by private parties, such as ISDA. But as ISDA shows with CDS, and as financial exchanges (e.g., the Chicago Board of Trade) have shown over the years in simpler contracts such as futures, those private governance systems can be fragile, and themselves subject to manipulation, pressure, and rent seeking. (Re exchanges, see my 1994 JLE paper on exchange self-regulation of manipulation, and my 1993 JLS paper on the successes and failures of commodity exchanges.)

Sometimes the courts govern how contracts are interpreted and implemented. But that’s an expensive process, and itself subject to Type I and Type II errors.

Meaning that it can be desirable to create contracts that have payoffs that are contingent on rather complex events–as a way of allocating the risk of such events more efficiently–but such contracts inherently involve higher transactions costs.

This is not to say that this is a justification for banning them, or sharply circumscribing their use. The parties to the contracts internalize many of the transactions costs (though arguably not all, given that there are collective action issues that I discussed 10 years ago). To the extent that they internalize the costs, the higher costs limit utility and constrain adoption.

But the basic point remains. Specifying precisely and interpreting accurately the contingencies in some contingent claims contracts is more expensive than in others. There are many types of contracts that offer potential benefits in terms of improved allocation of risk, but which cannot be automated. Trying to make such contracts smart is actually pretty dumb.

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April 7, 2019

The LNG Market’s Transformation Continues Apace–and Right On Schedule

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — cpirrong @ 7:14 pm

In 2014, I wrote a whitepaper (sponsored by Trafigura) on impending changes to the liquefied natural gas (LNG) market. The subtitle (“racing towards an inflection point”) captured the main thesis: the LNG market was on the verge of a transformation. The piece made several points.

First, the traditional linkage in long term LNG contracts to the price of oil (Brent in particular) was an atavism–a “barbarous relic” (echoing Keynes’ characterization of the gold standard) as I phrased it more provocatively in some talks I gave on the subject. The connection between oil values and gas values had become attenuated, and often broken altogether, due in large part to the virtual disappearance of oil as a fuel for electricity generation, and the rise in natural gas in generation. Oil linked contracts were sending the wrong price signals. Bad price signals lead to inefficient allocations of resources.

Second, the increasing diversity in LNG production and consumption was mitigating the temporal specificities that impeded the development of spot markets. The sector was evolving to the stage in which participants could rely on markets to provide security of demand and supply. Buyers were not locked into a small number of sellers, and vice versa.

Third, a virtuous liquidity cycle would provide a further impetus to development of shorter term trading. Liquidity begets liquidity, and reinforces the willingness of market participants to rely on markets for security of demand and supply, which in turn frees up more volumes for shorter term trading, which enhances liquidity, and so forth.

Fourth, development of more liquid spot markets will make market participants willing to enter into contracts indexed to prices from those markets, in lieu of oil-linkages.

Fifth, the development of spot markets and gas-on-gas pricing will encourage the development of paper hedging markets, and vice versa.

Sixth, the emergence of the US as a supplier would also accelerate these trends. There was already a well-developed and transparent market for natural gas in the US, and a broad and deep hedging market. With US gas able to swing between Asia and Europe and South America depending on supply and demand conditions in these various regions, it was likely to be the marginal source of supply around the world and would hence set price around the world. Moreover, the potential for geographic arbitrages creates short term trading opportunities.

When pressed about timing, I was reluctant to make a firm forecast because it is always hard to predict when positive feedback mechanisms will take off. But my best guess was in the five year range.

Those predictions, including the time horizon, are turning out pretty well. There have been a spate of articles recently about the evolution of LNG as a traded commodity, with trading firms like Vitol, Trafigura, and Gunvor, and majors with a trading emphasis like Shell and Total, taking the lead. Here’s a recent example from the FT, and here’s one from Bloomberg. Industry group GIIGNL reports that spot volumes rose from 27 percent of total volumes in 2017 to 32 percent in 2018.

There are also developments on the contractual front. Last year Trafigura signed a 15 year offtake deal with US exporter Cheniere linked to Henry Hub. In December, Vitol signed a deal with newcomer Tellurian linked to Henry Hub, and last week Tellurian inked heads of agreement with Total for volumes linked to the Platts JKM (Japan-Korea-Marker).* Shell even entered into a deal linked with coal. There was one oil-linked deal signed recently (between NextDecade and Shell), but to give an idea of how things have changed, this met with puzzlement in the industry:

The pricing mechanism that raised eyebrows this week in Shanghai was NextDecade’s Brent-linked deal with Shell. NextDecade CEO Matt Schatzman said he wanted to sell against Brent because his Rio Grande LNG venture will rely on gas that’s a byproduct of oil drilling in the Permian Basin, where output will likely increase along with oil prices.

Total CEO Patrick Pouyanne said he didn’t understand that logic.
“Continuing to price gas linked to oil is somewhat the old world,” Pouyanne said on Wednesday. “I was most surprised to see new contracts linked to Brent, especially from the U.S. Someone will have to explain this to me.”

I agree! In fact, the NextDecade logic is daft. High oil prices that stimulate oil production will lead to lower gas prices due to the linkage that Schatzman outlines. If you have doubts about that, look at the price of natural gas in the Permian right now–it has been negative, often by $6.00/mmbtu or more. This joint-production aspect will tend to make oil and gas prices less correlated, or even negatively correlated.

But it’s hard to believe how much the conventional wisdom has changed in 5 years. The whitepaper was released in time for the LNG Asia Summit in Singapore, and I gave a keynote speech at the event to coincide with its release. The speech was in front of the shark tank at the Singapore Aquarium, and from the reception I got I was worried that I might get the same treatment from the audience as Hans Blix did from Kim Jung Il in Team America.

To say the least, the overwhelming sentiment was that oil links were here to stay, and that any major changes to the industry were decades, rather than a handful of years, away. Fortunately, the sharks went hungry and I’m around to say I told you so 😉

I surmise that the main reason that the conventional wisdom was that the old contracting and pricing mechanisms would be sticky was an insufficient appreciation for the nature of liquidity, and how this could induce tipping to a new market organization and new contract and trading norms. These were ideas that I brought from my work in the industrial organization of financial trading markets (“market macrostructure” as I called it), and they were no doubt alien to most people in the LNG industry. Just as ideas about spot trading of oil were alien to most people in the oil industry when Marc Rich and others introduced it in the 1970s.

Given the self-reinforcing nature of these developments, I believe that the trend will continue, and likely accelerate. Other factors will feed this process. I’ve written in the past about how some traditional contract terms, notably destination clauses, are falling by the wayside due to regulatory pressure in Japan and elsewhere. The number of sources and sinks is increasing, which makes the market thicker and mitigates further temporal specificities. The achievement of scale and greater trading opportunities will encourage investment in infrastructure, notably storage, that facilitates trading. Right now most LNG trading involves only one of the transformations I’ve written about (transformation in space): investment in storage infrastructure will facilitate another (transformation in time).

It’s been kind of cool (no pun intended, given that LNG is supercooled) to watch this happen in real time. It is particularly interesting to me, as an industrial organization economist, given that many issues that I’ve studied over the years (transactions cost economics, the economics of commodity trading, the nature and dynamics of market liquidity) are all present. I’m sure that the next several years will provide more material for what has already proved to be a fascinating case study in the evolution of contracting and markets.

*Full disclosure: My elder daughter works for Tellurian, and formerly worked for Cheniere. I have profited from many conversations with her over the last several years. One of my former PhD students is now at Cheniere.

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December 27, 2018

The Market Is Down! Round Up the Usual Suspects!

Filed under: Economics,Exchanges,HFT — cpirrong @ 7:38 pm

Every time there is a major market selloff–like now–there is a Casablanca-like rush to round up the usual suspects. Treasury Secretary Steven Mnuchin blamed the Volcker Rule and HFT. This WSJ article blames algos (including HFT), but throws the kitchen sink in for good measure.

Truth be told, virtually every major market drop is unexplained at the time, and even well after, which only spurs the search for villains and scapegoats. There was no obvious spark for the Crash of ’87, and in the years since, many suspects have been named but none have been convicted. The same is true of the Crash of ’29. Perhaps the best effort–interesting, but not definitive–is George Bittlingmayer’s attribution of Black Tuesday to an unexpected shift in antitrust policy under the Hoover administration. But that came 65 years after the event!

The most recent selloff is no exception. The WSJ article lists a variety of bearish developments, but any such exercise smacks of post hoc, ergo propter hoc “reasoning.” Further, the article quotes various people who claim that the price decline is difficult to square with fundamental economic data–welcome to the club! The same is true for 1987, 1929, and other major declines. Recall Paul Samuelson’s aphorism: the stock market predicted 10 out of the last 5 recessions.

Part of the difficulty is that stock prices depend on expected cash flows, and expected returns, both of which can vary due to factors that are difficult to observe in public data. Asset pricing economists have a lot of theories of time varying expected returns–hinging on theories of time varying risk premia–none of which have strong empirical support. Modest changes in risk premia/expected returns can cause big valuation changes. Recent conditions (political/geopolitical risk, monetary policy changes) plausibly have affected risk premia, but our ability to map these relationships is virtually nonexistent, so at best we can formulate largely untestable hypotheses.

And untestable hypotheses are effectively speculations and opinions, and like certain body parts, everybody has one.

Given these realities, most major asset price movements are difficult to explain.

I vividly remember in the aftermath of the 1987 Crash, when I was a PhD student at Chicago. Gene Fama distributed a Mandelbrot article to all PhD students. The article presented a simple model in which long periods of price increases are followed by crashes. As I recall, the essence of the model was that if good news was received today, it was likely that there would be good news tomorrow, but if good news was not received today, the likelihood of receiving good news tomorrow was lower. In essence, it is a regime switching model, and a switch in from a good news regime to a bad news regime leads to a big valuation change, due to the transition probabilities.

Fama’s point in distributing the article was to emphasize that discontinuous changes in prices are not inconsistent with a “rational” market. Seemingly small fundamental shifts can lead to big price changes.

Again, a hypothesis–and a virtually untestable one.

What about blaming algos, a la Mnuchin and the WSJ? Well, blaming HFT–directly, anyways–makes no sense. Yes, HFT is programmed to respond to market signals, but it is negative feedback by nature. It tends to be stabilizing, not de-stabilizing.

There may be an indirect connection: HFT liquidity supply can dry up when order flow becomes toxic, and the decline in liquidity makes prices more sensitive to order flow, leading to larger price movements. The Flash Crash is a classic example of this. But that’s not unique to HFT. It is inherent to market making, and HFT basically puts what is in a market maker’s (e.g., old-time floor trader’s) synapses into code. Market makers pulling back–or shutting down altogether–occurred long before markets went electronic, and before anybody even dreamed of HFT.

If liquidity has declined–and the WSJ points to some limited evidence on this point–it is likely a response to market conditions, rather than a cause thereof. It’s something that occurs in almost every period of elevated volatility. It’s more of an effect of some common cause than an independent exogenous cause.

Further, by virtually every measure, the increasing automation in markets has led to greater liquidity. Much of the bitching–including in some quotes in the WSJ article–emanates from traditional liquidity suppliers who have lost out to more efficient competitors. Believe me, if order flow had become more toxic, these guys would have pulled back too, and probably more severely than HFT has done.

What can exacerbate market movements is positive feedback trading strategies. Portfolio insurance during the 1987 Crash is a classic example. The WSJ article points at algorithmic momentum trading strategies, and indeed these are positive feedback in nature. But they are not unique to algos: meatware implemented momentum/trend following strategies long before they were embedded in software. Momentum trading is something else that long predates the rise of the machines.

Several quotes in the WSJ article made me laugh. One was: “’Human beings tend not to react this fast and violently.’” Really? Heard of Black Monday? Black Tuesday? Silver Thursday? Black Friday? I’m sure there’s a Color Wednesday to fill in the week, but none comes to mind. Regardless, the point remains: human beings reacted rapidly and violently long before trading machines were even dreamt of.

Here’s another: “Today, when the computers start buying, everyone buys; when they sell, everyone sells.”

This is called “not an equilibrium.”

The bottom line is that the stock market sometimes decline substantially, without any obvious cause. Indeed, the cause(s) of some of the biggest, fastest drops remain elusive decades after they occurred. This is true across virtually every institutional and technological trading environment, making it less likely that any particular selloff is uniquely attributable to a change in technology. Furthermore, large market moves in the absence of any decisive event or piece of news is not inconsistent with market “rationality”, or due to some behavioral anomaly (which is inherently human, by the way).

But humans crave explanations for phenomena like big movements in the stock market, and this demand calls forth supply. That the explanations are for the most part untestable and hence not scientific only means that there is little check on this supply. Anybody can offer an explanation, which likely cannot be proven wrong. So why not? But if you understand that mechanism, you should also understand that you shouldn’t pay much attention.

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December 5, 2018

Judge Sullivan Channels SWP, and Vindicates Don Wilson and DRW

Filed under: Derivatives,Economics,Exchanges,Regulation — cpirrong @ 10:52 am
After two years of waiting after a trial, and five years since the filing of a complaint accusing them of manipulation, Don Wilson and his firm DRW have been smashingly vindicated by the decision of Judge Richard J. Sullivan (now on the 2nd Circuit Court of Appeals).

Since it’s been so long, and you have probably forgotten, the CFTC accused DRW and Wilson of manipulating IDEX swap futures by entering large numbers (well over 1000) of orders to buy the contract during the 15 minute window used to determine the daily settlement price.  These bids were an input into the settlement price determination, and the CFTC claimed that they were manipulative, and intended to “bang the close.”  The bids were above the contemporaneous prices in the OTC swap market.

The Defendants claimed that the bids were completely legitimate, and that they hoped that they would be executed because the contract was mispriced because of a fundamental difference between a cleared, marked-to-market, daily-margined futures contract and an uncleared swap.  The former has a “convexity bias” and the latter doesn’t.  DRW did some IDEX deals with MF Global and Jefferies at rates close to the OTC swap rate, which it thought were an arbitrage opportunity, and they wanted to do more.  And, of course, they  received margin inflows to the extent that the contract settlement price reflected the convexity effect: thus, to the extent that the bids moved the settlement price in that direction, they expedited the realization of the arbitrage profit.

Here was my take in September, 2013:

Basically, there’s an advantage to being short the futures compared to being short the swap.  If interest rates go up, the short futures position profits, and the short can invest the resulting variation margin inflow at the higher interest rate.  If interest rates go down, the short futures position loses, but the short can borrow to cover the margin call at a low interest rate.  The  swap short can’t play this game because the OTC swap is not marked-to-market.  This advantage of being short the future should lead to a difference between the futures yield and the swap yield.

DRW recognized this difference between the swap and the futures.  Hence, it did not enter quotes into the futures market that were equal to swap yields.  It entered quotes at a differential to the swap rate, to reflect the convexity adjustment.  IDC used these bids to determine the settlement price, and hence daily variation margin payments.  Thus, the settlement prices reflected the convexity adjustment.  Not 100 percent, because DRW was trying to make money arbing the market.  But the settlement prices were closer to fair value as a result of DRW’s quotes than they would have been otherwise.

CFTC apparently believes that the swap futures and the swaps are equivalent, and hence DRW should have been entering quotes equal to swap yields.  By entering quotes that differed from swap rates, DRW was distorting the settlement price, in the CFTC’s mind anyways.

Put prosaically, in a way that Gary Gensler (the lover of apple analogies) can understand, CFTC is alleging that apples and oranges are the same, and that if you bid or offer apples at a price different than the market price for oranges, you are manipulating.


The reality, of course, is that apples and oranges are different, and that it would be stupid, and perhaps manipulative, to quote apples at the market price for oranges.

Here’s Judge Sullivan’s analysis:

[t]here can be no dispute that a cleared interest rate swap contract is economically distinguishable from, and therefore not equivalent to, an uncleared interest rate swap, even when the two contracts otherwise have the same price point, duration, and notional amount.  Put another way, because there is some additional value to the long party . . . in a cleared swap that does not exist in an uncleared swap, the economic value of the two contracts are distinct.

Pretty much the same, but without the snark.

But Judge Sullivan’s ruling was not snark-free!  To the contrary:

It is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented that product.

I also wrote:

In other words, DRW contributed to convergence of the settlement price to fair value relative to swaps.  Manipulative acts cause a divergence between the settlement price and fair value.

. . . .

In a sane world-or at least, in a world with a sane CFTC (an alternative universe, I know)-what DRW did would be called “arbitrage” and “contributing to price discovery and price efficiency.”

Judge Sullivan agreed: “Put simply, Defendants’ explanation of their bidding practices as contributing to price discovery in an illiquid market makes sense.”

Judge Sullivan also excoriated the CFTC and lambasted its case.  He blasted it for trying to read the artificial price element out of manipulation law (“artificial price” being one of four elements established in several cases, including inter alia Cargill v. Hardin, and more recently in the 2nd Circuit, in Amaranth–a case that was an expert in).  Relatedly, he slammed it for conflating intent and artificiality.  All of these criticisms were justified.

It is something of a mystery as to why the CFTC chose this case to make its stand on manipulation.  As I noted even before it was formally filed (my post was in response to DRW’s motion to enjoin the CFTC from filing a complaint) the case was fundamentally flawed–and that’s putting it kindly.  It was doomed to fail, but the CFTC pursued it with Ahab-like zeal, and pretty much suffered the same ignominious fate.

What will be the follow-on effects of this?  Well, for one thing, I wonder whether this will get the CFTC to re-think its taking manipulation cases to Federal court, rather than adjudicating them internally in front of agency ALJs.  For another, I wonder if this will make the CFTC more gun-shy at bringing major manipulation actions–even solid ones.  Losing a bad case should not be a deterrent in bringing good ones, but the spanking that Judge Sullivan delivered is likely to lead CFTC Enforcement–and the Commission–quite chary of running the risk of another one any time soon.  And since enforcement officials are strongly incentivized to, well, enforce, they will direct their energies elsewhere.  I would therefore not be surprised to see yet a further uptick in spoofing actions, an area where the Commission has been more successful.

In sum, the wheels of justice indeed ground slowly in this case, but in the end justice was done.  Don Wilson and DRW did nothing wrong, and the person who matters–Judge Sullivan–saw that and his decision demonstrates it clearly.

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