. . . of SWP discussing clearing, here’s a video (approx. 90 minutes) of my talk on the subject at the Law and Economics Workshop at Columbia Law School from December of last year. You need to supply your own NoDoz.
There are a lot of jokes about economists that go something like: “An economist and a physicist are on the top floor of a skyscraper. Someone runs in screaming: ‘The building is on fire. The stairways are all blocked.’ The physicist immediately panics, then looks at the economist, who is amazingly calm. The physicist says: ‘How can you be so calm? We’re all gonna die.’ The economist smiles wanly and says: ‘No we’re not. First, assume a 100-story ladder.'”
That genre of joke came to mind when reading this:
Clearing houses for derivatives can help reduce risk to the financial system, Federal Reserve Governor Daniel Tarullo said in written remarks prepared for House Financial Services Committee testimony tomorrow.
“If properly designed, managed, and overseen, central counterparties offer an important tool for managing counterparty credit risk, and thus they can reduce risk to market participants and to the financial system,” Tarullo said.
Translation: “First, assume a properly designed, managed and overseen central counterparty.”
Yes, if we assume all those things are true, our assumed world is wonderful indeed.
But as I’ve written for the past two-and-a-half years (and I think I can honestly say “you read it here first!”), all that is easier assumed than done.
Reading an article by Samuel G. Hanson, Anil K. Kashyap and Jeremy C. Stein in the most recent issue of the Journal of Economic Perspectives helped crystalize a thought that is implicit in what I’ve written, but which I have not made as explicit as I should.
Specifically: Historically clearinghouses have been microprudential institutions, with the responsibility of ensuring that a particular set of claimants get paid what they are owed due to the default of a single trader or firm, just as bank regulation has been microprudential in its focus on ensuring that depositors get paid in the aftermath of the failure of an individual bank. But Dodd-Frank and all of the other initiatives around the world give CCPs huge macroprudential responsibilities.
As Hanson et al show, there can be substantial tensions between microprudential and macroprudential regulation: some things that are prudent microprudentially are very dangerous from a macro/market-wide/systemic perspective. I do not believe that Frank-n-Dodd, Geithner, Gensler, the EC, you name it were or are fully cognizant of the difference. And therein lies the danger.
Here’s the most obvious example. CCPs utilize margins–collateral–to control counterparty exposure. That’s sensible microprudentially. But as I argued beginning in 2008, and as Brunnermeir and Pedersen formalized in 2009, collateralization and rigid mark to market can be systemically destabilizing. I referred to this as the “collateral death spiral.” Prices change a lot, imposing big MTM losses on some parties, who liquidate their positions, exacerbating the price moves, which leads to more liquidations. This positive feedback mechanism is what creates serious systemic risks.
Brunnermeir and Pedersen emphasize that a purely mark-to-market system that bases margin calls only on price moves, and makes no effort to distinguish between fundamentals-based price moves and those that result from mispricings or liquidity effects are the most systemically dangerous. And that’s exactly how CCPs work. They are ruthlessly mechanical. If you talk to people in the futures business, that is a feature, not a bug. I can’t count the number of times I’ve heard about the virtues of the “discipline of a rigorous daily mark-to-market system.” Microprudentially–agreed. Macroprudentially–not true, and more than that, dangerously misleading.
So, there is a fundamental disconnect between Timmy!’s and GG”s paeans to rigid collateralization and mark-to-market and their assertion that mandatory clearing will eliminate the prospect that derivatives will be a source of systemic risk. Indeed, evaluated properly, the reverse is more likely to be true. In times of market stress, rigid collateralization can be a doomsday machine.
That is a reality that can’t be assumed away–but has been. And don’t count on that ladder saving our collective rear ends when–when, not if–the next financial firestorm occurs.
The big news in Exchangeworld is the likely merger of NYSE-Euronext and Deutsche Borse.
This reflects in some sense a return to financial normalcy in the aftermath of the crisis. The years leading up to the crisis saw a plethora of exchange mergers and combinations, but the pace of consolidation slowed noticeably in 2008-2010. Now it is picking up again.
Both NYSE-Euronext and DB operate cash equity and derivatives exchanges. The former operates NYSE, of course, and also European equity markets in the Netherlands, Portugal, France, and elsewhere, and the LIFFE derivatives exchange in London. The latter operates the German stock market, a US-based options market ISE (a purchase in the pre-crisis boom which turned out to be a rather bad deal for DB) and the Eurex derivatives exchange which trades equity options and a wide range of financial futures. DB is highly vertically integrated; most importantly, it operates its own execution and clearing platforms in both equities and derivatives. LIFFE historically outsourced its derivatives clearing to LCH.Clearnet, but is also vertically integrating into clearing (although it still contracts with LCH for some clearing services).
Cost savings are the major driver of this merger. There are substantial scale and scope economies in execution systems. In derivatives, moreover, there are substantial scale and scope economies in clearing. In particular, margining and netting efficiencies reduce customer capital costs.
The competitive effects are likely to be relatively small, even though that has been a focus of a lot of the commentary. Cash equities are already ruthlessly competitive, especially in the United States: RegNMS socialized order flow, eliminating any tipping effects, as demonstrated by the precipitous decline in NYSE market share from the mid-80s to the mid-20s in the years following RegNMS.
With respect to derivatives, the LIFFE and Eurex do not compete head to head in any major product. Cross-product competition is relatively tame in futures. And just as with the CME-CBT merger, putting LIFFE short term interest rate futures and UK government bond futures and Eurex European bond products on the same platform would facilitate spreading trades and enhance liquidity and reduce trading costs and execution risks for customers.
Nor do LIFFE and Eurex compete head-to-head with any CME product. Thus, the direct competitive effect of the merger on CME is also likely to be relatively mild. By reducing trading and clearing costs, a LIFFE-Eurex combination may attract some business from CME product groups to its product groups, but again, these inter-product class cross elasticities do not appear to be large. Order flow has not been socialized by regulatory fiat in derivatives on either side of the Atlantic, meaning that the order flow network effect is still in place. This means that LIFFE and Eurex could not credibly compete against CME on its home turf (each had conspicuous failures trying): it also means that a combined LIFFE-Eurex will face daunting obstacles in trying to do so. Indeed, I doubt they will seriously try; twice burned, thrice shy would be a reasonable motto.
Consistent with this, CME Group’s stock price has been up close to 2 percent since the news of the potential tie up became public.
The biggest uncertainty surrounding the deal involves European antitrust approval. As noted above, the merging exchanges are not direct competitors in any major product. In the US, in the mergers of CME and CBT and CME and NYMEX, that fact was decisive in avoiding Justice Department challenges. It should be in Europe too, but I’m not as familiar with European antitrust thinking or precedents so I’m not sure they’ll see it the same way.
The most interesting question involves clearing. European policymakers have been critical of vertical integration in clearing. (The USDOJ is too, but only disclosed its (economically nonsensical) objections after the CME-NYMEX merger closed.) They deem vertical integration as anticompetitive, and have failed to consider seriously the efficiencies that integration can generate (a subject I’ve written a lot about on SWP and my academic research).
Given this skepticism, the Euro antitrust folks may view this merger as an opportunity to open up access to clearing at Deutsche Borse and LIFFE. That is, I could see them conditioning approval of the merger on the parties’ agreement to open up access to their clearing services. It will be interesting to see whether they attempt to do so: I estimate that there is a non-trivial probability of this happening. If they try, it would likely be a deal killer. DB in particular has been adamant that integration is an essential part of its model and strategy, and LIFFE has adopted that view as well. A deal becomes much less attractive–and, in my opinion, unattractive–if it requires a fundamental transformation of the exchanges’ business models.
The news of the potential deal has sparked considerable speculation about other tie-ups. One commonly heard belief is that CBOE is the odd-man out, and that it should tie up with CME. Other than the fact that both have “Chicago” in their names, these entities don’t have a lot in common, or a lot to gain by combining. In particular, there are no benefits on the clearing side. There are no economies on the regulatory/compliance side. There are not really big advantages on the system side either. So, other than savings on letterhead and some management salaries, there is nothing to be gained by merging.
It is likely that many more possible combinations will be mooted and discussed in the coming days. I’ll be among those discussing them, but that will have to wait. For teaching calls. It’s rough work, but somebody has to do it.
The SEC is continuing to flog the idea of imposing obligations on high frequency traders:
Regarding market structure, Schapiro said more work needs to be done to shore up investor confidence and transparency amid advances in high-speed trading.
“We are examining trading or other obligations that might be required of today’s de facto market makers: the high-frequency traders,” said Schapiro during remarks at SEC Speaks, a conference hosted by the Practising Law Institute.
“We are asking if these firms should be subject to an appropriate regulatory structure, including with respect to their quoting and trading activities.”
As I’ve said numerous times before: ain’t nothing for free. Obligations impose costs, and the costs may be large as what Schapiro describes would constrain HFTs to offer more liquidity during times of high risk/uncertainty; if the obligations are binding, it means that HFTs must incur very high costs to supply liquidity during these periods as some prefer to make no market at all, or only very wide markets then. They only act in that way if it is extremely risky–costly–to make markets then.
These costs must be covered. Since entry into the market is relatively free, market makers earn a competitive rate of return on their capital. Higher costs in some states of the world depresses that rate of return, leading to an exit of capital and higher trading costs for liquidity consumers at other times. Thus, imposing obligations will reduce liquidity on average, and redistribute liquidity over time.
It’s also important to remember that the withdrawal of capital will offset even in volatile times the liquidity-enhancing effects of the obligations. Yes, those market makers who remain will put a bigger fraction of their capital at risk during those periods, but there will be less of it overall to risk. The net effect is likely to be positive during these volatile times, but probably not as much as Schapiro and others believe. It seems that they assume that the obligations are costless and will not affect the supply of market making capital.
It is also costly to enforce these obligations. It is costly to specify them. This is especially true with HFT. Liquidity has many dimensions. How do you specify obligations on all dimensions? What happens if crucial dimensions are left out of the rules? How can programmers game the rules? I have seen no serious discussion of these issues from Schapiro et al. Economists are often–rightly–ridiculed for assuming the existence of 100 story ladders to rescue them from burning high rises, but regulators and legislators are far, far worse in this regard.
Historically, the NYSE imposed obligations on specialists. But it compensated the specialists by giving them privileges: these privileges inflated trading costs during periods when the constraints weren’t binding. Enforcing the constraints wasn’t easy, and in periods of extreme stress–such as 19 October, 1987–it is hard to judge whether they really performed the way their advocates would like.
Other markets–the futures exchanges, most notably, and the OTC stock and derivatives markets–have never imposed obligations. It’s by no means clear that they’ve suffered as a result. If these constraints are beneficial, why wouldn’t exchanges implement them unilaterally?
For once, I would like to see a serious analysis of the costs and benefits of obligations. Schapiro keeps touting them, hyping their benefits but never even acknowledging the costs.
A serious argument would require identification of some sort of externality. There have been papers (Greenwald-Stein in the aftermath of the ’87 Crash comes to mind) that have done so. But even in the context of those models, it’s not obvious that market making obligations are the best way to respond to uncertainty shocks. Greenwald-Stein argue that trading halts–circuit breakers–can handle the problem. In the old NYSE, specialists could call trading halts when order imbalances became extreme. This has some advantages over price-based circuit breakers, but in the current decentralized market structure, it’s hard to observe aggregate order imbalances–ironically, this is a consequence of an earlier SEC initiative, RegNMS.
Schapiro talks a lot about market maker obligations. Well, what about regulator obligations? Like the obligation to make a serious case based on a well-thought out diagnosis of the problem, and a careful identification of the sources of costs and benefits, and quantification thereof. Liquidity was in short supply during the Flash Crash, but regulators acting in such a responsible way are in chronic short supply, especially in the world of Frank-n-Dodd.
The controversy over the merits of the CME-NYMEX crude oil futures contract (West Texas Intermediate, WTI, also known as light crude, CL) vs. the Brent alternative is heating up again. In recent months, the spread between WTI and other crudes has widened, with WTI trading substantially lower than Brent, and US Gulf Coast prices (e.g., Louisiana Light Sweet–LLS–and Mars blend).
Critics of WTI question the long run viability of the contract. This is economically non-sensical. If there is a problem with WTI, it is a short run one; the very price relations that have drawn criticism provide the signal and incentive that will lead to its correction in the “long run”–as economists define it. Not “in the long run we are all dead” long run, but in the time frame that it takes to make adjustments to fixed capital such as pipelines and refining. This long run will arrive far before most of us are dead (based on reliable actuarial information:)–a period measured in months, rather than many years.
The WTI “disconnect” as it is sometimes termed reflects fundamental conditions in the oil market. (As an aside, those who obsess about the impacts of speculation should explain how speculation can wildly distort levels of prices but fundamentals drive intra-commodity price relations/spreads.) Increasing Canadian and US oil production has ensured that the US Midcontinent is well-supplied with crude. Indeed, along with demand that is still somewhat sluggish, this increased supply has led to increased inventories of crude in beautiful, windswept Cushing, OK. Cushing is the largest storage location in the US, and is the delivery point for the CL contract. At present, oil cannot flow from Cushing to the Gulf Coast. Gulf Coast refineries rely on US domestic crudes produced in the Gulf of Mexico (GOM) and imported crudes. The abundant supply of crude to the Midcontinent combined with the current inability of oil to flow from the Midcontinent to the Gulf has led to the widening basis.*
If you have been long WTI and short LLS (or some other Gulf Coast price) that relative price change is a problem (although it has been a boon if you have been short WTI and long the Gulf). But that problem is also an opportunity. It is a signal of the value of investments in capital that can move oil from the Midcontinent to the Gulf, and in refining capacity in the Midcontinent that can soak up some of that additional oil.
And indeed, a pipeline project–the third stage of the Keystone pipeline–is currently awaiting regulatory approvals. With timely approval, the pipeline could go online in early-2013.
Indeed, adjustments are occurring even in the short run: the price relations are such that it is attractive to ship oil by rail–almost a throwback to the Rockefellar days–from the rapidly growing Bakken fields in North Dakota to the Gulf. Moreover, Midcontinent refiners are operating at substantially higher rates than those elsewhere in the US. (It is likely that in the longer run that refining capacity in the Midcontinent will expand relative to capacity in the Gulf to reflect the increased supplies of crude in regions tributary to the Midcon.)
Ironically, environmentalist opposition supposedly intensified by the Mocondo spill is the main obstacle to timely completion of Keystone. Ironic because pipeline transportation is safer than deepwater production and seaborne transport (although it is not without environmental risk). So delaying the pipeline only increases reliance on the riskier alternative.
So, like many economic “problems”, this one is self-correcting if the market is allowed to respond rationally to price signals. Economic actors are ready to respond rationally. Now it remains to be seen whether the political actors will do so. Always a much more problematic proposition.
Several people have asked me whether it would be advisable to develop a new futures contract that would price off of seaborne crude or domestic production in competition with seaborne crudes: an LLS contract, for instance.
Having been intensely involved in the design of several commodity futures contracts, I am less than enthusiastic. Sometimes the “long run” in designing a futures contract–going from the idea to the actual implementation–is longer and more treacherous than doing something like building a pipeline over hundreds of miles of Oklahoma and Texas prairies. The implementation details are very difficult to get right. Moreover, there are many parties with conflicting interests who try to influence the design to benefit them. A futures contract is a one-size-fits-all endeavor, and it is very difficult to choose which suit gives the least bad fit to the most people.
Moreover, there is a kind of Heisenberg principle at work. Designing a futures contract around a particular location and grade can change the pricing behavior of that location and grade. You have to be sure that the logistics and infrastructure are robust enough to handle the demands of being a delivery point (or cash reference point). That’s not easy to do.
What often happens is that dissatisfaction with one delivery design leads to inquiries which prove that that design is the worst possible one, except for all others that could be tried.
With respect to WTI, the economic factors that are the fundamental source of the current criticism could be a boon in the longer run, especially if the market is allowed to function and capital adjusts in response to changes in production and consumption patterns. Historically, the US market was in supply deficit, and WTI traded at a premium to attract Brent in addition to other foreign crudes. But currently the forward curves for WTI and Brent show WTI at a discount going out years. This means that the market is anticipating that Cushing will be abundantly supplied for years–while Brent/North Sea production is inexorably declining.
The major problem that raises worries about the long run viability of a futures contract design is lack of supply. Long run changes in grain marketing patterns put the terminal market in Chicago into terminal decline (no pun intended). That caused serious difficulties with CBT corn, wheat, and soybean futures contracts. Those problems took years to correct, and only after extremely rancorous infighting over how to change the contracts to address the problem. (Efforts that I was involved in from 1990 through 1997–that timeline alone speaks volumes. And I can speak authoritatively about the rancor, having had some of it directed my way–almost resulting in a fistfight with a prominent grain trader. True story.)
The increased Canadian and North Dakota production, reflected in part by the forward WTI discount vis a vis Brent, suggests that over the longer term the Cushing-based WTI contract does not face the prospect of a similar supply problem. Moreover, the delivery in-store (or through pumpover) design for the CL contract offers many advantages over the much more cumbersome and opaque Brent pricing mechanism, not least due to the fact that Brent trades in huge cargoes whereas delivery in-store at a market served from a variety of supply sources with a variety of demand outlets permits greater flexibility in logistics and trade sizes.
In sum, the conditions that have created the wide spreads are self-correcting: those self-same spreads give the incentive to make adjustments in transportation (and also production and consumption) that will re-integrate Midcontinent prices with waterborne prices. And it’s also important not to exaggerate the magnitude of the de-linkage. As I documented in a study released about a year ago, even during the throes of the financial crisis when spread and basis relations were also well out of historical norms, WTI still exhibited high correlations with other crude prices, including LLS and Mars. (I am working now to update the main results of that study.)
In a dynamic market, changes in supply and demand patterns are inevitable. By necessity, futures contract designs are relatively static–particularly so for something like crude oil, where contracts are traded going out to ten years so you just can’t change contract designs willy-nilly and strand a lot of open interest in the out months/years. This mismatch between dynamic markets and static contract designs means that from time to time the contract will get out of alignment with the fundamentals. Sometimes that mis-alignment is likely to be enduring–as with Chicago-based grain and oilseed contracts, which necessitated a major change in design. Sometimes that mis-alignment is fleeting, because the price effects of the mis-alignment lead to adjustments on various margins that tend to bring things back into alignment. That will almost certainly happen with WTI–if regulators allow it to happen.
And one point deserves repeating: the change in supply conditions that is causing the changes in price relations that are drawing so much attention will also help ensure the long run viability of the WTI contract. If the supply is there, you can build pipelines to get that supply from low price locations to high price ones. But you can’t base a futures contract on a market with no supply.
*Note how this represents a fundamental, and salutary change over conditions in the 1990s. At that time, declining domestic production was turning the Midcontinent into a deficit region, and the Seaway Pipeline was built to bring crude from the Gulf to Cushing and the Midcon.
Writing in Commodities Now, Reuters reporter John Kemp takes issue with my criticism of the CFTC proposal on position limits. I appreciate the attention, but I’m underwhelmed by his arguments.
There are a lot of details, but the gravamen of his complaint is that my view on the purpose of position limits is far too narrow:
Pirrong defines the rationale for intervention too narrowly. Large leveraged positions run by the Hunt Brothers did indeed threaten to bring down their own brokers and several other financial institutions. But systemic risk is not the only reason for regulators to intervene to prevent market manipulation.
Kemp directs his beef at the wrong guy. His real problem is with the CFTC because these were the only–I repeat only–reasons the CFTC set out it its NOPR. My critique of the proposal is that it was a vastly overinclusive way to achieve the objectives the CFTC set out. Again, the objectives the CFTC set out. I was responding to what was in the proposal, but I did mention quite pointedly that the CFTC was utterly silent on whether speculation was culpable in the mid-2000s price spikes, or those going on now. How is it possible to respond to arguments and assertions that are not made?
Since it was the CFTC that was setting out the rationale for its proposed intervention, if that rationale is too narrow, Kemp should direct his ire where it belongs–the CFTC–not where it doesn’t–yours truly.
Kemp also critiques my views on manipulation and the proper way to deter it. Oh no! Please don’t throw me in the manipulation briar patch, Brer Fox!
Actually, born and bred in the briar patch, John. We are agreed that past efforts to deter manipulation through ex post enforcement have been troubled, at best. In this, Kemp is no doubt late to the game, because I’ve been making that argument since the mid-1990s.
That said, I’ve noted that manipulation is not inherently “unprosecutable” (a word Kemp lifts from Jerry Markham). The problems with detecting, deterring, and punishing manipulation can be corrected by a proper understanding of the economics, and a judicious use of, yes, econometrics–something that apparently sends Kemp into apoplexy.
Moreover, I have made very concrete recommendations as to how manipulation law can be reformed to address the problems it has experienced. (Not that you would know that from reading Kemp’s description of my views and arguments.) The problem is that instead of taking a new, economics-based approach to the problem, Congress keeps returning to the vapory SEC 10(b)-5 “manipulative contrivance or device” standard, like a dog returning to its own vomit. Doing the same thing over and over again and expecting different results is insane. I’ve recommended specific and practical ways to stop the insanity.
As an aside, Kemp laments that manipulators have only been subject to civil, rather than criminal, sanctions. There are a couple of issues here. The first is that criminal sanction–imprisonment–is socially inefficient when defendants are not judgment proof. The second is that Kemp’s lament actually supports the point I made in the previous paragraph. Judge Miller in Houston found the existing anti-manipulation statutes unconstitutionally vague, and threw out criminal indictments against BP propane traders. The suggestions as to how to correct the law would go a long way to addressing that vagueness problem that impedes criminal prosecution.
Speaking of econometrics, here Kemp is extremely misleading, and puts words into my mouth that I did not utter, and which do I endorse. He says that I propose that the CFTC not “set limits or commence enforcement proceedings unless econometric tests showed an unequivocal effect” [emphasis added].
If there is anything unequivocal, it is that his statement is unequivocally false, for I never said any such thing. Indeed, insofar as manipulation is concerned, he turns reality on its head. For what I have shown in numerous articles, a book, and in testimony, is that econometric evidence and economic analysis generally is the best way of proving manipulation, rather than being an obstacle that makes prosecution of manipulators virtually impossible. It is a sword that can be wielded against manipulators, not a shied that defends them: although it is effective as a shield protecting the innocent. Rigorous analysis of data is the best way to cut through trader BS, and prosecutor ignorance.
And that’s the point: we want methods that avoid false positives and false negatives. My work shows that econometrics, when combined with rigorous economic reasoning and other economic tests that are not econometric per se, can do just that.
Before characterizing my views, John, you might want to be more familiar with what they actually are.
Even with respect to the issue of whether speculation has distorted prices in ways other than the Hunt-type scenario, I have been quite open about the basic limits of econometric analysis. Here’s what I wrote in a piece in Regulation last summer:
One of the most important functions of markets is to discover prices; to provide a mechanism whereby information about supply and demand dispersed among millions can be aggregated. Thus, no one has the information to know what the price “should” be; if someone did, we wouldn’t need markets. But this always makes it very difficult to rebut assertions that a particular market price is distorted by speculation, or to prove that they were.
Moreover, in that article, I use some econometrics, but only very little. I instead utilize some non-econometric approaches to test the implications of the speculative distortion story. Thus, to attribute to me a slavish and myopic devotion to econometrics is just wrong. I have a very catholic view of what kind of evidence is persuasive.
But I am a firm believer that data and evidence should be decisive. Kemp argues that “policymakers must act on the balance of probabilities.” Fine. But just where, pray tell, are those probabilities to come from? Kemp bashes econometrics, but advances no alternative. Zero. Zip. Nada .
Sorry, but that just doesn’t cut it. Econometrics is one tool that can be used to inform judgments about probabilities. There are other tools–qualitative comparisons, and rigorous analysis of the economic logic of purported causal connections between speculation and price distortions, for instance–that can also inform those judgments. The best approach integrates statistics, econometrics, qualitative comparisons and rigorous economic reasoning. That’s the kind of approach I favor, and the kind of approach I’ve used–though you would never guess that in a million years if your only impression of my work is Kemp’s description thereof.
In the end, Kemp takes refuge in the position that as a matter of law, Congress has required the imposition of position limits, and that’s the end of that. He worries that the CFTC could be sued if it failed to adopt such limits.
But even that legalistic defense is incomplete. Congress has mandated the imposition of limits to achieve a specific purpose: the prevention and diminution of “unwarranted fluctuations” in prices. Limits that are unnecessary to achieve that goal–because such unwarranted fluctuations are extremely unlikely to occur–or limits that are so overinclusive that they impede the achievement of other Congressionally mandated objectives, shouldn’t hide behind the fact that courts may find the exercise of such powers Constitutional. “We do it because we can” is a recipe for regulatory mischief that undermines the very goals that Kemp claims to endorse.
My criticism of the CFTC NOPR is that it (a) identified a way in which large positions could cause unwarranted fluctuations, and (b) imposed limits that were completely unnecessary to address the very problem the CFTC identified. Maybe Kemp has different theories regarding (a). If so, he should spell them out, and specify his proposed remedies so that they can be evaluated and critiqued in order to ensure that they are indeed problems and the remedies are an efficient and effective way to address them.
In the end, I guess I do agree with Kemp on one thing: it comes down to an issue of the burden of proof. I believe in markets more than regulators. He apparently takes the opposite view. I am more than willing to debate this anytime, anywhere.
But contrary to what Kemp insinuates, I do not believe that markets are unerring, that market power is not a problem, and that certain laws and regulations can improve the performance of markets. I am not some sort of Dr. No, insisting upon unreasonable level of empirical support to reject the hypothesis that the Market Is Always Right. (Indeed, a former colleague, upon reading my work on manipulation, referred to me as a “Chicago apostate.”) I have a presumption in favor of markets, but it is a rebuttable presumption. And with respect to manipulation in particular, I have both rebutted the widespread view that manipulation is not a problem, and recommended specific, targeted legal responses to mitigate that problem.
When it comes to speculation and position limits, however, those who have questioned markets have come no where near to rebutting the presumption in favor of markets. I note–indeed emphasize–again that the CFTC does not even try beyond the specific areas identified in the NOPR: areas which Kemp believes are too narrow. But Kemp hasn’t provided a credible alternative either.
Given the havoc that bad regulations routinely inflict on markets, a credible story and at least some evidence should be required to support a particular policy proposal. A fair acknowledgement of the potential for unintended consequences is also appropriate. I note too that Kemp does not even attempt to critique the unintended consequences of the CFTC proposal that I lay out in my comments.
When it comes to the specifics, Kemp ironically endorses my view–although he does not acknowledge this. He says:
Reversing the burden of proof, it is worth asking opponents why anyone would want to run positions above the very high levels set out in the CFTC’s proposals. Are there legitimate reasons to want to run very large net positions, including in the spot month? Or is the only reason to exercise market power?
Uhm, that’s very close to what I recommend. Give the CFTC the authority to question the legitimacy of very large positions, and intervene accordingly if there is no legitimate reason. But that’s a far, far, different thing from a blanket prohibition of positions in excess of a particular size.
In sum, I stand by my specific criticisms of the CFTC position limit proposal. Moreover, I emphasize that Kemp has presented a distorted view of my arguments, beliefs, and work. His arms must be tired from giving a straw man such a thrashing.
But I’m still standing.
I have written a comment letter about the CFTC’s proposed rule on position limits, which I will submit tomorrow. A draft is here. It’s fairly long, so I’ll summarize it here.
I have said repeatedly that it is imperative for the Commission to identify the specific problems that it believes position limits will mitigate, and how they will do so. Creditably, in its NOPR, the Commission does set out specific ways in which large, concentrated positions can inefficiently destabilize markets. It is best described as a Hunt Brothers scenario, in which a levered player takes a large concentrated position in a market. Such a leveraged player may be forced to liquidate, and the liquidation of such a large position can cause extreme price moves, and perhaps, pose a systemic risk.
Fair enough. I’ve written about the Hunts in the past, and have made similar points. So that is a danger. But crucially, the CFTC does not identify any other ways in which large positions can cause “unwarranted” price fluctuations, which is the basis for its position limit mandate. Therefore, per the CFTC’s own analysis, its position limits should focus on addressing a reprise of the Hunt situation.
But the major problem with the CFTC proposal is that it will constrain the trading of many market participants who in no way pose the dangers that neo-Hunts would. That is, the proposed limits are over-inclusive.
In particular, they will constrain trading by exchange traded funds (ETFs) which are (for the most part) unleveraged. Indeed most ETFs are completely collateralized. Moreover, even if an ETF is big, it is different than a single trading entity like the Hunts because ETF trades are driven by the decisions of thousands of ETF investors.
In other words, ETFs are nothing like the kind of speculator–and the only kind of speculator–the CFTC has identified as a danger, but they will suffer collateral damage as a result of the CFTC’s limits.
They will not be the only innocent casualty. Many other “massive passives”–such as pension funds–will also be affected, even though they do not pose the risks that the Commission uses to justify the imposition of limits.
The problems with the proposal don’t end here. In particular, although “crowding out” is not explicitly in the new proposal (in contrast to the Commission’s proposal of January 2010), the new proposal has a feature that is just as pernicious, and just as inane: the “within-class” limit.
Due to the powers granted by Frank-n-Dodd, the CFTC now has the power to regulate positions in both OTC swaps and futures, whereas before it only had authority over the latter. The Commission proposes to create two classes of positions: the futures class and the OTC class. It proposes several limits imposed on the classes collectively and individually. For one of the limits, the two classes will be netted against one another, and any speculator must have a net position for all months and a single month that are less than or equal to the speculative limit. But in addition, each speculator’s OTC position must be smaller than the spec limit, and its futures position must also be smaller than the spec limit.
Here’s the problem. Assume for simplicity that the limit is 100. Consider a swap dealer who is short 150 swaps to customers, and hedges this using 150 futures. This complies with the across-class limit, because it nets out to zero. But it violates the futures class and the OTC class limits.
This feature therefore limits the ability of intermediaries–swap dealers–to hedge risks. It is effectively a tax on swap dealers, and will reduce liquidity in the swap market.
There are reasonable grounds to suspect, based on the past statements of some Commissioners, that this is a feature rather than a bug from their perspective. In my opinion, however, it is flat wrong. OTC market making is a legitimate activity, and OTC deals (hedged by exchange transactions) are often the most economical way for some market participants to take on the investment or speculative positions they desire. There is no reason to penalize this activity the way the proposed rule does.
Indeed, by limiting liquidity the rule threatens to exacerbate large price moves in response to shocks. Prices have to move more in less liquid, less flexible markets in order to accommodate big shocks. Stifling liquidity through the within-class rules is therefore counterproductive.
I would also note that the Commission provides no economic justification for this restriction. In particular, it doesn’t even try to show how this restriction addresses the Hunt Problem that is the sole substantive justification for the limits in the first place.
The Commission also fails to justify the size of the limits it proposes, which approach 2.5 percent of open interest for large markets. To put things in perspective, the Hunts’ position was over 25 percent of the market at times. So maybe 25 percent held by a single leveraged trader poses a risk: how does that justify a 2.5 percent limit on everybody, including non-leveraged traders who are in fact agents for myriad individuals making independent trading decisions (e.g., ETFs)?
The Commission also fails to recognize that its limits could drive business into the physical markets, thereby distorting prices producers receive and consumers pay. This is perverse, given that the ostensible purpose of the limits is to prevent and diminish such distortions.
In sum, the non-spot month limit proposal is fundamentally defective. It identifies a problem, and then identifies a blunderbuss-like “solution” that will hit a lot of trading activity that does not and cannot cause this problem.
The spot-month limits are flawed too, because they are logically inconsistent. The proposal limits caps spot-month delivery-settled derivatives positions at 25 percent of deliverable supply, but does not explicitly place a cap on the amount of deliverable supply a speculator can hold. The proposal caps cash-settled positions at 5 times the delivery settled limit, i.e., 125 percent of deliverable supply, and also permits the holder of cash-settled positions to hold 25 percent of deliverable supply.
Spot month limits can be justified as a means of preventing corners. Well, corners can be carried out by holders of cash-settled positions as well as delivery-settled ones. Indeed, that happened a lot in the Brent market in the 90s and early-00s, and may in fact be happening right now. Somebody can manipulate a cash-settled contract by buying excessive quantities in the cash market, driving up prices, and thereby artificially inflating the settlement price of the derivative.
If the objective of the limits is to prevent market power manipulations in both cash-settled and delivery-settled markets, the limits are logically inconsistent. The delivery-settled limit implicitly assumes that it is possible to distort prices by accumulating less than 25 percent of deliverable supply. Well, you can do that with the cash-settled contract, and then get a profit on a position that is five times larger.
In sum, the position limit proposal is a good example of bad regulation. It inflicts harm on “massive passives” (perhaps intentionally) even though this type of trader does not pose the only threat that the Commission has identified: this is a massive fail.
I should also note that the proposed rule provides not a word of justification of the widespread view that speculation caused the price spikes of the 2007-2008 period, or is causing the current runup in commodity prices. It certainly provides no evidence. But such price spikes are routinely evoked in Congress, the press, and even in statements by Commissioners, as evidence of the need for such limits. Since the Commission apparently does not have the confidence in such a belief to include it as a justification for limits in the formal proposed rule, this should play no role in deliberations over the rule going forward. To do so would be to play bait-and-switch.
Instead, the rule should be evaluated solely on the basis of its efficacy and efficiency in addressing the specific problems with speculation that the Commission has identified. When this is done, it is clear that the rule is grossly excessive because it impedes legitimate conduct that poses none of the risks that the Commission believes warrant regulation. The rule should therefore be rejected, and if replaced at all, replaced with something that is targeted at the specific ill that the Commission has diagnosed.
The US Department of Justice’s Antitrust Division hardly covered itself in glory the last time it weighed in on derivatives market structure when it criticized vertical integration of trading systems and clearinghouses in 2007 (if memory serves), in the aftermath of its (apparently grudging) approval of the CME-NYMEX merger. I excoriated that “analysis” on SWP, and I have been told that the posts I wrote made the rounds on Capitol Hill, causing (in the words of somebody in a position to know) one senator’s “head to explode” in anger (at the DOJ, not me) when he read them.
Well, the Antitrust Division is at it again. They submitted a comment letter in response to the CFTC’s proposed rulemaking on conflicts of interest at exchanges, SEFs, and clearinghouses. It is slightly better than the Parthian shot fired at the CME in 2007, but that is praise only in the “you don’t sweat much for a fat girl” variety, for the economic analysis in the comment is weak on the issues it discusses, and completely ignores salient economic considerations.
In brief, the DOJ recommends that the CFTC adopt a tougher rule that imposes “an aggregate ownership cap on major derivative dealers” because it fears that the absence of such a cap would “[preserve] the opportunity for these powerful entities to achieve majority ownership in DCMs/SEFs” thereby jeopardizing competition.
The Department argues that “limiting aggregate ownership and imposing stringent governance requirements . . . may prevent the emergence of a dominant trading platform controlled by major dealers to the detriment of other market participants.”
Let’s unpack that particular set of claims. Is it the “emergence of a dominant trading platform” that bothers the DOJ, or the fact that it might be “controlled by major dealers”? It is quite possible–and indeed, I would claim likely–that the nature of liquidity (specifically, its network aspects) strongly–strongly–favors the “emergence of dominant trading platforms.” If market power is the concern, who controls the dominant platform is of secondary or tertiary importance, at best. Does the DOJ believe that multiple platforms that compete aggressively are likely to emerge if dealers are precluded from controlling them? What is the basis in economics for this claim? I’m not aware of any. I would argue that the tendency for a single entity to emerge is driven by liquidity, and technological scale and scope effects (e.g., the ability to trade multiple instruments on a single platform).
There is, in fact, a stark example of this phenomenon staring the DOJ in the face: the very same CME that exercised the DOJ so mightily in 2007. The CME is not dealer dominated, but it has emerged as the dominant exchange in the US in the past decade.
This means that the Division’s belief “that an aggregate ownership cap on Enumerated Entities may facilitate competition by encouraging the creation of new DCMs/SEFs” is seriously misguided. What is going to drive market structure is the economics of liquidity (which could, in fact, be affected by CFTC SEF regulations, with exchange-like limit order book systems more susceptible to natural monopoly) and the economics of scale and scope driven by technology.
The Division anticipates this argument by saying that “[i]t could be argued that economies of scale in trading are so pronounced that derivatives markets will best be served by a single trading platform.” It then rejects this by saying “[t]his claim would seem to be inconsistent with developments in other financial markets–for example, cash equities–where multiple trading platforms have flourished.”
Two responses. First, that claim is not inconsistent with developments in most derivatives markets in the US and overseas, which are the markets of interest. Those markets are almost universally dominated by a single large exchange. (With respect to options, (a) index options are still dominated by single exchanges, and (b) in the US, for options on individual stocks, order handling rules effectively socialize order flows in a way that eliminates tipping that creates a dominant exchange).
Second, in equity markets, many of the trading platforms (e.g., dark pools) are means by which demonstrably uninformed traders reduce trading costs. As I’ve written before, it is price discovery that is the natural monopoly: dark pools and other mechanisms (e.g., internalization) that don’t contribute to price discovery aren’t subject to network effect driven economies of scale. Moreover, those mechanisms have not, heretofore, developed in derivatives markets, likely because the information intensity of trading is not as acute. Moreover, Reg NMS in US equities essentially socialized order flows and created a network of interconnected platforms, where the interconnection is mandated and regulated; prior to RegNMS, a single exchange dominated equity trading in the US, and single exchanges dominate equity trading in most other markets (that lack a RegNMS-type rule). Without a similar regulation in derivatives trading, the tipping tendency will prevail, leading to the dominance of one or a small number of platforms, ownership restrictions or no.
The kind of “competition for monopoly” story that DOJ tells (p. 6) is a more reasonable one, but ownership and governance restrictions are not going to affect one whit whether such competition occurs. Regardless of who owns a dominant exchange, there is a lot of money to be made displacing it, giving an incentive for somebody–anybody–to attempt to displace it. All that takes is money and technology, which is pretty widely available.
I also consider it ironic in the extreme that DOJ holds up BrokerTec as an example of an entity that spurred technological innovation through a competition for the CBT’s monopoly on Treasury futures. It’s ironic because BrokerTec was a dealer initiative. Similarly, the most recent competitor for the CME (which is not dealer owned or dominated) is a dealer dominated ELX, and CME’s strongest competitor in energy is the dealer-dominated ICE. And dealer dominated Turquoise has tried to oust non-dealer dominated LSE in British equities. So, if anything, dealer ownership limits would have hamstrung these competitors to dominant exchanges.
The focus on control of a dominant entity by dealers seems to reflect politics, rather than economics. The Antitrust Division’s concern should be about competition and market power generally, not about who collects market power rents. It has definitely not made the case–nor do I think it is possible to make the case–that restrictions on ownerhsip will have a material effect the magnitude of market power rents.
That said, (a) I’m not advocating intrusive regulation of competition in derivatives trading, and (b) I’m not advocating RegNMS-like rules for derivatives. I’m just saying that if your desire is to create multiple competitive platforms, something like RegNMS is necessary, and governance and ownership restrictions are superfluous at best, and counterproductive at worst.
The DOJ’s discussion of joint ventures (p. 6) suggests they just don’t understand the economics of exchanges and financial trading. They are concerned about a joint venture between dealers that admits too many members! The concern should be quite the opposite. As shown in my 2002 JLEO paper, exchanges can exercise market power by (a) admitting enough members that allow them to achieve scale economies that make them immune to competitive entry, but (b) which have fewer members than optimal. This is a consequence of the liquidity network effect. DOJ should be concerned about limits on membership, not that membership is too inclusive. The analogy between exchanges and airline alliances is completely off point.
With respect to clearing, the DOJ’s concern that restricting access to CCPs could serve to reduce competition is well-grounded; indeed, that’s exactly the kind of point I just made in the previous paragraph. I made that argument long before they did. But what is missing from its analysis is any consideration of the effects on ownership and governance regulations on (a) the willingness of institutions to commit the capital necessary to ensure that CCPs have the financial wherewithal to absorb large defaults, thereby mitigating systemic risk, and (b) CCP decisions on margins and capital levels that also impact their financial soundness and ability to withstand large price, volatility and liquidity shocks. As I’ve argued over and over, it is difficult to balance these considerations. But given that the whole purpose of clearing mandates is to reduce systemic risk, you’d think that these considerations should predominate. What’s more, it’s just inexcusable to ignore the financial safety/systemic risk issue altogether. Trade offs are hard, but ignoring them is unpardonable.
Indeed, the DOJ treats this issue dismissively: “[t]hese actions against potential new clearing members could be explained away, for example, by expressing risk management-related concerns.” Yeah, sure, somebody is likely to make that argument, and it deserves consideration rather than dismissal because these concerns are of first-order importance. Not that you’d learn that from reading the DOJ comment.
This is a very important issue, one that deserves careful, honest, and balanced analysis, none of which the DOJ provides.
With respect to governance recommendations, the DOJ comment is similarly incomplete and superficial. It focuses on conflicts of interest, but says nothing about ensuring that ownership structures align the incentives of those bearing the risk and those making the decisions. Misalignment would court disaster. To overlook this issue completely is quite disgraceful.
All in all, this is a fundamentally flawed analysis of the economics of derivatives trading and clearing, competition in those markets, and the benefits of restrictions on ownership and governance. Despite its crowing about its expertise in these markets, DOJ exhibits glaring deficiencies in its understanding of the economics of competition in trading and in clearing. As a result, if the CFTC has any sense, it will dismiss DOJ’s recommendations out of hand.
Yeah. I know.
The scariest kind of counterparty risk is “wrong way” risk. This kind of risk occurs when there is a dependence between the size of the exposure (i.e., the amount that can be lost in the event of a default) and the probability of the counterparty’s default. In particular, wrong way exists when the exposure is large when the probability of a counterparty default is large.
A canonical example of wrong way risk is a firm that writes a put on its own stock. If the firm goes bankrupt, and its stock becomes worthless, it defaults. When it defaults the exposure is as large as it can be: the strike price of the put. In contrast, a firm that writes calls on its own stock has “right way” risk. If the firm does badly, and indeed goes bankrupt, default losses on the call are zero because the call is out of the money.
Central counterparties–clearinghouses–are touted specifically as ways of mitigating counterparty risk. Post-Financial Crisis, they have been particularly advanced as a means to reduce systemic risk by reducing counterparty risk absorbed by big financial institutions. This raises interesting questions: Do CCPs have a wrong way risk problem? If so, what implications does this have for the performance of CCPs during systemic crises?
The answers in brief: yes, they may well have a wrong way risk problem, and that means that it is dangerous to rely on them as a means of reducing the likelihood and severity of truly systemic crises.
As I noted before, the defining feature of wrong-way risk is a dependence between default probability and the size of exposure. This is often characterized as a “correlation” between default risk and exposure. But as I’ll discuss below, “correlation” is too limiting a concept. Correlation implies dependency, but dependency does not imply correlation.
The magnitude of wrong way risk depends on the nature of transactions and counterparties involved. In particular, out-of-the-money options exposures, very senior tranches of structures, and highly rated counterparties are most vulnerable to wrong way risk. (For a good book on this subject, see Jon Gregory’s descriptively titled Counterparty Credit Risk.)
Moneyness matters because a deep out of the money option generates an exposure only if the underlying price moves a lot. But if the underlying price and the creditworthiness of the option writer tend to move in the same direction, a big movement in the underlying that puts the option in the money also tends to be associated with a dramatic erosion in the creditworthiness of the writer. Thus exposure and default risk peak simultaneously.
The seniority of a tranched structure matters for a similar reason. There will be losses on a senior (or supersenior) tranche only in the event of an extreme adverse shock hitting near simultaneously many of the credits underlying the structure. If this same adverse shock puts the writer of protection on the tranche into financial difficulties, the writer is most likely to default at the same time that it is supposed to payoff on the protection it sold. Think monolines, or AIG.
The credit quality of the counterparty matters because a high quality counterparty is likely to default on a contract only if it suffers a severe adverse shock to its balance sheet. With the right kind–or should I say wrong kind?–of dependence between the exposure and the counterparty’s balance sheet, this big adverse shock leads to a big move in the value of the contract. Thus, exposure is big precisely when the counterparty is highly likely to default.
Let’s see how this relates to CCPs, and in particular to the default funds of CCPs that are the ultimate backstop of cleared contracts. Default funds are analogous to protection written on supersenior tranches. The collateral (margin) that firms must post to CCPs when they hold derivatives positions absorbs most of the losses due to movements in market prices. Indeed, margins are usually set to absorb 95-99 percent of market moves. Beyond margin, CCPs often have their own financial resources to cover the losses associated with the default of any member firm not covered by margin. If the margin and CCP-resource elements of the CCP “waterfall” (note the similarity of terminology used to describe tranched structures and CCPs) are breached, then the members must absorb the remaining default losses, up to some pre-established commitment level.
This means that CCP members must cover defaults only in extreme circumstances, just like writers of protection on supersenior tranches must cover defaults only under extreme circumstances. Indeed, the oft-touted features of CCPs, such as collateralization create the seniority/out-of-the-moneyness that gives rise to wrong way risk if the pre-requisite dependencies also exist.
So it seems that CCPs are potentially vulnerable to wrong way risk. They are effectively financial structures of a type that can, given the right (or wrong, depending on your perspective) dependence, give rise to a serious wrong way risk problem. Which raises the question: are the dangerous dependencies likely to be present? That is, are the contributors to a CCP default fund likely to be in bad financial straits just when their contributions are needed to absorb default losses? Are those that are insuring default losses (through mutualization) likely to be in dodgy condition precisely when they are most likely to have to pay off on that insurance?
Given that we are talking about tail events, it’s difficult to assess that question analytically and empirically. But there are reasons to believe that these dependencies are in fact lurking.
A big financial shock that is sufficient to cause movements in derivatives prices big enough to breach margin levels, and/or which damages a CCP member’s balance sheet (or multiple members’ balance sheets) severely enough to force it (them) into default is likely to be associated with severe financial difficulties at other CCP member firms. For instance, during the financial crisis all banks were cratering simultaneously and prices were moving dramatically; their stock prices all plunged together and their CDS spreads all spiked togehter. They were all exposed to the same big underlying risk–in the event, real estate prices. When those prices went south, all financial institutions were in distress, most of them in severe distress. The financial tumult also resulted in big moves in stock prices, interest rates, credit prices, and commodity prices–all of which could have and did create widening exposures on derivatives trades. Indeed, since CCPs have zero net positions, a big move in any price is going to create a big exposure for the CCP.
And it’s not just price movements that matter. Financial and economic shocks are also associated with big changes in volatilities that affect exposures on non-linear positions (notably options or contracts with embedded options). Moreover, big volatility makes it more likely that exposure values and creditworthiness will move substantially.
Perhaps even more crucially, big financial and economic shocks tend to result in correlations in prices shooting towards one and minus one. This has both direct and indirect effects. The direct effect is to move–often by a lot–the mark-to-market values on correlation-sensitive positions (e.g., CDOs, multi-product options). The indirect effect is perhaps even more pernicious, as it is exactly these high correlations between the value of assets on financial institutions’ balance sheets and the values of derivatives exposures that generate acute wrong way risks. That is, the effects of stressed–crisis–financial conditions on correlation creates the very form of dependency that gives rise to wrong-way risk.
Liquidity effects of crises can also create dependencies. Liquidity tends to decline during crises, which tends to increase volatilities, thereby exaggerating movements in exposures and creditworthiness. It also makes it more difficult to manage the risk on exposures, and to trade out of positions in order to reduce exposures. (The common liquidity shock may be one reason why correlations tend to risk towards one in absolute value during crises.)
These dependencies can be especially exaggerated for certain kinds of products and CCPs. Consider, for instance, a CCP that clears CDS, a substantial portion of which are written on financial names, and which has financial firms for members. Exposures tend to spike for such a CCP at the very same time its members are suffering dramatic declines in creditworthiness. Not good.
Thus, in crisis periods, dependencies between the value of the backers of CCPs–the member firms (often banks)–and the exposures that CCPs are effectively writing protection against are highly likely to be of the wrong way variety.
This means that CCPs offer dubious protection against systemic risk. A huge economic shock, like that suffered in 2007-2008 creates dependencies that give rise to wrong way risks. They also give rise to big changes in exposures. The structures of CCPs have features that are particularly vulnerable to these dependencies.
Even if a CCP does not fail during a crisis, the wrong way risk problem means that the financial institutions that backstop it will have to make payouts at precisely the times that they are under strain. That is, CCPs load risk onto big financial institutions precisely during crises that are already stressing them.
This is not to say that CCPs cannot share garden variety default risks more efficiently than bilateral arrangements. But that’s not what the advocates of CCPs hyped when arguing for clearing mandates. No, these advocates repeatedly and specifically held them up as an antidote for crisis, as a bulwark against systemic risk.
The foregoing analysis of wrong way risk implies, however, that CCPs themselves are most vulnerable to default precisely at the time that their advocates look to them to be the breaks that contain financial firestorms. Consequently, any sense of security against financial contagion that they provide is very likely a tenuous one, and arguably a false one. Such complacency is particularly worrisome as it can undermine the urgency to find more effective and reliable measures to reduce the vulnerability of the financial system.
I am not saying that CCPs are as defective in concept as monoline insurers, or as AIG was. (Jon Gregory argued back in 2008, and argues again in his book, that the monolines and AIG were fundamentally, fatally and irredeemably flawed.) I am just pointing out that they share key features with those casualties of the last crisis, and as a result, may well be casualties in the next one.
It should also be noted that the Basel III capital requirements for CCPs that I discussed in an earlier post do not capture this risk in any meaningful way. They cannot provide, therefore, an incentive to reduce it in any meaningful way.
In a classic Rocky and Bullwinkle episode, Captain Peter “Wrongway” Peachfuzz sailed his ship up Wall Street. Let’s hope that’s not a metaphor for the effect of mandated clearing. But you should be concerned that clearing concentrates wrong way risk, and that this guy becomes the poster child for Frank-n-Dodd and its clearing mandates:
My post on the “points” system under which the CFTC would monitor positions, and then intervene on a discretionary basis when any position breached pre-set levels (“points”) brought to mind a story about the famous–or notorious, depending on your perspective–speculator, Arthur Cutten. Cutten engaged in massive speculations in wheat during the 1920s. In 1925, he made the largest income tax payment up to that time in the history of northern Illinois–over $500,000. Importantly, as a result of his market activities, Cutten attracted the attention–and the ire–of the government.
The Grain Futures Act of 1922 required large speculators to report their positions to the government. Speculation continued apace despite this requirement, and the authorities were impatient to do something to stop it. Calvin Coolidge’s Secretary of Agriculture, W.M. Jardine, demanded that the Chicago Board of Trade do something to stop the “gambling” in grain. In response, the CBT created the Business Conduct Committee.
Even in the aftermath of the creation of the BCC, Cutten continued his speculations. Cutten bought millions of bushels of May, 1926 wheat. The Grain Futures Administration, the division of the Department of Agriculture responsible for enforcing the GFA, “suggested to the Board of Trade that Cutten’s holdings were too large for one person” (Ferris, The Grain Traders, p. 180). The BCC swung into action and called in Cutten for a little chat.
When Cutten arrived for the meeting May wheat was selling at $1.65/bu. (He had bought at around $1.50/bu). His arrival at LaSalle and Jackson* was observed, and traders soon discerned its import: wheat began selling off as he ascended in the elevator to the conference room where the BCC was meeting.
The BCC told Cutten: “the Grain Futures Administration has made the complaint that you are carrying too much open stuff.” Cutten resisted selling, but the committee persisted. Finally, one of the committee members put his arm around Cutten, and told him: “You ought to sell some wheat for the sake of the Board of Trade. You know, this committee is the device we settled upon to keep the government from taking fuller control of trading in futures. They get the figures and watch the accounts from day to day.”
Cutten still resisted: “Why should I sell before I’m ready?” The committee member responded: “For the sake of the Board of Trade.”
Cutten finally relented. Prices fell further. He later lamented that the elevator ride to the BCC meeting had cost him a million dollars.
The mechanism that forced Cutten to sell looks remarkably similar to that proposed under the point system. The government monitored large positions, and exerted pressure on a particular trader–in this case, through the CBT–and that trader eventually capitulated.
What is worrisome about this story is that the intervention that forced Cutten to sell occurred in an overtly politicized environment. The Secretary of Agriculture, in step with a long line of Senators and Representatives viewed commodity speculation as a social ill. Jardine had demagogued the issue repeatedly: he had dragooned the CBT into creating not only the BCC, but to mandate clearing of all grain transactions as well. A speculator who had gained considerable notoriety for his previous operations in the market was targeted for pressure. At least insofar as the public record is concerned, there is no evidence that the GFA or its handmaiden BCC undertook any serious inquiry to determine whether the speculator’s actions had or threatened to distort prices. Similarly, there is no evidence that less intrusive measures were considered or proposed: to mitigate concerns about a corner, for instance, the BCC could have limited Cutten’s ability to take deliveries of wheat in quantities necessary to effectuate a squeeze.
Thus, one reasonable interpretation of the events of 1926 is that the GFA–the great-grandfather of the CFTC–intervened in the market for political purposes, rather than on the basis of a well-reasoned and empirically supported concern that the market had in fact been distorted by the actions of a particular individual.
Having watched closely–and up close–the fevered battles over commodity speculation in the past several years, I have no confidence that the same thing wouldn’t happen under the points system. In fact, I would put that more strongly: I have every confidence that the same thing will happen again. Discretionary authority is subject to political pressure, not to mention the whims of regulators. Consequently, it is inevitable that such authority will be abused.
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