Streetwise Professor

Through the miracles of web search, with an initial boost from Highgamma’s comment linking to a 1996 WSJ story, I have reconstructed what happened in cheese in 1988 that led to my first foray into commodity manipulation.

For many of the gory details, you can read this summary of a very long report on the goings on in the cheese market in the ’88-’96 time frame.  Here’s a GAO take on it.  (Who knew cheese was such a big deal?!)

The Cliffs’ Notes version is pretty simple.  Starting in 1988, Kraft started selling large quantities of cheese on the National Cheese Exchange.  At first glance, this seems peculiar, because Kraft is a major cheese buyer.  But at second glance it makes sense.  Kraft bought most of its cheese on contracts tied to the NCE price.  So driving down the NCE price reduced its acquisition costs under the contracts.  Put differently, Kraft was short cheese forward contracts, and had an incentive to drive down prices.  Given the thinness of the NCE market, selling a few carloads at the Friday auctions accomplished just that.

Kraft, it should be noted, vociferously denied these allegations.  But the case set out in the report seems pretty damning.  In particular, in a manipulation of cash-settled forwards (which Kraft’s cheese purchase contracts were), the manipulator loses money on the transactions used to distort the price, but makes it up on the forwards.  That definitely appears to be the case here.  Relatively small volume transactions on NCE lost money, but had a big price impact which benefited Kraft’s far larger volume of cheese purchases.

In other words, Kraft’s strategy was right out of my 2001 J. Business article “The Manipulation of Cash-Settled Futures Contracts.”

I’m sure you have all been on tenterhooks waiting for those details.  Or not.

Corruptocrat Jon Corzine is whining about the MF Global Bankruptcy Trustee’s decision to assist customers who lost money as a result of the MFers in their attempts to recoup their losses by suing Corzine and other executives of the firm:

Corzine, along with other current and former MF executives, filed an objection in court on Wednesday arguing that their ability to defend themselves would be hurt if trustee James Giddens is allowed to assign his legal claims to plaintiffs in existing cases.

The executives are defendants in multiple lawsuits accusing them of mismanaging the firm and playing a role in its October 2011 collapse.

“Nothing in the Bankruptcy Code authorizes such limitations on the objectors’ rights and defenses or an enlargement of the trustee’s rights,” lawyers for Corzine and the other executives wrote in documents filed in U.S. Bankruptcy Court in Manhattan.

If allowed to join the customer cases, Giddens would have the right to limit the information and documents available to the executives through discovery, as well as dictate which documents the executives would turn over to plaintiffs, lawyers for Corzine and the other executives wrote.

Sorry.  I’m getting all choked up.   Hard to type through the tears.

JK.  MF him.

It looks like Corzine is going to skate on criminal charges, as in a reversal of usual procedure prosecutors appear to be focusing on low level employees, and not as a way of getting at bigger-and rotten-fish like Corzine.  (I’m sure that he’s a made man in the Democratic Party and a big fundraiser for Obama has absolutely nothing to do with that.)

Given that, one can only hope that he spends a good part of the rest of his life in civil legal torments, and ends up coughing up large sums to the injured customers who he victimized.  For regardless of his culpability in diverting segregated customer funds, his recklessness was the proximate cause of their losses: his ill-judged and ill-designed (i.e., improperly funded) bet on PIIGS debt put the firm in the straits that led someone to consider it necessary to take money that wasn’t the firm’s in a vain attempt to save it.  Moreover, even if he did not give the order to use seg funds, it happened under his watch: the choice is between scienter and negligence.  It still stuns me that a guy who was head of a major clearing firm claimed ignorance of the mechanics of the clearing process.  I guess he was too busy figuring out how to gamble his firm to resurrection.

So encroach away, Mr. Giddens!  Rough justice perhaps, but that’s exactly the kind Corzine deserves.

The CME Group has announced plans to open a European exchange, following its earlier announcement of its launch of a European clearinghouse.

Just another unintended consequence of Frankendodd.  Another bucket emptied by the Sorcerer’s Apprentice’s regulatory broomsticks.

Why do I say that, pray tell?  Because that’s what CME Group is saying, quite clearly:

The Chicago-based exchange said that as policymakers overhaul the global market infrastructure, it was becoming increasingly important for market infrastructure providers to offer a choice of regulatory regimes. Derek Sammann, managing director of CME Group’s global interest rate and FX business, told Financial News immediately after the announcement: “Clients should not have to choose to trade with us in the US regulatory environment, or not to trade with us at all. That is not a real choice.

He added: “The more we have invested in our global infrastructure, the more we have realised that there are customer acquisition opportunities by creating regional access to our services.”

. . . .

Phupinder Gill, chief executive of CME Group, in June told an international derivatives conference IDX in London that the exchange group’s non-US clients had raised concerns that they would become ensnared by the Dodd-Frank rules if they traded with the US-regulated company – a phenomenon commonly known as extraterritoriality.

He said: “The question that many of our clients ask is if they are going to get ‘Dodd-Franked’.”

No, no, no, Gill!  It’s “going to get Frankendodded.”  Get with the program!  We need to feed the meme!

The reporting has been rather unclear on what the CME Group’s plans are going forward.  The new UK-based exchange will offer FX futures contracts.  The CME press release, and the reporting, do not say explicitly, but it looks like these would be new products, distinct from the CME’s FX contracts traded on Globex.  This means that liquidity and clearing would be fragmented, so that regulatory cost savings for European customers would be offset to some degree by higher trading and clearing costs.  Great!  And regulators note: the market will become more complex and difficult to oversee, with divided jurisdiction and the consequent need for regulators to coordinate in the event of market stress.  There will be arbitrageurs-including, no doubt, those HFT demons-buying and selling between the two markets, leading to more message traffic, more complexity, and more potential for breakdowns and technological glitches.  That is, the adverse technological consequences of fragmentation that have accompanied fragmentation in equity markets may rear their ugly heads in futures as well, with the added twist of fragmentation across international jurisdictions.

Given the difficulties associated with building liquidity, it is uncertain how the CME’s UK initiative will fare: it may be the case that Europeans decide that the liquidity and clearing costs savings exceed the regulatory burdens.  But it is relatively inexpensive for CME to put its toe in the water in the way it has.  It is a cheap way to buy an option on regulatory uncertainty.  If Frankendodd turns out to be the real monster that I think it will be, European customers will be willing to incur higher liquidity and clearing costs in order to avoid the monster’s grasp.  CME Group will add more contracts that mirror its US offerings.  The market will become more fragmented, and more complex.

Exactly what Frankendodd and Gigi and Timmy! intended, surely.

I have crossed pixels with Felix on occasion, most notably over the issue of “empty creditors,” in which I took the Coasean position.  But today, I largely agree with his take on the Knight Capital implosion:

We’re seeing the same thing with the fiasco at Knight Capital, where a highly-sophisticated high-frequency stock-trading shop lost an enormous amount of money in a very small amount of time, and small investors lost absolutely nothing. On the grounds that we can’t present this as news without somehow determining that it’s bad for the little guy, it took no time at all for grandees to weigh in explaining why this really was bad for the little guy after all, and/or demonstrates the need for strong new regulation, in order to protect, um, someone, or something. It’s never really spelled out.

Knight lost $440 million.  That really stinks for its shareholders, but its loss is a windfall for those on the other side of its Hal moment.   Every dollar lost by Knight is a dollar gained by someone who entered an away from the market limit order that Knight triggered, or arbitrageuers that took advantage of the price anomalies.  You might argue that the temporary distortions in prices for dozens of stocks is a source of welfare loss, but I defy you to identify a real decision (e.g., the amount of investment by an affected firm, or its capital structure) that was affected by the very short lived fluctuations.

The final score: Knight -$440 million.  Others who bought and sold the affected stocks: +$440 million.  Third parties (not counting those who get the vapors when the markets don’t work as neatly and tidily as they think they should): $0.  Net result: $0.

Not quite, though, because of the pour encourager les autres aspect of Knight’s travails: to me this episode is an example of Darwinian selection in action.  Those who don’t adequately check their code are driven from the market (or almost are-Knight was rescued from bankruptcy on very harsh terms by a group of brokers and dealers).  Indeed, the outcome here is likely to be more efficient than a purely Darwinian one: here others can learn from Knight’s tale (“there but the grace of a geek go I: I’d better be extra vigilant”) whereas that learning mechanism doesn’t operate under pure natural selection.

Although I sometimes agree with Felix Salmon, the same cannot be said of me and John Kemp, another Reuters writer.  The correlation between our views pushes -1.

That’s true today, with respect to Kemp’s analysis (if that’s the right word) of ICE’s decision to relabel swaps as futures.  Kemp presents this as a smashing victory for Frankendodd.  Now it may seem churlish of me to criticize, given that Kemp did give my blog post extended play in his piece: I am aware of Brendan Behan’s dictum that there is no such thing as bad publicity, except where your obit is concerned.  But duty calls.

Kemp spends inordinate space in a disquisition on the Talmudic distinctions under the Commodity Exchange Act between contracts for future delivery and commodity forward contracts.  All of which is completely irrelevant because the ICE contracts transubstantiated from swaps to futures are definitely not commodity forward contracts exempt from CEA exchange trading requirements.  Kemp quotes my statement that nothing of economic substance changes as a result of the relabeling-and doesn’t disagree.  But he cavils:

Pirrong has been critical of Dodd-Frank and much of the CFTC’s rule-making. In this instance, he appears to argue that the sole outcome will be another round of regulatory arbitrage. (“A swap by any other name” Aug 2)

Arguably, however, ICE’s decision to re-label its cleared swaps as futures suggests regulators have won this round of the battle, ensuring that all contracts with an economically equivalent purpose will be treated in the same way, rather than subject to an artificial distinction.

Note the attempt to cast doubt on my analysis by pointing out my (unapologetic) criticism of Frankendodd, and Igor’s (i.e., the CFTC’s) implementation thereof. (“Distrust the skeptic!”)

Sorry, but I’m finding it hard to see the great regulatory victory here.  Nothing of economic substance has changed: Kemp does not dispute this, and in fact agrees with it (though he doesn’t go far enough, because the transactions are equivalent in form and substance as well as purpose).  The “artificial distinction” he criticizes is in fact a creation of the regulation: it is the direct result of Frankendodd’s establishment of a separate regime for swaps.  By revealed preference, the regulatory regime that ICE has chosen to operate under is less burdensome that the swap regime created by Frankendodd.  Since the economic substance of the transactions at issue hasn’t changed, this implies that either the swap regime is inefficiently costly (at least for some transactions), or the futures regime is inefficiently lax but a mere relabeling permits ICE and others to take advantage of that laxity.

I guess you have to take your victories where you find them, but that’s pushing it.

The Intercontinental Exchange (not to be confused with the Intercontinental Railroad!) has announced the end of cotton, coffee, sugar, cocoa and OJ options floor trading.  The futures floor was closed some time ago.

The decision was spurred by the movement of options trading to ICE’s computerized trading system.  This is significant, and is likely the beginning of the end of floor trading.  Options have been the last major bastion of open outcry.  Many options trades involve more complicated multi-leg strategies (including spreads of various sorts) that are more difficult to computerize than simple outright futures trades, or simple futures strategies like calendar spreads, but which can be done efficiently on the floor: locals on the floors quote many of the common spreads.   If options can be done on the screens, there’s nothing really left for the floor to do.

Thus, we are witnessing the culmination of a process that began about 20 years ago.  I first did some research on electronic trading in the early-1990s, and remember the disdain with which the futures and options communities looked on computerized markets.  In 1995, I wrote a study comparing the electronic DTB and the open outcry LIFFE market which found that the former was as liquid, or more liquid than the latter: this study was met with much derision by LIFFE, and by most people in Chicago.  The derision of electronic trading died down substantially in 1998, when volume in the Bund futures market tipped completely to DTB’s successor (Eurex), and LIFFE suffered a near death experience.

The floor held out in the US for sometime longer, but by the early-2000s the writing was on the wall here as well.  By the mid-2000s options trading was keeping the floors going.  But that’s no longer true of ICE, and it is likely a matter of time before it is no longer true on CME/CBT or NYMEX.

Near zero interest rates are wreaking havoc among FCMs. I recall reading something about that.  Heck, I remember writing something about that about a week ago.

There is a puzzle here, though.  Why don’t commissions vary inversely with interest rates?  The FCM business is pretty competitive, meaning that FCMs should earn the competitive rate of return, i.e., roughly speaking revenues should equal costs plus a fair return on capital.  If interest rates rise, generating more revenues for FCMs, competition should lead them to cut commissions in order to attract customers.  Conversely, if interest rates fall, reducing FCM revenues, competitive pressures should induce them to raise commissions.  Why have commissions remained at rock bottom levels despite the loss of revenues from interest on customer funds that the FCMs hold and invest?

One possible explanation is that due to technological change (e.g., the expansion of electronic trading) there is excess capacity in the FCM industry, and some firms should exit.  The excess capacity keeps downward pressure on commissions, which will not rise until there is a significant shakeout.

Perhaps MF Global, or Peregrine, or both, were unwilling to concede that they were no longer economically viable and should exit.  Frequently the need to secure external funds to keep operating is what forces unviable businesses to exit even though individual managers or owners may want to try to gamble or cheat for resurrection.  Financial firms’ (including FCMs’) ready access to cash (even if it isn’t really theirs) can permit them to engage in these sorts of actions without securing external funds.  This is why financial sectors under stress are particularly vulnerable to fraud and excessive risk taking: not only do stressed firms have the incentive to engage in this kind of conduct (which is true of stressed firms in other industries too), but they have opportunities that stressed firms dependent on external finance do not.

A couple of LIBOR-related items.

1. Timmy! claims that he and the FRBNY were “very forceful from the beginning” in dealing with LIBOR manipulation.  This is an example of why Timmy! (AKA Rodney Dangerfield) gets no respect.  His letter to the BOE was a classic example of bureaucratic CYA and buck passing: the BOE then exchanged the buck and passed the pound to the BBA which did . . . nothing.  More nothing happened for over three years, and it wasn’t the FRBNY that drove the process.  The scary thought is that is what passes for forceful in Timmy!’s world: the scary alternative is that Geithner is just BSing about his past forcefulness.  The thought that Geithner’s 2008 actions were forceful is Pythonesque, really:

Cardinal Ximinez: Cardinal Fang! Fetch… the Comfy Chair!
Cardinal Fang: [horrified] The Comfy Chair?
[Fang scuttles off, then returns with the Comfy Chair and sits the old lady down in it]
Cardinal Ximinez: Now, you will sit in this chair until lunchtime, with nothing but a cup of coffee at 11!

2. Central bankers are looking for an alternative to LIBOR, EURIBOR, etc

Central banks are exploring whether financial markets might be steered to adopting benchmarks other than Libor. Mr. Bernanke suggested a few alternatives at his hearings this week. Among them: The rate that financial institutions charge each other for short-term loans in “repo” markets in which they use their large securities portfolios as collateral for short-term loans. He said derivatives markets also provide alternatives, such as “overnight index swap,” or OIS, rates, which track central bank lending benchmarks.

That’s great going forward, but what about the $800 trillion or so in notional and/or principal amount of outstanding derivatives, loans, and other financial instruments with payments tied to LIBOR and its European and Asian cousins?  That would be a helluva lot of contracts to orphan.

LIBOR needs to be fixed, because of this massive amount of legacy contracts.  But how?  It won’t be easy, since the transactions that LIBOR et al should be related to-unsecured interbank transactions-aren’t orphaned: they’re damned near extinct.  Any decree by regulators that henceforth LIBOR should be something different than the creature that existed at the time these contracts, loans, etc., were created would potentially result in the shift of many billions of dollars of wealth, and spawn intense legal challenges.  (Ironically, any fines or damages arising from LIBOR manipulation-related legal actions will weaken banks and make the return of unsecured lending all the more remote a prospect.)

Looking for a replacement going forward is the easy problem: market participants have an incentive to come up with something more robust, there will be experimentation and competition, and perhaps with a little regulatory shepherding, in not too long something better (no doubt some sort of secured rate) will emerge as the benchmark.  Going forward, market participants can find transactions and benchmarks that are mutually beneficial.  That provides an incentive to get it right.

Finding a way to deal with the legacy of the past is going to be a much, much more difficult problem.  The primary effects of changes will be redistributive, rather than creative.  This will give rise to massive rent seeking and legal conflict.  Much fun will be had by all.  Especially the lawyers.

I owe thanks to Tim Worstall (never to be confused with Timmy!) for his Forbes blog post on, and compliments of, my Blame it on Ben? piece from Saturday.

I also owe Tim props, for he recognized the dangers that low interest rates pose to the traditional broker model back when MF Global went bust.

One clarification.  I didn’t mean to suggest that low interest rates caused MF Global, or Peregrine, or the Whale, in the sense that low rates were a sufficient condition for these things to occur.  Low interest rates aren’t necessary either: some firms take risk or commit fraud when interest rates are high, obviously.

But risk taking (such as MF Global’s gambling for resurrection) and fraud (such as Peregrine’s) are more likely when firms are on, or over, the financial brink.  Low interest rates put these firms on the brink, and made the courses of action that Corzine and Wasserman chose more attractive and compelling than they would have been had they been making money the old fashioned way.  Put differently. low interest rates increase the odds of such conduct.

With that clarification made, just let me say thanks Tim, and keep up the good work.

During all the whinging about WTI, and the claims that it was inferior to Brent as a benchmark, I pointed out that although the former was subject to short term issues that could be fixed by investment in infrastructure, the latter was plagued by far more intractable problems that would compromise its viability over the medium-to-long term.  Indeed, WTI’s problems reflected an unexpected supply surge that actually bodes well for its long term viability, whereas Brent’s inexorable production decline would be virtually impossible to fix.

That reality is now becoming more widely recognized, pace Javier Blas’s piece in the FT:

The drop in production is putting the Brent benchmark in danger. Platts, the pricing agency that acts as the de facto regulator of the Brent physical market, is looking for solutions. It will need to work closely with ICE Europe, the exchange home of Brent futures and options, and the UK’s Financial Services Authority, which has an interest in the Brent derivatives market running smoothly.

The usefulness of West Texas Intermediate, the US crude oil, as a global benchmark has suffered over the past two years due to the so-called ‘Cushing syndrome’ – a glut at the Oklahoma town that serves as the delivery point of the contract. This glut is due to surging production and limited pipeline offtake capacity, and pushed WTI prices below what global fundamentals suggested.

Brent is now suffering from the opposite problem. The ‘North Sea syndrome’ – falling regional output combined with unlimited seaborne offtake capacity. The problem could push Brent prices above what global fundamentals suggest.

It is a lot easier to build pipelines than develop vast offshore oilfields. (Well, it is if administrations I won’t bother to mention let pipeline development proceed.)  This means that WTI’s “problems” can be fixed-and indeed, that its problem (a surge in supply in regions tributary to the delivery point) is a feature not a bug.  Brent’s.  Not so much.  Meaning that before very long CME/NYMEX is likely to be laughing, and Platts and ICE will be sobbing.

As I’ve written before, there is good HFT and there is bad HFT.  The crucial policy choice is how to encourage the former and discourage the latter.

As I’ve also written extensively, going back to the very first days of the blog, many of the problems with electronic trading are best addressed by exchange pricing policies.  In particular, to the extent that abusive trading strategies involve distinctive patterns in orders and cancellations, exchanges can devise pricing structures that make it costly, and perhaps prohibitively so, to utilize these strategies.  Exchanges can also implement pricing strategies that encourage beneficial HFT strategies that increase market liquidity.  Although it would be stretching it to say that exchanges internalize all of the costs and benefits associated with deterring abusive and promoting constructive HFT strategies, they certainly have a far more powerful incentive to get it right, and far better information and knowledge, than does a regulator.

Exchanges around the world, and in different asset/instrument classes, are indeed responding to development.  The latest is the Oslo Bors:

Oslo Bors will issue punitive charges to traders if they send too many orders into the exchange that do not result in deals being done, as the industry seeks to crack down on the practice of “quote stuffing”.

. . . .

Bente Landsnes, chief executive of Oslo Bors, said: “A market participant does not incur any costs by inputting a disproportionately high number of orders to the order book, but this type of activity does cause indirect costs that the whole market has to bear.

“The measure we are announcing will help to reduce unnecessary order activity that does not contribute to improving market quality. This will make the market more efficient, to the benefit of all its participants.”

Oslo Bors’s action is just another example of organizational and strategic innovation in response to a technological shock.  With many exchanges introducing such strategies, they will learn from each other’s experiences, and use this knowledge to refine their strategies.

The demands for regulatory actions against HFT will no doubt continue despite the actions of exchanges to price utilization of their systems in ways that promotes liquidity and deters abuse.  This is because, as is almost inevitably the case with regulation, many of the demands for intervention are self-interested efforts to hamper more efficient competitors.  HFT has undercut many traditional liquidity suppliers, and made their skills obsolete.  As surely as day follows night, and as reliably as the sun will rise in the east tomorrow, this process of creative destruction is leading those on the destroyed end of the process to importune governments to hamstring those on the creative end.

And spare me the nostalgia for the old floor days.  There was a lot of corner cutting-and worse-on the floor, and many abusive HFT strategies have clear parallels in abusive strategies that were used by floor traders.

In a very ironic twist, this debate brings to mind two conversations, held more than ten years apart, with a legendary trader.  In the circa 2000 conversation, he welcomed the advent of electronic trading because he believed that electronic trading leveled the playing field.  He said he was tired of “getting raped by the floor.”  In the circa 2011 conversation, he lamented the rise of HFT, because he couldn’t make money in the new electronic age.

That’s creative destruction at work.  Yes, the innovations are not always-in fact, never-entirely beneficial.  But remember that these innovations destroy incumbents, and are especially effective at doing so when they result in substantial efficiency gains. Thus, the innovations that reduce costs most often generate the greatest hostility-and hence the most insistent demands for regulation by those the innovation displaces.

Since the innovations often do have some negative consequences or uses, those crying for regulatory intervention often have examples to bolster their case. But as the actions of Oslo Bors and other exchanges illustrate, market participants have an incentive to devise means that mitigate and perhaps eliminate the negative effects of the innovation.  Market participants also have legal recourse to attack others.  The proper scope for prescriptive regulation is limited to those effects that market and legal responses to the innovation cannot address.  And even then, it is imperative to be circumspect about regulatory responses, given the susceptibility of regulators and legislators to self-interested efforts to hamper competition and more efficient competitors.