Streetwise Professor

I am working on a project about the economics of commodity trading firms.  One of the interesting questions is what physical assets commodity trading firms own.  In my research on this question, in an attempt to get some historical context, I turned to the excellent Federal Trade Commission Report on the Grain Trade, a five volume study released in the early-20s.  (There is reputedly a sixth volume on manipulation which I and others-Jerry Markham, for one-have feverishly searched for without luck.)   This is truly an excellent piece of work.  Many of the analyses are off, but as a detailed portrait of the grain trade in the 1900-1920 period, it cannot be beat.  Unfortunately, there is nothing comparable for other time periods.

In perusing Volume I, on country grain marketing, I came across this choice quote from the president of the CBOT in 1887:

The alliance between railroads and elevators has resulted in reaching out after millions of bushels not naturally tributary [to Chicago] and when gathered here preventing it by such tricks of the trade as you are familiar with from ever getting away again as long as storage can be collected on it.

. . . .

The grain bought elsewhere by warehouse proprietors is promptly sold to you here on future delivery, which, however, you can only get on payment of such premiums as the urgency of demand may enable them to exact.

. . . .

While the elevator proprietors are willing to pay 1 cent per bushel more for grain to “go into store” in their own warehouses than the market price of the same grain in store . . . is conclusive that the first storage charge is not legitimate, and also that the subsequent terms of storage are unduly profitable.

Replace “grain” with “aluminum”, and you could run this as a news story in 2013.  Goldman’s operations at Metro are almost identical to the operations of the warehousemen in Chicago that President Wright fulminated about 126 years ago.

The FTC study also notes that shuttling grain between warehouses was a part of the game more than a century ago.  It quotes Taylor’s magesterial history of the CBOT, describing an event from 1896:

The Armour Elevator Co. was charged with having transferred 1,200,000 bushels of wheat from one part of the north side system to another, without inspection, on such dates that the receipts resulting therefrom were just regular on the delivery day, May 1.

And not a bankster in sight.  (It is an interesting coincidence that 1896 was the year Goldman-Sachs was invited to join the NYSE.)

The morals of the story.  First, the ability to play warehouse games is inherent to the business of public warehousing of commodities. Second, banks are not uniquely susceptible to playing those games: when conditions are right, whoever owns the warehouses can play the games.  Third, systems of self-regulation are often incapable of addressing these problems.

On the last point, it is important to remember that the seminal case in the history of regulation in the United States, Munn v. Illinois, grew out of the warehousing battles in Chicago during the Civil War and its immediate aftermath.  The Supreme Court decided that the State of Illinois had the power to regulate grain warehouses, and this decision provided the basis for subsequent exercise of regulatory powers by states and the Federal government.

In other words, what is old is new again.  Journalists and regulators and legislators act as if the kinds of games played today are somehow new and unique.  They aren’t.  The commodities business hasn’t changed that much in a century and a half.  The things that were good, bad, and ugly in 1869 are around today, and will be around in 2069 and 2169.

Going through my news clips this morning made me feel like I was in a video game fighting off hordes of zombies. Commodity market critic zombies.

Zombie #1: Gretchen Morgenson, with an article on RINs. It is a farrago of innuendo and idiocy.  Really, it is 9 pages long, and I could write 20 listing all the fundamental flaws.  I don’t have the energy for that (no pun intended), so I’ll limit myself to the greatest hits.  In a nutshell (emphasis on the nut), it is a typical Morgenson piece: if banks are involved it’s bad;  if people are speculating it’s bad; if there are unintended consequences of government policies, it’s not the fault of the stupid government, it’s the fault of those who have to deal with the stupidity, and who figure out ways to make money out of artificial bottlenecks created by the stupidity.

The article is an assemblage of assertions and allegations totally lacking in evidence.  Morgenson alleges JP Morgan has speculated in RINs.  Which it denies.  She insinuates that the market might be manipulated, but provides no evidence.  She mentions a “corner”, but obviously doesn’t understand how a corner works: that would require the accumulation of a long futures/forward position, but she provides no evidence that anyone has accumulated such a position. (CME shows a grand total of a whopping 558 RIN contracts outstanding.)

Morgenson is obviously very suspicious of speculation-kind of funny, since her entire article is completely speculative-and suggests that speculation distorts-i.e., manipulates-prices.

Assume arguendo that Morgan or some other evil bank did figure out that the blend wall would hit and that RINs would become more valuable as a result, and hence accumulated them.  If it is right, it will profit when prices rise.  That doesn’t mean it caused the prices to go up. Prescience isn’t the same as manipulation.

Morgenson should be forced to write on the blackboard, Bart Simpson-like:

Speculation≠Manipulation

Speculation≠Manipulation

Speculation≠Manipulation

Speculation≠Manipulation

Speculation≠Manipulation

. . . .

The real problem here is something that makes only a cameo appearance in Morgenson’s story: the artificial RIN bottleneck created by an idiotic government policy that was adopted based on a forecast of future gasoline consumption (‘cuz yeah, we’re so good about making energy forecasts) and an ignorance of the technological realities of ethanol.  It is inevitable that someone would figure that out, and make money off it.  Inevitable.

Quite honestly, you’ll learn more about the reality of RINs from one of those ubiquitous Hitler videos than the New York Times (h/t @izakaminska):

Speaking of tow-headed troublemakers named Bart . . . that brings us to Zombie #2. Taking a break from edifying us all about the evils of HFT, polymath Bart Chilton went off on the evils of banks in commodities:

Mr. Chilton, in prepared remarks viewed by The Wall Street Journal, said it’s “nearly impossible to figure out exactly what banks own.” He said the CFTC can see what banks are trading in derivatives markets tied to commodities, but doesn’t know what physical assets like oil tankers and aluminum they hold.

“Unless we can see that, we can’t reasonably and responsibly protect against market manipulations,” Mr. Chilton, a Democrat, plans to say in speech to a business association in Michigan Saturday.

The CFTC has been investigating firms that store and deliver aluminum, including Goldman Sachs and J.P. Morgan, after complaints from companies that use the metal. Beer and soda companies, can makers and other end users said firms that warehouse aluminum inflate prices by holding onto it for longer than necessary.

Banks that trade commodities have come under fire from government officials, companies and consumer groups who say they exert too much influence over markets for some raw materials.

Mr. Chilton plans to raise that concern in the speech, saying banks that own commodities and trade in derivatives based on the prices of those commodities have a potential conflict of interest.

“The prices of commodities are supposed to be based upon supply and demand,” Mr. Chilton plans to say. “However, what if you control, or have significant influence upon, the supply or the demand?”

Mr. Chilton also is expected to say the public should be able to “easily locate and click on a link to find out” what physical commodities banks own. He will also call on lawmakers to rein in banks’ role in the buying and selling of physical commodities and not leave the decision to the Federal Reserve.

Click on a link to find out physical positions.  Right, Bart.  Uhm, you can’t even do that for futures positions.  And care to share any evidence demonstrating that any banks exert a “significant influence” on supply and demand in any energy commodity?  Their market shares in physical tend to be very small.  Check out the stat on Morgan Stanley in the Morgenson article-Montaigne markets 2.5 percent of gasoline in the US. Big freaking whoop. JP Morgan serves one piddling refinery on the East Coast.  Sheesh.

Conflict of interest: the classic problem raised by people who don’t have a real argument. Speaking of real arguments, how’s this for a doozy:

“Maybe it’s just me, but I don’t think the American public wants banks owning grain elevators, electric companies, large warehouses or shipping and distribution interests,” Chilton said in the speech.

Wow.  Let no one ever question Bart’s ability to make a substantive economic argument, backed with empirical evidence.

Zombie #3: Lina Khan, in The New Republic. Again, far too much idiocy to deconstruct in detail.  One illustrative example: the insinuations about “inside trading.”  Trading on private information is quite different than inside trading.  The later involves the violation of fiduciary duty or the theft of corporate information that belongs to shareholders.  Trading on private information is the lifeblood of virtually all markets.  It’s called “price discovery.”

The huffing and puffing about Cargill and Trafigura operating hedge funds is another faux controversy.  These funds are regulated just like funds operated by other entities.  Moreover, there are Chinese walls restricting the flow of information between the company-managed funds, and other trading operations.

Furthermore, Khan makes broad allegations of manipulation.  I assure you that yes, manipulation does occur in commodities markets, and that trading firms sometimes execute these manipulations.  But manipulation is subject to regulation (contrary to the statements that these markets are unregulated).  Moreover, the allegations of manipulation in the article are amazingly vague, and unsupported by any evidence.  The article is a classic illustration of the Clayton Definition of Manipulation: Any Practice That Doesn’t Suit the Person Speaking at the Moment.

For instance:

Experts warn that this degree of involvement across the entire production cycle gives a handful of sizable firms even greater unchecked power over our most basic goods. “Clearly if you control the physical stock and stand to gain from managing the release of that stock, it would be foolish to expect companies not to take advantage of that,” said Sophia Murphy, senior adviser at the Institute for Agriculture and Trade Policy and author of “Cereal Secrets,” a report on the major grain traders.

Part of the trouble is that no public body oversees global physical stocks. Andres Missbach, co-author of Commodities: Switzerland’s Most Dangerous Business, said the vast storage capacity these companies have amassed equips them to create artificial shortages in the short-term if they wish. “We have no idea if they are manipulating,” he said. “We can only say they have the capacity to, and that there is no regulator ensuring that they are not.”’

Unchecked power? Seriously?  What fraction of global physical stocks does any firm own?  The article says that Glencore “controls” 50 percent of the trade in some commodities.  If you read Glencore’s statements, they refer to “freely traded” supplies, which are a fraction-and often a small fraction-of total supplies.  For commodities like oil, the biggest trading firms account for 5 percent or less of total supply.

“We have no idea if they are manipulating.”  LOL.  Remember what Judge Easterbrook wrote: “The undetected manipulation is the unsuccessful manipulation.”

I am quoted in the article, but my quotes are rather innocuous. Khan tried to get me to support her trading-firms-are-evil line, which I obviously declined to do: in fact, I disagreed strongly. Those quotes didn’t make the story, naturally. Yeah. No agenda there.

One last thing. All three are rather strange zombies, because they are apparently afraid of the dark.  Each mutters ominously about dark markets, trading in the dark, blah blah blah.

News flash: the “lit” transparent futures markets are the exception that proves the rule.  Virtually all commodity markets are bilateral search markets with little pre- or post-trade transparency.  This makes good economic sense given the heterogeneity of commodities, the idiosyncrasies of and variability in supply and demand for specific varieties, the desire to customize terms, and the low rate of transaction flow in any particular variety or at any particular location.  Commodity trading firms essentially customize commodities by transporting, refining, blending, storing them, etc.  The one size fits all standardization that is necessary to support continuous, centralized markets (like futures markets) is completely maladapted to the trade of actual physical commodities.  Physical markets and futures markets serve vastly different functions, and accordingly operate on vastly different lines.

Zombies that are afraid of the dark.  Too funny. Get a frickin’ night light, Gretchen, Bart, and Lina.

It never ceases to amaze me how commodities bring out the loons, and cause people to lose all ability to reason.  Like zombies.  Like Gretchen, Bart, and Lina.

I’m supposed to be in Geneva right now, but United Airlines decided that what I really wanted to do was to sit around Dulles for 5 hours waiting for them to figure out they couldn’t fix a mechanical problem, and then to sit around a hotel for a day waiting for today’s flight.  Luckily I was able to get the last seat on that plane, so I don’t have to do something like Dulles-Newark-Frankfort-Geneva like some of the other folks on the canceled flight.

So that gives me some time to catch up on reading (and blogging).  And it takes some time to read this loooonnnnggggg Bloomberg encomium to Gary Gensler, which describes his valiant St. George-like battles against the big, bad banking dragons.

The basic theme is that anything the banks don’t like must be good, and anything the banks do like must be bad. The profile confirms that’s Gensler’s view of the world, and Silla Brush and Robert Schmidt pretty much adopt that template.

If only the world were that simple.  Yes, regulatory capture by major financial institutions is a major danger, and happens.  Freddie and Fannie illustrate that in spades, for sure.  So one should always approach the lobbying efforts of large incumbent players, especially large financial institutions, with incredible skepticism.

But at the same time, one has to remember that regulators do stupid things, and adopt regulations that are grossly counterproductive and impose costs far in excess of any conceivable benefits.  Banks potentially subject to such regulations reasonably fight against those, which means that bank opposition to a regulation is not a sufficient statistic to determine whether it is a good or bad policy.

The two regulations that Gensler fought for that are covered extensively in the Bloomberg piece are definitely examples of bad regulations.  The article devotes the largest share of pixels to the battle over the request for quote battle.  You may recall that I named Gensler’s RFQ proposal as the Worst of the Worst of Frankendodd.  The SEF mandate itself is seriously misguided, and mandating how many quotes those wanting to buy or sell a swap must obtain is totally cracked: it is predicated on the paternalistic belief that those who are doing the trading don’t have the ability to make the appropriate trade-offs between information leakage and greater competition to get their business.

The article also details the battle over the de minimis level of trading activity that would determine who has to register as a swap dealer, and thereby incur the additional compliance, collateral, and capital burdens.  Gensler wanted the level set at a piddling $100 million, which would catch pretty much everyone of even modest size in the CFTC’s swap dealer web.

If the purpose of the swap dealer designation is to reduce systemic risk, the level of trading activity is a very poor means of determining which entities should be subject to the higher level of regulation and scrutiny.  And seriously, many firms that must register as swap dealers under the $3 billion level eventually settled upon-against Gensler’s furious opposition-are not systemically risky, either.

Relatedly, the article identifies futurization as an end run around regulation.  As I’ve written before, futurization is a predictable response to regulations that treat economically identical instruments differently.  Swaps are treated more punitively, due to more onerous collateral standards, and because swap trades count towards the de minimis swap dealer trading level but identical futures don’t.  So, duh, people will choose futures over swaps that are otherwise economically equivalent.  If this also allows firms that aren’t systemically important to escape the burdens of swap dealer registration, that’s all for the better.

Moreover, it should be noted that futurization has been over-hyped.  Its main effect has been in energy.  There is no way that the real swap dealers who are systemically important-the JP Morgans, Citis, etc.-are going to be able to avoid being designated as swap dealers by switching their business to futures.  (Don’t interpret that to mean that I believe that swap dealer designation will materially reduce systemic risk.)  A lot of their business is in instruments for which futures are not a viable substitute.  In contrast, in energy (and commodities generally) for the bulk of the business futures and swaps are close substitutes.

Indeed, there is an irony here.  Large quantities of energy swaps were “NYMEX lookalikes” virtually equivalent to futures traded on NYMEX (and then the CME after it acquired NYMEX): firms traded the swaps because under the CFMA, they were subject to a lighter regulatory touch than futures.  So the energy swaps business was largely a product of regulation, and when the regulation changed, the business changed.  The business went to where the regulatory burden was lowest.  Go figure.  Given that part of the premise of Frankendodd is that the futures regulatory structure was the right model that made an appropriate trade off between costs and benefits, the migration to futures should be considered an improvement even by Frankendodd supporters.  It brought the business back to where it should have been all along, according to the advocates of Frankendodd.

The article also writes a lot about extraterritoriality, a subject that makes my eyes glaze over.  The most revealing aspect of this battle is Gensler’s regulatory imperialism, and his stubborn resistance to near universal opposition.  In Gensler’s view-and in the article-everybody was out of step but Gary.

One interesting omission (as if you think anything could be omitted in a 20 page article) is anything related to position limits, another Gensler hobby horse.  Perhaps this is because he eventually prevailed in the Commission, and got it to pass a rule to his liking, so it doesn’t fall into the category of where Gensler’s views lost out to intense political opposition.  But it does fall into the category of a regulation that was opposed vigorously by the banks, who prevailed-at least for now-in getting the regulation stopped.  The difference is that they fought and won that battle in court (though appeals are ongoing).

The article does devote some coverage to the systemic risk of clearinghouses.  Ironically, it indicates that Gensler is aware that CCPs concentrate counterparty risk, which can be problematic.  This is quite contrary to many of his public statements on the issue, including in an FT oped mentioned in the Bloomberg piece, in which Gensler suggests that CCPs are a magic box that makes risk disappear.  So was he misinformed before, and has he come to a better understanding of the way things really work?  Or was he deceptive in his earlier advocacy?

It’s good to know that there is some recognition of this issue, but sadly, the diagnosis of how CCPs contribute to systemic risk is cramped and simplistic.  Yes, the failure of a CCP is a major worry, but as I point out in the paper I will present in Paris next week (assuming UA cooperates!) measures to keep CCPs immune from failure can create systemic risks too.  There is too little systematic thinking about systemic risk.

In politics and journalism, good versus evil narratives are easy and comforting.  The problem with that is that when you are talking about something as complicated as derivatives regulation, the world isn’t that simple.  Rent seeking and capture happen, resulting in industry-friendly regulations that may create or perpetuate systemic risks, or fail to mitigate real problems.  But regulatory stupidity happens too.  This is especially likely when you have a regulatory crusader who believes that he is on the side of good fighting evil, and who approaches complicated markets with a very narrow set of simple beliefs, rigidly held: Transparency good! More transparency better! (Ironic, given that SEFs reduce transparency about the identity of counterparties, even if they increase pre- and post-trade price transparency).  Clearing good!  Banks bad and anti-competitive!

As you know, I believe that the intellectual assumptions underlying Frankendodd are fundamentally flawed.  The adverse consequences of those fundamental bugs are only exacerbated when the individual with the primary responsibility for implementing the law believes the bugs are actually features, and approaches his task with a Jesuitical zeal that treats any opposition as the result of malign and self-interested motivations.  Gensler’s rigidity and self-righteousness, and apparent unwillingness to contemplate the possibility that people were opposing him because, he was, you know, actually wrong, have made the process costlier and more contentious, and made the resulting regulations more costly and less beneficial.  Consequently, Gensler’s defeats on these issues-which are minor in the scheme of things, really-are to be welcomed, not lamented.

A couple of people have expressed interest in my paper on clearing mandates and systemic risk.  So here it is.

In a nutshell: the arguments that clearing (and non-cleared derivatives) collateral mandates will reduce systemic risk are fundamentally flawed.  Ironically, this is because the analyses do not take a truly systemic approach.

My counterarguments will be familiar to those reading my posts on clearing over the past five years (!) but this piece lays them out in one place.  One stop shopping, as it were.  Or maybe one stop slashing.  (One of my lawyer clients remarked to his partner yesterday that I wrote “slashing” blog posts.  I said “Don’t leave out the burning!”)

The BIS has released a report titled “Macroeconomic impact assessment of OTC derivatives regulatory reforms.” It concludes that the benefits of these reforms-including Frankendodd-will greatly exceed the costs, because (a) financial costs of a financial crisis are immense, and (b) the reforms will greatly reduce the probability of a financial crisis.  Specifically:

In its report, the MAGD focuses on the effects of (i) mandatory central clearing of standardised OTC derivatives, (ii) margin requirements for non-centrally-cleared OTC derivatives and (iii) bank capital requirements for derivatives-related exposures. In its preferred scenario, the group found economic benefits worth 0.16% of GDP per year from avoiding financial crises. It also found economic costs of 0.04% of GDP per year from institutions passing on the expense of holding more capital and collateral to the broader economy. This results in net benefits of 0.12% of GDP per year. These are estimates of the long-run consequences of the reforms, which are expected to apply once they have been fully implemented and had their full economic effects.

Don’t believe it for a minute.  The methodology of the analysis is irretrievably flawed.  The net benefits are the free-est of lunches, because the report does not take into account the redistributive aspects of the collateralization and netting that results from clearing, capital, and uncleared derivatives collateral mandates.  That is, it fails to recognize that the reduction in counterparty credit losses on derivatives that result from the “reforms” are accompanied by an increase in losses suffered by somebody else.  It accounts for a transfer as a social gain.

In broad strokes, the BIS analysis goes as follows.  Financial institutions are connected to one another by OTC derivatives trades.  One way of measuring this interconnection is the CVA-the credit value adjustment on derivatives trades.  The CVA is (roughly speaking) loss given default per dollar of exposure times credit exposure times the probability of default.  If a given bank, B say, takes a hit of X to its balance sheet, due to a bad investment, or a rogue trader loss, or whatever, its probability of default goes up.  This raises the CVA.  This is immediately recognized as a mark-to-market loss, dollar for dollar, by its counterparties.  These counterparties tend to be systemically important banks, and the loss makes them more leveraged.  The greater leverage makes them riskier, and more subject to default.  This raises their probability of default, which imposes CVA losses on their counterparties, and on and on.  In this way, a shock to one bank propagates throughout the system, and feedback effects intensify the original effect.  The end result is that major financial institutions become more leveraged, and the more leveraged the system, the more prone it is to a very costly crisis.

But Frankendodd lurches to the rescue!  By collateralizing and increasing netting*, Frankendodd reforms reduce credit exposure in derivatives.  Therefore, the CVA hit from a given rise in the probability of default is smaller.  The leverage in the system doesn’t rise nearly as much when bank B takes the hit of X to its balance sheet.  So a given shock has a substantially smaller impact on systemic leverage, and hence systemic risk.  Yay!

Not so fast, people.  Notice the flaw in the logic?  Remember what started the cascading effect in the pre-Frankendodd world: an increase in the probability of default at B due to some adverse shock to its balance sheet.  Collateral and clearing mandates reduce the exposure of derivatives counterparties to this shock.  But a default doesn’t just affect derivatives counterparties: it hurts all of B’s creditors.  Roughly speaking, the total cost incurred by B’s creditors as a result of an increase in the probability of default due to the loss of X is loss given default times total liabilities times the change in the probability of default.  Given total liabilities, this does not change when derivatives are collateralized or netted more extensively.  This, in turn, means that the decline in derivatives CVA that results from more derivatives collateral and netting is matched by an increase in losses suffered by other creditors.  The “reforms” shift around the losses: they do not reduce them in aggregate.

That is, the “reforms” don’t reduce the losses that result from the balance sheet shock that raises B’s probability of default: they redistribute them.  Note, moreover, that many of the same big financial institutions that benefit from the decline in derivatives CVA are hurt by the loss on B’s other liabilities, because these institutions are exposed to one another through a variety of claims, not just derivatives.  Moreover, some of the others (non-bank creditors) that suffer from the redistribution may be systemically important too: money market funds that invest in the short term debt of financial institutions (including B) are one example.  Repo is another example.  Thus, the overall effect of Frankendodd and EMIR on systemic risk is quite equivocal.  It shifts around losses, and there is no guarantee that the shift in losses improves the stability of the financial system.

But the BIS study does not treat the redistributive effects of the derivatives reforms.   It treats them has a net gain.  This is fundamentally, basically, and irredeemably wrong.  Wrong, wrong, wrong.  When evaluating systemic risk, it ignores the systemic redistribution of losses.  As a result, it overestimates the gains of the regulatory changes.

To a first approximation, given the redistributive nature of their effects, the benefits of the reforms is zero.  The BIS recognizes that they involve costs.  Meaning that to a first approximation, Frankendodd and EMIR reduce wealth, rather than increase it.

But that’s just a first approximation.  To understand fully the effects, you’d have to know how losses are redistributed, and the systemic importance of those who suffer bigger losses and of those who realize smaller ones.  You’d also have to understand how financial contracts will change in response to the new set of creditor priorities inherent in the Frankendodd and EMIR rules.   Financial contracts-capital structures, if you will-will change in response to the new rules.  Claims will be repriced.  There is going to be a new, different equilibrium structure of financial contracts.  Maybe this new structure is less fragile.  Maybe it is more so.  I don’t know: the system is so complex that it will respond to this big shock in surprising ways.  All I do know is that this where you need to look to figure out the effects of the so-called reforms on systemic risk, and this ain’t where the BIS looks.  It counts benefits conferred on some subset of claimants, while ignoring the costs imposed on others (that are approximately equal in magnitude).

In other words, the BIS is hawking a free lunch, and as Friedman said, there ain’t no such thing.

The BIS study also has a particular model of systemic risk: the counterparty credit contagion model.  B takes a hit, that spreads to C, D, and E, which then spreads to F, G, and H, and on and on, until most everyone drops dead like Aztecs fell to the smallpox.  This is a common way of formalizing systemic risk, but reminds me of the story of the drunk looking for his keys under the lamppost because the light is better there, not because he lost them there.  If you look at the history of financial crises, they almost never look like the systemic crises in these contagion models.  An idiosyncratic shock at one institution doesn’t bring a house of cards crashing down.  The collapses of individual institutions (Bear, Lehman) are symptoms of a deeper-and systemic-rot.

In sum, the BIS analysis is fundamentally flawed, and hence gives a wildly misleading estimate of the social benefits of the clearing and collateral mandates embedded in Frankendodd and EMIR and regulations adopted by other G20 nations.  It is a sad, sad example of a reputable institution falling prey to free lunch fallacies.

It is particularly sad because it’s not as if this hasn’t been pointed out before.  I raised the problem five years ago.  So you may say-well, who are you anyways?  Well, Harvard’s Mark Roe, one of the most accomplished bankruptcy scholars in the legal academy, has made the same point (and graciously cited my work).  And, truth be told, it is a staple of the bankruptcy literature.  And it’s also sad because I hear such “logic” over and over from regulators (e.g., scholars and policymakers at the Fed).  They presume to identify systemic benefits based on analyses that look at only a portion of the system.

And speaking of sad.  Could the BIS please spring for a typesetting program like LaTeX that prints readable equations?  Please?

* It is by no means clear that moving more trades to clearing will reduce credit exposures in derivatives via netting, especially given the fragmentation of CCPs by product and jurisdiction.  CCPs permit multilateral netting, but (a) bilateral trades can be compressed multilaterally, and (b) cross-product netting of exposures within dealer books can be larger than multilateral netting in single-category CCPs.  But that’s really a secondary issue.  The most important thing to remember is that the primary effect of netting is to redistribute default losses from derivatives counterparties to non-derivatives creditors.

Nasdaq shut down for 3 hours yesterday, the second electronic trading SNAFU of the week (the first being the Goldman option fiasco).  The problem?  Another example of the effects of a SLOB (simulacrum of a limit order book).  One of the links in the US SLOB is the SIP (Security Information Processor) connecting NYSEArca and Nasdaq.  This sends information about quotes from one exchange to the other.  This information is necessary to link the markets: in order to prevent locks and crosses, and to direct orders to the best priced market, each venue needs to know the quotes at the others.  According to Nasdaq, irregularities in the SIP were causing problems with its system, so it shut down to prevent a more catastrophic failure.

Moral of the story: links are major points of failure in a SLOB.  (Though it is interesting to note that on the same day Globex was displaying crossed markets in the bean complex, and Globex is a true CLOB not a SLOB.  But trading continued.)

My first thought on hearing of the shutdown was a SLOB problem.  My second was hacking.  There has been a spate of stories of late about exchanges being major potential targets of hackers/cybercriminals.

This is one of the reasons why I take an interest in Appelbaum, Snowden, Anonymous, etc.  Exchanges, and financial infrastructure generally, are major targets of these psychopaths for at least a couple of reasons.  First, some are just criminals, who like Willie Sutton target banks and the like because that’s where the money is.  Second, the hacker movement is a hotbed of anti-capitalist ideology that motivates attacks on capitalist institutions.

Meaning that the defenses of our financial infrastructure are vitally important.  And this is another source of major concern, which the Snowden affair puts front and center.  Infosec workers are recruited from the same milieu as the hackers.  The membrane between hackers on the outside and supposed defenders on the inside is very permeable.  There is lots of talk about the color of hacker hats, but ethically and ideologically the distinctions between black, white, and grey hats are quite blurry, and the boundaries are transgressed often.

Snowden is a classic example of that.  Former head of the NSA, General Hayden, said that perforce NSA and the government generally has to recruit from this group, but find ways to protect from those with a “romantic attachment to absolute transparency at all costs.”  Yes, the transparency romantics are a potential problem, but I think they’re the least of our worries: transparency romanticism is often a public pose for those motivated by malign anti-US and anti-capitalist beliefs.

The narcissism and grandiosity that Snowden exhibits are also all too common in this community, both inside government and financial institutions, and outside.  Indeed, there is a very strong and widespread tendency of these people to view themselves as superior in some way, and justified in acting as judge, jury, and executioner when it comes to the release of information, and operations against targets that violate their highly tuned-and self-righteous-moral senses.  Again, Snowden is a perfect example: he arrogated to himself the ability to decide what was illegal and immoral.  So did Bradley Manning, though he (and yes, he is still a he and he was a he when he made this statement, so I’m passing on the Chelsea thing) repudiated that in his pre-sentencing statement.

Indeed, this is a common theme in the infosec community.  Take a look at the attached video by a Pied Piper of this community, ex-priest (and, alas, University of Chicago grad) Richard Thieme.  (H/t @libertylynx, who also raised many of the points below.) This guy is lionized in this community.  He matters.  He is viewed as the voice of many. Check out the fawning, personality cultish comments to the video.

Thieme basically asserts that infosec specialists answer to a higher law, in part because there is a nexus between law enforcement and criminality, and in part because traditional legal distinctions (e.g., foreign vs. domestic) have been obliterated by technology and shadowy, scary supra-state actors.  Check out the rants around minute 32:00.  And for a dose of virulent anti-bank rhetoric, which really has to be heard to be believed, fast forward to minute 43 or so.

You know that there are infosec people in banks-and exchanges-who idolize this guy, and buy into his message.  The message is banks are criminal.  The government is criminal.  So it’s not criminal to attack them. Indeed, one can be justified in doing so.  Yes, many of the would-be attackers are on the outside, but as Snowden shows, there are inevitably many on the inside. And some on the inside have no problem in dealing with Appelbaum and the like. Case in point, an infosec guy I interacted with on Twitter until he blocked me. (Thin skin seems to be another occupational hazard.) He would countenance no criticism of Appelbaum.

Meaning that the most dangerous threats to exchanges and financial infrastructure may be those who are hired to defend them.

So this is one of the reasons I write about Snowden, and Appelbaum, and Assange, and Greenwald, and the rest of this crowd. Their agendas and connections need to be understood-and broadcast. For these avatars of transparency are notoriously protective of their own activities and connections. Given the inevitability that some of those to whom they are connected are on the inside of vital financial and government institutions, this is a matter of grave concern. And a matter that mainstream journalism has been shockingly negligent in investigating and reporting.

Appelbaum and Poitras are in Berlin now, and Berlin-land of the Pirate Party-is arguably the epicenter of this community. But it is an international community, and what happens in Berlin doesn’t stay in Berlin. It could be coming to a bank or exchange near you. If it hasn’t happened yet, it’s not for lack of trying, or the lack of potential acolytes within these very institutions.

The CME has seen increased volumes in its cash settled Brent contract in the aftermath of its launch of a program that pays rewards to those who trade the contract.  This is a standard way to attract volume to a contract competing against an incumbent/dominant contract.  Indeed, it’s probably the only way to do it.

Eurex tipped the Bund market away from LIFFE in 1998 after implementing a fee holiday, which LIFFE smugly refused to match, so confident was it of its liquidity advantage.  But Eurex had enough organic order flow that it was fairly liquid already, and the fee cut made it cheaper to trade Eurex Bunds, as I document in my paper “Bund for Glory: Or, It’s a Long Way to Tip a Market” (which will be a chapter in a book I’m currently writing).  The market tipped within a period of mere months.

Other exchanges didn’t repeat LIFFE’s near fatal mistake, and responded to fee cutting entrants by cutting their own fees to match.  This is how CBOT saw off Eurex’s attempt to enter the US Treasury futures market in 2003, and how CME torpedoed EuronextLIFFE’s attempt to enter into the Eurodollar futures market a few years later.

Here’s the deal: incumbents have a huge liquidity advantage that entrants must overcome.  How can this be done?  The only way, really, is to cut fees, or actively reward volume to attract enough liquidity to compete with the incumbent.  And the odds are still long, especially if the incumbent follows the CBOT script, and matches the reduced fees.

But if you want to encourage inter-exchange competition, you have to look favorably on entrants using strategies that reward volume as a way of building liquidity to make themselves into viable competitors.

This basic fact makes this FT article very disappointing.   It criticizes the CME initiative, and only quotes those who are critical or dismissive of the endeavor.  Yeah, it’s probably true that the only reason why those who participate in the incentive program trade is to collect the rewards.  But their order flow can attract order flow from others: other traders see that there is two-way activity, and can be more confident that if they establish a position, it won’t be a Hotel California that they can check into, but can’t leave.  Meaning that it’s BS to say, as one anonymous source to the story says, “there is no economic benefit to the trades whatsoever.”  The economic benefit is that it can make the entrant a more viable competitor to the incumbent.

And quoting Bart Chilton.  Please.

The quote that claims that spread trades-which dominate the activity in the CME Brent contract-“make no loss because they buy and sell at the same price” is just a crock.  Yes, spread trades are lower risk, but calendar spreads do move.

The CME is engaging in a penetration pricing strategy.  The only real strategy that permits competition against an incumbent.  If you like competition, you should like a strategy that harnesses the greed of trading firms to generate liquidity and volume.  Because, quite frankly, that’s the only way to compete.

But if you like monopoly, go ahead and denigrate what the CME is doing.

It would also be interesting to see how ICE built market share in its WTI cash settled contract that competes with the CME’s flagship oil contract.  It is my recollection that ICE rebated fees for firms that brought volume to the ICE contract.  (The structure of the ICE inducement, and Eurex’s in Bunds, were interesting.  They basically made it a tournament, with rebates/bonus payment being limited to the top three-if memory serves- order flow providers.  That provides a very high powered incentive while controlling the cost of the program.)  If my recollection is correct, doesn’t that mean that sauce for the goose is sauce for the gander?

Competition in futures markets, where order flow is not socialized, is highly imperfect.  Incumbents have huge advantages.  Aggressive price competition-pentration pricing, specifically-is about the only way that an entrant can hope to dent the incumbent monopolist’s huge liquidity advantage, and even that is a highly dicey proposition.  The FT story would have been much better had it recognized this reality rather than taking an all too critical view, and containing only quotes that were no doubt music to Jeff Sprecher’s ears.

I just read Haim Bodek’s “The Problem of HFT.”  It reinforced my belief in what I’d long concluded, namely, that the problematic aspects of HFT result from the decision of the SEC to create a Simulacrum Limit Order Book-a SLOB-rather than a true Central Limit Order Book-a CLOB-when it promulgated RegNMS.  As I noted at the time, the SEC chose an “information and linkages” approach to create a National Market System that consisted of interconnected competing exchanges, rather than to create a single CLOB.  In achieving competition, it was hugely successful.  Whereas NYSE dominated trading in its listings pre-RegNMS (with a market share in the low-to-mid 80s), now executions are divided rather equally among a handful of exchanges.  There are few rents in securities execution in the US anymore, in contrast to the old floor days.  NYSE’s equity business contributed relatively little to the price paid by ICE for NYSEuronextLiffe.

Part of the decision to  was political economy: politically, the SEC couldn’t have realistically favored one venue, or displaced existing exchanges by creating a new national CLOB.  Part of this decision was predicated on a defensible and understandable desire to encourage competition in securities trading, in fees, rules, liquidity, and technology.  However, the SEC didn’t anticipate how the market structure would evolve, and in particular, how HFT would transform securities trading.  I can’t say that anybody did.  I certainly didn’t.  I thought that automated trading would link markets, but I didn’t see it playing out like it did.

I call what the SEC wrought a “simulacrum” order book because although it incorporates some aspects of a central limit order book, specifically price priority across exchanges for the top of book, it lacks several crucial features of a true CLOB.  Price priority is for top of book only.  Time priority (or other secondary priorities) are not enforced across trading venues.  Markets can cross or lock-which can’t happen in a CLOB, where locked or crossed orders execute automatically.  Moreover, latencies, particularly in the public feed of the NBBO create behaviors and incentives that diverge from a CLOB.

Because it links multiple execution venues, the SLOB has many seams.  And one thing we know is that traders traders look for and exploit seams like Tom Brady looks for and exploits the seams in a zone defense.  Bodek’s little collection of essays goes into considerable detail on how traders have worked the seams, and how their methods have changes in the last 6 years.

The most critical seam in the SLOB, in Bodek’s accounting, is the rule on locked and crossed markets.  The SEC rules state that an order on exchange A that locks or crosses an order on exchange B cannot be displayed.  This complicated the task of quoting aggressively: an HFT that submitted an order that locked or crossed a market would not be able to establish position at the head of the queue.  To address this, traders first used spam and cancel: repeatedly sending orders that were canceled if they locked or crossed, but which would go to the front of the queue as soon as the quote in the away market changed.  Exchanges had implemented algorithms that re-priced orders that locked or crossed away markets, and put them at the end of the price queue.  HFTs circumvented this using hidden order types that were not displayed if they locked or crossed, but which were displayed-and crucially went to the head of the queue at the new price-the instant their price would no longer lock or cross an away market.  HFTs also used sweep orders to establish priority.

The common features behind all of the things Bodek criticizes are that (a) they are all intended to establish priority, and facilitate aggressive quoting, and (b) they can happen in a SLOB, but not a CLOB.  They give an advantage to HFT firms that invest in the technology and in understanding the order types, to the detriment of those who don’t (including many institutional investors): this is Bodek’s main beef.  They are an artifact of the prohibition on locks and crosses, and this can only occur in a fragmented market structure that precludes locks and crosses.  If locking and crossing orders were matched against one another and executed, as would happen in a true CLOB, much of the gaming of order types Bodek laments would go away: I suspect, however, that latencies across a system of linked exchanges would make this impractical.

This relates to, and complicates, points I made in my writing on exchange competition in the late-90s and early-00s.  Competition between privately operating CLOBs with no obligation to route orders to markets displaying better prices is likely to result in the survival of a single dominant platform that exercises market power.  This is arguably the case in futures markets.  A CLOB utility that is regulated to mitigate this market power problem raises myriad difficulties.  Who will operate it?  How will rates be regulated?  How will access be regulated?  (One way to exercise market power is to limit access to the CLOB.)  How will the CLOB utility be governed?  How is capture (by major intermediaries, for instance) to be avoided?  How can the CLOB be incentivized to be technologically innovative, rather than a lazy monopolist (especially since some technological changes may be very disruptive to the business models of important market participants)?

Socializing order flows by requiring exchanges to route orders to other markets displaying better prices encourages competition, and seemingly avoids the problems posed by private CLOBs and utility CLOBs, but raises its own difficulties.  Indeed, these are the problems that we are experiencing today, and which Bodek identifies.  This raises the question: can we clean up SLOBs so they are more truly CLOB-like, while retaining interexchange competition that mitigates market power problems?  The answer to this question has both technological and political components.   A system of linked exchanges necessarily has seams and latencies and inter-market coordination issues absent in a true CLOB, and these are vulnerable to gaming and breakdown, and even during normal operation represent a more complicated and error-prone way of allowing all orders to interact with one another than a true CLOB.  The political components arise from the fact that interested parties, most notably exchanges, major sell side intermediaries, and big buy side institutions, will strive to shape the system’s design and rules to advance their interests.

The trade off is therefore pretty stark: it’s a pick-your-poison kind of thing.  Don’t socialize order flow and live with market power, or socialize order flow to facilitate competition, and grapple with the technological challenges of creating a virtual CLOB, and fighting the never ending battle against attempts to exploit the seams.  I don’t claim to know the right choice, but I think that framing the issues in this way will permit far more constructive debate than the one currently ongoing.  This debate has become Manichean: good vs. evil: black hats vs. white hats.  It is oddly ahistorical, in its failure to recognize the problems with the previous system.

Perfect is not an option here.  Which is why debates over securities and derivatives market structure have been raging for as long as securities and futures have been traded.  The debate would be more productive-less sterile-if the choices were framed more clearly.  I’ll keep trying.

It’s all so confusing.  During the last spasm of Congressional criticism of the “financialization” of commodity trading, mainly during the Frankendodd “debates” over position limits, the target of criticism was evil speculators who trade commodities for purely financial reasons, and who have no involvement in the physical markets.

In the latest incarnation, the alleged problem is that financial firms that trade commodities paper do have physical commodity operations:

What concerns Brown and Senator Jeff Merkley, Democrat-Oregon, is that banks have numerous physical commodity holdings as well as the means to deliver those commodities, including oil tankers, transmission rights and pipelines, while they at the same time trade on energy prices in futures and swaps markets.

Big banks can buy “vast quantities” of commodities and pipelines, tankers and warehouses, said Merkley. This gives them “a huge amount of market information that’s very advantageous in trading” and gives them a “thumb on the scale in the terms of supply and demand and being able to have some influence over the price,” he said.

“If you’re simultaneously allowed to bet on the price and you’re allowed to have your thumb on the scale in reflecting the price it’s a huge conflict of interest,” he said.

“Financial institutions own fleets of oil tankers and can withhold delivery, while wagering on the price of oil or they can speculate on the price of energy while controlling supply,” Brown said.

This, the senators said, is a clear conflict of interest that is driving up commodity prices.

Make up your minds, people (which generously assumes you have them).  Is the combination of physical and financial trading a good thing, or a bad thing?

As someone who has arguably written more about commodity market manipulation than anyone alive, I can say definitively that the most costly manipulative strategies-corners and squeezes-involve trading of “paper” (e.g., futures contracts) and the physical commodity.  These strategies involve either taking excessive deliveries, or buying in excessive quantities in the physical market.  Engaging in a market power manipulation requires some involvement in the physical market.

Historically, many of the biggest manipulations have been undertaken by hedgers.

And that’s the key point that escapes the Washington hand-wringers.  On one of their wringing hands, they lament the involvement of non-hedgers in markets (let’s leave aside how you can have hedgers without speculators to take the other side of trades).  On the other, they bemoan the fact that those involved in both the physical and financial commodity markets-who are often hedgers-can sometimes exploit market power to enhance profits.  But if you believe that a primary function of commodity derivatives markets is to facilitate risk management by those involved in the producing, marketing, storing, and processing of commodities, you have to permit the physical traders to trade derivatives.

One of the consequences of that is that there will be manipulations by physical players.  But severing physical and financial trading in order to prevent manipulation, which is what Brown and Merkley and others are suggesting, is crack-brained.  It throws the hedging baby out with the manipulative bath.

And it is particularly crack-brained to focus on just one category of market participants, like banks.  The potential for manipulation exists due to frictions in the physical market, and the ability of some market participants to trade both derivatives and the underlying commodities.  Someone will step into the banks’ role if they are precluded from the market, and the potential for manipulation will remain.  Taken to its logical conclusion, the Brown-Merkley “conflict of interest” standard would preclude any entity-not just banks-from trading both commodity derivatives and the underlying physicals.

So what’s the best way to attack manipulation?  Not by destroying the ability of the markets to perform their vital risk transfer function.  Instead, as I’ve argued for going on 20 years, the best way is to impose penalties after the fact for manipulative conduct.  Thus, at least conceptually, I support FERC and CFTC enforcement efforts.  The problem is that practically their efforts are often misdirected and intellectually confused.

Congress should economize on its limited comprehension of these issues by focusing on the key problems, rather than throw around vapid phrases like “conflict of interest” and recommend policies that undermine the ability of financial and physical commodity markets to function effectively.  Better anti-manipulation laws predicated on a clear understanding of how manipulation works would be the place to start.  And no, this does not involve the Xeroxing of 10(b)(5) of the Securities and Exchange Acts and inserting it into commodity trading laws, which has been Congress’s default response for about a decade.  There is a complete mis-match between the fraud-based thrust of 10(b)(5) and the market power problems that sometimes arise in commodity markets.  I’ve made recommendations over the years on the right regulatory/legislative approach that would target market power problems more precisely.  This approach would permit the markets to exploit the synergies between paper and physical trading while at the same time improving the efficiency of these markets.

But instead, we get Congressional schizophrenia and meat cleaver approaches that would, if taken to their logical conclusion, destroy the markets in order to save them.

A further thought.  Those who have the ability to trade the physical, and who have extensive information and developed logistical capabilities are usually the best positioned to break corners, and to mitigate the frictions that make corners possible.  They also have the strongest incentive when they have a derivatives position that would be hurt by a manipulation.

I’ll post a link when I have a chance, but P.D. Armor’s breaking of the Leiter wheat corner in 1898 is a great example of this.  There are many others.

Earlier in the year I wrote about the obscure, but very important, regulation of futures commissions merchants that essentially requires them to hold enough of their own money to cover shortfalls in customer margin accounts.  This “residual interest” rule has caused a wholesale freakout among FCMs and market participants, and for good reason, as I pointed out in that post.  The rule would not have prevented an MF Global or Peregrine situation-those involved fraud and/or numerous rule violations.  Moreover, the rule puts further strains on the funding liquidity of the futures markets.  There are already new strains aplenty, and liquidity shortages are a major source of systemic risk.  A rule ostensibly designed to protects customers puts the entire system at greater risk.

The near universal opposition of the industry is leaving the CFTC unmoved.  But the CFTC’s response is purely legalistic, and does not even attempt to address the fundamental economic issues:

But on Thursday, at an open meeting of the Agricultural Advisory Committee to the CFTC, regulators were unmoved by the criticism.

The proposed rules, said Ananda Radhakrishnan, director of the CFTC’s division of clearing and risk, merely clarify what the law already says: funds from one customer must not be used to pay for the position or deficit of another customer

“Nobody’s been able to make the argument, with all due respect, that what we are suggesting is not what the law says it is,” Radhakrishnan said. “The arguments we’ve heard … (are) that it’s going to be expensive, the earth is going to fall and so on and so forth. But nobody has done, to my view, a legal analysis saying, ‘your analysis is wrong.'”

Translation: “The law may well be an ass, but we’re rolling with it.”

I have some sympathy, because Congress has handed the CFTC many legislative directives that are at odds with economic common sense, and which are actually contrary to the purposes of the legislation (notably, the reduction of systemic risk).  But where there’s a will, there’s a way.  I get the sense that the CFTC is just hiding behind the legalisms in order to force through a proposal that it-and most likely Gensler-wants.  If it had the will, it could likely find a way to adhere to the law as written but substantially mitigate the negative impacts of the regulation on liquidity, costs, and systemic risk.  The failure to do so, and the appeal to the “Congress made me do it” defense (seen so clearly in the position limits regulation, and repeated in its appeal briefs) strongly suggests that the CFTC doesn’t have a strong economic justification for its regulation, can’t rebut the arguments of the critics, and is playing legal rope-a-dope in order to force through one of Gensler’s (and perhaps the staff’s) bright ideas/obsessions.