Streetwise Professor

I’ve written a lot about clearing mandates, but less on the Dodd-Frank Act’s attempts to alter the way derivatives trades are executed.  In part, this reflects the incredible uncertainty about just what a “swap execution facility” must be and do.

But, it is pretty evident that there is deep suspicion about bilateral OTC market dealings, both in Congress and especially among regulators.  CFTC Chairman Gary Gensler in particular has criticized bilateral trading mechanisms.  He, and many others, want to move the vast bulk of trading activity to exchange-like systems.  The standard argument is that the opaque OTC markets work to the advantage of dealers and to the disadvantage of customers.  The greater pre- and post-trade transparency in auction-based, order driven exchange markets, the story goes, will undermine the information advantage that dealers have in OTC markets, thereby eroding their profits.

As was routine in the clearing debate, this begs crucial questions.  Most importantly, why would customers choose to trade in opaque dealer markets?  Why can’t exchanges win in competition for customers with OTC dealers, if the former offer a better deal?

There is a tremendous diversity of trading mechanisms across products, and within products.  In products where exchanges compete with dealer markets, dealer market shares vary widely.  The dealer share is virtually 100 percent in FX and FX derivatives.   It is large–on the order of 80 percent–in linear interest rate derivatives.  It is closer to 50 percent in interest rate options and equity derivatives.  In the cash equity markets, a lot of trading took place on anonymous exchanges, but a good deal once took place in non-anonymous upstairs markets.  Nowadays, the upstairs markets are less important, but dark pools serve similar functions, notably facilitating large trades.  Cash Treasuries were long dealer markets, and still are to a large degree, although electronic markets have made in-roads.

There is also time series variation.  Biais and Green have an interesting paper that documents how the municipal and corporate bond markets migrated from exchange trading (on the NYSE) to a bilateral dealer market.

The simplistic “dealers scalp their poor customers” story doesn’t explain this cross sectional and time series variation in the market shares of “wholesale” dealer markets.  There must be something else going on.

What many of these off-exchange markets have in common is that they screen out informed trading.  Dark markets and third markets utilize screening technologies, or trading mechanisms that are unattractive to informed traders (e.g., crossing networks).  Others, like the upstairs markets, block markets, and OTC derivative and bond markets (govvies, corporate, and munis) rely on reputation, and are not anonymous.  Dealers reduce their risk of dealing with counterparties with private information by knowing who they trade with.  They are “opaque” in the sense that there is little pre- or post-trade transparency.  But they are far less opaque than exchange markets–especially electronic markets–in the crucial dimension of the observability of the identity of the counterparties.

The empirical evidence shows pretty conclusively that big traders incur much smaller trading costs by trading in these venues.  Which is pretty obvious: the big traders aren’t stupid, and are going to trade where they get the best prices.  The Biais-Green piece is interesting in this regard.  The market moved from exchange to OTC when insurance companies and pension funds began to dominate bond trading.

So, the claim that customers are victimized in dealer markets is hard to square with the evidence.  Big customers often benefit by trading in markets that are opaque in some dimensions, but transparent in others.  Dealer-based “wholesale” markets favor a particular kind of customer, and those customers choose to trade there.  They aren’t victims.

I am also less than persuaded that OTC market customers are all that ignorant about values.  For instance, a customer buying or selling an OTC interest rate swap can look to the Eurodollar futures market and to the Treasury futures as a source of information on the yield curve that they can utilize to evaluate the bids and offers of OTC dealers.  It’s even easier in the energy markets, to compare a dealers bid and offer on a NYMEX lookalike product with the real McCoy trading on the screen.  Moreover, those who are trading OTC have the opportunity to trade these close substitutes in highly liquid exchange markets–but they don’t.  Presumably because it is cheaper to trade off exchange than on, even though they are allegedly trading with rapacious dealers who keep them in the dark.

And this raises an issue that has been the focus of debates about “fragmentation” between exchange and dealer markets in the past, but which has strangely disappeared from sight in the current debate.  Once upon a time, a major objection to off-exchange trading was that “free rides” off of exchange price discovery, and worsens liquidity on the exchange market.  In essence, those who can verifiably demonstrate they are not privately informed can get lower trading costs by trading off exchange, thereby leaving those who cannot demonstrate that they are uninformed more vulnerable to trading against the informed, and incurring higher trading costs as a result.  That is, off exchange venues like block markets and dealer markets “skim the cream.”

This can’t be the case in some markets.  In corporates and munis, for instance, there’s no market to free ride off of, for all intents and purposes.

Even in markets where cream skimming and free riding are possible, it is not clear that the net effect of this is welfare reducing.  If the exchange market is perfectly competitive–and this is a huge if, and a huge implicit assumption in most of the literature on fragmentation and cream skimming–then the externality associated with price discovery means that off-exchange trading is welfare reducing.  But exchange markets are not necessarily perfectly competitive.  As I’ve shown in my academic work, exchanges exercise market power, through entry limits (e.g., limits on the number of exchange members), organizing member cartels, and super-marginal cost pricing.  They can do so because the “tippiness” of anonymous markets tends to make price discovery a natural monopoly.

If exchanges exercise market power, we aren’t in a first best world anymore, and therefore what would normally be considered a market failure–like an externality–can actually improve welfare.  I show this explicitly in a couple of papers, one published in the JLEO, and in a working paper titled “Third Markets and the Second Best.”  In these models, competition from off-exchange markets reduces exchange market power, leading to lower total execution costs (and higher aggregate surplus).

But even if this happens, off-exchange trading has distributive effects.  Those who can avail themselves of the off-exchange opportunities gain, those who can’t, don’t.  But the gains of the former are bigger than the losses of the latter.  These distributive effects are the reason, though, for the intense controversy over market structure.

This means that forcing trading onto exchanges can reduce competition and increase total trading costs.  Ironically, the biggest losers in this would be those who are ostensibly being helped: those who voluntarily choose to trade in dealer markets, like the OTC derivatives markets.

Some who fret about the persistence of opaque bilateral markets attribute their persistence to the “tippiness” of financial markets.  For instance, Biais and Green argue that muni and corporate bond markets have remained OTC because it is hard to tip order flow away from established markets.

I find this argument unpersuasive for two reasons.

First, and most importantly, tipping occurs in anonymous markets, as a consequence of informed trading.  The uninformed like to cluster in a single market because that minimizes their losses to the informed.  But the whole thing about many wholesale markets is that they allow the uninformed to avoid losing to the informed through another mechanism–transparency about trader identity and type.  Markets fragment between price discovery natural monopolies (where informed and uninformed trading take place) and other markets where less price discovery occurs because these trading mechanisms screen out many of the informed, making the uninformed who trade there better off.

Second, the tipping argument may be plausibly persuasive in corporates or munis, but not in many OTC derivative markets.  For instance, there are extremely liquid markets for Eurodollar and energy futures.  Traders who choose to trade OTC could avail themselves of this liquidity–but they don’t.  Again, because it is cheaper to trade someplace else.  Put differently, tipping may be able to explain something like munis where there’s only one market (though I doubt that): it cannot explain the side-by-side survival of two big markets, like Eurodollars and interest rate swaps.

In brief, there is a diversity of trading mechanisms because there is a diversity in trader types.  Forcing trading onto a one-size-fits-all platform will inevitably have distributive effects, and will almost certainly have efficiency effects too.   These efficiency effects are likely to be adverse, because anonymous trading venues where trades with private information can buy and sell tend to have market power.  Reducing competition from non-anonymous trading venues, like OTC dealer markets enhances the market power of the anonymous markets, and their owners can profit accordingly.  Moreover, in profiting, they price their services in a way that creates deadweight market power losses.

We should never expect financial markets to approximate even remotely perfectly competitive markets.  But fragmented markets in which some traders participate in face-to-face dealer markets can be better than having everybody trade on “transparent” exchanges.   This is because usual descriptions of transparency focus on price transparency, and that’s not all that matters.  Markets that offer the most price transparency often offer the least counterparty transparency.

Gary Genlser has repeatedly used the analogy of going to the store and buying an apple at a posted price to argue that everybody should want to trade on markets with pre-trade transparency.  But there is diversity even in apple markets: wholesale and retail markets are different, and offer different degrees of transparency.  The same can be said with even greater force in financial markets.

Which is why I conclude that if Gensler and those of like mind get their way, and succeed in forcing–yes, it would be by force–more trading onto anonymous, exchange-type markets, trading costs will rise and welfare will fall.  And the biggest losers will those who are the alleged victims of the lack of price transparency in OTC markets.  They will be losers because that lower price transparency is more than offset by other advantages of trading in non-anonymous markets.

Russia is going to ban wheat exports, and is “coordinating” with the members of its “Customs Union,” Kazakhstan and Belarus, to do the same.  This ban has caused a worldwide spike in wheat prices; prices on the CBT and KCBT were limit up, about an 8 percent move on the former, and a 7 percent move on the latter.  Moreover, the cancellation is undermining Russia’s reputation (yeah, I know) as a reliable trading partner.

Cargill makes the point that Adam Smith made in the Wealth of Nations in the chapter “A Digression on the Corn Trade:”

Cargill, the world’s biggest trader of agricultural commodities, criticised Moscow’s move. “Such trade barriers further distort wheat markets by making it harder for supplies to move from areas of surplus to areas of deficit, and by preventing price signals from reaching wheat farmers,” it said.

Russian exporters argue that the precipitous announcement will make it harder for Russia to export going forward:

Arkady Zlochevsky, president of the Grain Union lobby group, said that the swift imposition of the ban risked undermining Russia’s reputation as a reliable supplier.

.  . . . .

Arkady Zlochevsky, president of the Grain Union lobby group, said the government needed to warn exporters ahead of such a decision and give them time to meet existing contracts, according to Interfax. “What are we to do with the grain that has already reached port?” he asked. “We have no mechanisms for returning it.”

There are understandable domestic reasons for this decision.  It is political, not economic, and reflects the government’s concern about a rekindling (no pun intended, given the current circumstances) of inflation, which has abated in recent months.   The immediate takes precedence over the future, especially in many Russian decisions.

The interesting question is the “coordination” with Kazakhstan and Belarus.  I haven’t been able to find out whether a Union-wide ban would prevent exports from say Kazakhstan to Russia, or just prevent exports from within the Union to without it.  I would imagine the latter.  Since it appears that Russia is hardest hit by the drought, a “coordinated” ban would benefit Russia, at the expense of the other two countries.  Is Russia leaning on the other countries in the Union?  Given recent Belarussian obstreperousness, it will be interesting to see how it reacts.  Will the threats fly?   Reporting I’ve seen doesn’t permit me to answer these questions now, but I will try to keep an eye on how Russia handles this particular issue in the “Near Abroad.”

Update (8/5/10, 2000 CT): Just saw a Stratfor video piece on the grain export ban.  According to Stratfor, (a) Russia is leaning on Kazakhstan and Belarus to export to Russia, rather than elsewhere, and (b) is making it plain that this is a loyalty test.  Loyalty being, like many Russian roads, a one way street.

Jeremy Grant is going to town with stories and video interviews on the implications of clearing mandate on his FT TradingRoom site.  One that particularly caught my attention was this interview with Guy Sears.  They discussed the implications of clearing mandates on pension funds.  Sears says (about the 5:55 mark):

It’s about the governance and who carries the risk in this model.  Clearinghouses work by seeing an instrument and worrying about the risks of failure in an instrument.  How far away has it got from its original price?  What’s the market risk in the instrument?  At the end of the day, of course, what really matters is whether the guy holding the instrument is good for his money.  We would say that the pension schemes and savings pools are good for their money.  Making them provide margin to pay for everyone else’s risk is asking them to take part in socializing risks they really should have to pay for because they aren’t risky.

Sears makes a point that I’ve emphasized from early on that has largely been overlooked.  Specifically, two factors interact to determine the risk of default: instrument risk and balance sheet risk.  CCPs price instrument and generally don’t price balance sheet risk, except in the crudest and most problematic of ways.*

As Sears says, balance sheet risk–the risk that “the guy holding the instrument is good for his money”–is crucial.  Not pricing it leads to distortions in the allocation of trading activity across market participants.  It also means that those who use clearing do not pay a price for adding balance sheet risk, which distorts their risk taking decisions.

Sears effectively objects to charging pension funds the same price for risk as a hedge fund pays.  This is a fair objection.  It harms pension funds directly, but it can also distort trading activity, causing hedge funds to trade derivatives relatively more than they should, and pension funds relatively less.  Does this reduce systemic risk?  That seems difficult to argue.

Moreover, different entities have different ways of effectively undoing the effects of clearing.  High and frequently adjusted margins on cleared products mean, essentially, that market users are not in a credit relationship with the CCP, in the same way that they can be in a bilateral dealing.  But this means that mandating clearing frees up credit capacity that can be used to undo, in whole or in part, the debt-reducing effects of clearing.  Some entities, notably pension funds, have less ability to leverage up (and indeed, given their high creditworthiness, are not really in that much of a credit position relative to their counterparties in any event).  This means that a clearing requirement would hit pension funds particularly hard, and unjustifiably.

Pension funds will respond by (a) reducing their usage of derivatives, and (b) reducing their investments in higher return assets in order to accumulate the cash needed to post margins on the derivatives they do trade.  Response (a) means that these funds will incur higher transactions costs to achieve their investment and liability management objectives, and will bear more risks.  Response (b) means that pensions will be less remunerative.

The Frank-n-Dodd bill exempts retirement funds from the clearing mandate to the extent that they utilize derivatives for risk management/hedging purposes.  It is ambiguous whether this exemption would, for instance, cover a fund’s use of an equity derivative or commodity derivative contract to achieve an investment objective.  But the recognition that retirement funds might deserve different treatment is one good thing I can say about Dodd-Frank.  (Although it’s not evident whether this exemption was the result of a fluke moment of lucidity, or the lobbying power of pension funds–including public and union funds.  The latter would be rich indeed.)

But Sears’s main point holds.  Balance sheet risks are an important determinant of counterparty risks.  CCPs don’t price this risk.  This lack of risk pricing is costly.

* CCPs often impose capital requirements, but these are generally multiples of margins.  Since margins don’t vary with balance sheet risk, these capital requirements don’t either.  Moreover, CCPs sometimes condition margins on credit ratings.  Given the crudity of these ratings, and the perverse feedback that results from ratings change-induced increases in margin, this is a coarse and potentially destabilizing way of pricing balance sheet risk.

Today’s FT runs another cringe-worthy PDA with Anthony Ward of Armajaro.  It is as probing and hard hitting as anything you would expect to read in, say, TigerBeat.  Its tone runs the gamut from credulous to worshipful.

I found the last two paragraphs particularly entertaining:

He is said to argue now as he did in 2002, that all he has done is go to the futures market “to buy cocoa in the most efficient and low-risk way possible”. The trade is likely to bring a stream of profits to Armajaro, particularly if the new Ivorian crop, due in October, disappoints.

Even if prices decline, Mr Ward is unlikely to suffer. A competitor who knows him well has no doubt he will have hedged his position. One admiring executive says: “No one knows the cocoa market better than Anthony.”

Paragraph 1: He’s long cocoa, so if prices rise due to a disappointing crop he reaps a stream of profits.

Paragraph 2: He’s hedged, so if prices fall, he doesn’t lose.  That is, he isn’t long cocoa.

If both of those things are true, he would indeed be a great trader: prices rise he wins, prices fall, he doesn’t lose.  He’s long the upside but not the downside.

How does that work, exactly? I mean, these diametrically opposed statements are in adjacent sentences.  Didn’t an editor think that such a feat was unlikely, or at least sufficiently intriguing to demand further investigation, explanation, and reconciliation?

There is, of course, a way that it could work: Armajaro could be long cocoa puts.  But this seems highly unlikely, as the traded put market is small relative to the deliveries that Ward has taken.  At the very least, though, the tension between the last two paragraphs should have spurred the report to do some actual, you know, investigation and reporting, to see whether the put story has any factual basis, and if so to provide some background on the cost of the puts and its effect on the profitability of the strategy.  And if it doesn’t (as is likely the case), to state forthrightly that Armajaro’s position is a risky one subject to a risk of losses symmetric to the prospect of gains.

But instead the reader gets a breathless fan mag portrayal of the hero who is able to do things that are impossible, or at least so unlikely as to demand further explanation.

This is all bad enough, but nothing compared to the apparent failure to ask any aggressive questions to test the reasonableness of Ward’s denial of squeezing or cornering the market.   If the questions were asked, but not answered, that should have been made plain, or the piece shouldn’t have run at all.  But that would ruin a nice piece of hagiography.

Mr. Ward’s evident hold over the FT is very curious.  An enterprising competitor could do worse than trying to figure out why–after, of course, doing some serious reporting on what has transpired in the cocoa market in recent weeks.

I have a  couple of recent publications that may be of interest to some of you.

A couple of folks have expressed interest in my recent Energy Law Journal paper on manipulation.  Here it is: my policy recommendations are at the end.

Cato just released a Policy Analysis I did on clearing mandates. The link is here: you can download the paper from that page.

I have been a close observer of manipulation since the mid-1980s, when the Japanese were squeezing the 30 year while I was devising interest rate hedging strategies for the clients of the FCM I worked for.  Since then, I have examined, intensively and forensically, manipulations in soybeans, Brent, Bunds, Treasuries, canola, copper, aluminum, propane, natural gas, WTI, and other things.  I have researched every major manipulation that I could identify, dating back to the 1860s.

I have heard all of the lame alibis, sometimes directly from the manipulators’ mouths, sometimes from the mouths of their mouthpieces.  Excuses from the likes of them are to be expected.  It is disappointing, however, to see the Financial Times regurgitate their tripe.

Yesterday the FT ran an editorial that recycled many of the tired tales that manipulators tell in defense of Anthony Ward’s actions in the cocoa market.  None of it is exculpatory, in the least.

To start with, the FT opines:

Armajaro breached no rules when, in pursuit of its view that cocoa prices would rise after a poor harvest, it snapped up contracts to purchase cocoa beans on the Liffe futures exchange. These gave it the right to take physical delivery of the beans if it chose. What stirred the controversy was that Mr Ward exercised that prerogative over 24,100 contracts. These amounted to about 7 per cent of annual world production.

Yes, the old “I had the contractual right to do what I did” defense.  But a market power manipulation involves the opportunistic use of this contractual right to distort prices and the flows of a commodity in commerce.  This action degrades the effectiveness of futures contracts as a risk shifting and price discovery mechanism, and leads to wasteful use of the commodity.  If “contractual right” trumps everything, then rules against corners are a nullity.  If that’s the way the game is played, maybe I should start The Corner Fund and go to town.  I’ll hire the FT to flack for me.  But I probably won’t even have to hire it: it seems it’s willing to do it for free!

The FT continues with another old standby: the “They had it coming to them for walking in this neighborhood alone dressed in shorts like that” story:

There is no doubt that his decision caused agony for some on the other side of the contracts. A number of cocoa traders use Liffe to hedge against falls in the prices of the stocks they hold. They suffered because they not only hedged their beans – but their holdings of cocoa powder and butter also. These were ineligible for delivery against the contracts, thus forcing the hedgers to settle contracts for cash at penal premiums or to buy sufficient beans to close the trade.

It is hard to see how Mr Ward can be blamed for this. The hedgers did not need to run a mismatch risk. They could have found other ways to insure their exposures – such as entering into a derivative with a bank. That would have been more expensive, but would also have been safer.

But the whole point of centralized markets is to concentrate liquidity, thereby permitting out-of-position hedgers to reduce risk with maximum flexibility while incurring low transactions costs.  They willingly trade basis risk for transactions costs.  That is no reason to excuse opportunistic actions that exacerbate basis risk.  The risks of being cornered induce hedgers to take costly preventative measures, such as investing collecting information about the activities of other traders that is socially wasteful because it is merely intended to reduce the risk of being the source of a wealth transfer, or using markets where transactions costs are higher.

Beating me to the punch, Tullet Prebon’s CEO T.C. Smith skewers the FT’s fatuousness–and hypocrisy:

Many commentators maintain that one lesson of the financial crisis is that all over the counter derivatives should be traded on exchanges.

I wonder how the revelation in your editorial, that the cocoa consumers who attempted to hedge their powder and butter through the imperfect mechanism of the Liffe futures in cocoa beans would have suffered much less if they had taken out OTC contracts with banks which precisely hedged their risk, fits their theory.

They can file your editorial with the reports on the as yet unexplained “Flash Crash” of May 6, in which Apple’s shares traded at one cent per share and $100,000 a share within 20 minutes.

But then, why let the facts get in the way of their theory? It will all be safer and more transparent when everything is on exchange.

Couldn’t have said it better myself.

The FT then plays three card monte and attempts to distract attention from the real issue:

It has been suggested that Mr Ward’s conduct was akin to cornering, and thus led to a disorderly market. But this is a hard case to sustain. Disorderly markets occur when two-way prices cease to be made – thus making cash settlements impossible. But the open interest on the cocoa contract fell in the weeks prior to expiry.

That is, shall we say, an idiosyncratic definition of “disorderly market.”  In fact, in many corners trading activity can reach a frenzy.  There are two-way prices, but the prices are far above where they would be in a competitive market, and the “cash settlements” are at essentially extortionary prices.  Apparently that’s hunky dory with the FT.  And even in cornered contracts open interest typically falls.  In fact, that’s almost always true.  Indeed, it often falls the most when the cornerer makes money by liquidating futures at supercompetitive prices.

The FT then suggests that the quiet word among gentlemen approach is preferable in such matters:

However, squeezes can be managed. Liffe tries to do this by directly stepping in where necessary to guide the activities of traders. This approach, which has been compared to being summoned to the “headmaster’s study for a quiet word”, effectively substitutes for a detailed rule book. The flexibility it provides can be valuable so long as the market is actively policed.

Yeah.  That works, except when it doesn’t.  And the London markets provide numerous examples of it not working.  Remember Sumitomo, and the LME’s rather, shall we say, prone, not to say accommodating, posture in dealing with Hamanaka right to the end?  Or all of the Brent shenanigans that occurred over the years?

And in that vein, a shout out to LIFFE, for validating my 1995 JLE article arguing that exchanges were unlikely to act against manipulation.  It would be hard to write a letter that does a better job at missing the elephant in the room.

Perhaps due to space limitations, the FT does manage to overlook some of the standard lines from the manipulator’s manual.  But a couple of commentors over at SeekingAlpha fill the void.

In this case, it appears that Armajaro already had customers for the cocoa delivered to it.  See!, the commentor says, there is real demand, real customers.  Well, if you know anything about manipulation, you know that the biggest danger is related to burying the corpse of the manipulation: that is, selling the massive deliveries that you take to squeeze the market.  A clever fellow bent on manipulating the market pre-arranges the funeral.  If the reports about forward sales of old crop cocoa to processors are correct, that was done in this case.  So, rather than being exculpatory, such sales are actually evidence of manipulative intent.

(I’d be interested to know who is making the deliveries.  It would be telling if any of the deliveries were made by those who had contracted to buy from Armajaro.  It would also be interesting to know more of the details of those contracts, not just the pricing terms but any other features in the contracts relating to use or marketing of the cocoa, and the delivery locations for the contracts.)

The other common excuse, again seen in my SA comments, is that the stuff that is delivered will be consumed.  Well, duh.  It’s not like the guy is going to eat it all himself, or burn it, or build houses out of cocoa beans.  It is going to be consumed.  But manipulation distorts consumption pattens–the timing and location of consumption.  The stuff is consumed, but in the wrong place at the wrong time, and too much of it is shipped around to the wrong places.  The fact that the delivered cocoa will eventually be consumed does not imply that the deliveries are efficient.

All in all, none of the arguments raised in Armajaro’s defense are even remotely exculpatory, and some are actually adverse.  A final judgment would require a full forensic and econometric evaluation of prices, pricing relationships, price-quantity relationships, and movements of cocoa.  Time permitting I hope to do some of that.  But at this juncture, there is sufficient evidence to conclude that there is a colorable case against Armajaro, and that the arguments raised in its defense are risible.

Taking huge deliveries in a large backwardation is consistent with manipulation.  This is especially true when one party takes all the deliveries.  Delivery economics are pretty straightforward, and if they work for one party they tend to work for several.  One firm taking all of the deliveries is suspect.

Moreover, the purported rationale for the trade–an expectation of a small new crop in the autumn–does not explain why the old crop price richened relative to the new crop price.  If the real motivation was a view that the market did not appreciate sufficiently the likelihood of a small crop, then the trade should have been to go long the new crop and cash in if and when that view was validated.  Taking delivery into a big backwardation, and seeing the backwardation actually increase as result of the deliveries, is not a sensible way to play an anticipated shortage in the new crop.  The backwardation across crop years screams: “don’t carry over inventory into the new crop year.”  So current inventories do nothing to alleviate future shortages (because the spreads signal that all of the cocoa should be consumed before those shortages arise).  (As an example of how the market should work in response to anticipation of a crop shortfall, during the big US drought of 1988, the old crop-new crop spreads for corn and soybeans snapped into a huge carry; indeed, the spreads exceeded full carry charges measured using official storage rates.  The warehouses in Chicago were filled to the top with grain and beans. That’s because the market realized that it was desirable to carry over old crop supplies in larger quantities than usual to alleviate the anticipated shortfall in the 1988-1989 crop.)  (Ferruzzi told the same lame betting on a new crop shortfall story during its bean manipulation in 1989.)

The rise in the London price relative to the NY price is also what you’d expect to observe in a corner.

I’m not rushing to judgment.  But neither should the FT .  Its unseemly haste to play Ward’s mouthpiece, its heaving up of tired excuses made for manipulators from time immemorial, and its complete lack of any skepticism, are not befitting a premier financial publication.

This is not the summer for the corner Starbucks.  This is the summer for the Starbucks corner.  First, there was an episode in coffee.  (Yeah, Arabica, not the kind of stuff you’ll usually find at Starbucks, but work with me here.)  And now, cocoa.  There were huge deliveries stopped on LIFFE’s cocoa contract, which calls for delivery in various European warehouses.  There are reports that a single trader stopped all the deliveries.  The name mentioned in this episode is Anthony Ward.

The cocoa market has moved into backwardation and there are reports of a large differential between European and US cocoa prices.  (I haven’t had time to run the data yet.)  The coexistance of a backwardation with large stocks is frequently symptomatic of a manipulation–a corner.

Stories say that Ward is speculating on short crops in the coming season.  But if that’s true, he could profit on that view without taking delivery.  He could just buy futures, and if he’s right, the futures price will rise and he can profit by liquidating his futures position.  Also, if he believes that there will be a shortage in the new crop, that view is best acted on through a purchase in the new crop contracts, not taking delivery.  Furthermore, a looming shortage in the new crop should lead to a rise in the new crop price relative to the old crop price in order to encourage the holding of stocks to meet future shortages.  The reverse has happened: rather than the curve moving to contango, it has become severely backwardated.  Thus, non-manipulative explanations are hard to credit.

The commodity markets, especially for the softs, are relatively small compared to the amount of money that can be amassed by hedge funds and others.  This means that the markets are potentially vulnerable to manipulation.  It looks like that’s going on in the Starbucks commodities this summer.  Look out, sugar!

I have long been fascinated by Black Friday, 24 September, 1869.  On that day, a massive corner in gold collapsed, throwing the American financial system into chaos.

My initial interest in the subject stemmed from my interest in corners: the opening paragraph of my book on manipulation (#2,306,956 on Amazon!  Available on Kindle!) uses the story of the collapse of the Fisk-Gould gold corner as the hook into the subject.  The episode shows how corners work; how they can fail; and interestingly, illustrates some of the game theoretic aspects of corners.  Specifically, Fisk and Gould were in a prisoners’ dilemma, and in the event, Gould ratted out on Fisk, selling when prices were driven up at the end by a surge of Fisk buying.  When Fisk stopped buying, the price collapsed, leaving Fisk with a boatload of losses, and Gould with a nice gain.  (Gould was actually selling to his erstwhile partner Fisk in some of his trades.)

But Black Friday also relates to one of my other obsessions–clearing.  Since about 1997, I’ve used the story of Black Friday to show that (a) clearinghouses can fail, and (b) that the consequences of said failure are catastrophic.

Here’s the story in a nutshell.  Gold trading started in the US in 1862, when during the Civil War the US government issued fiat currency (“greenbacks”) and made them legal tender.  Almost immediately, there was speculation on the value of gold vs. paper dollars.  The business began in the streets of New York, but soon became big enough that interested firms and individuals started a Gold Exchange and moved the business indoors.  The business boomed during the Civil War, and the price of gold ebbed and flowed with Union military victories and reverses.

Originally, deals were settled by the delivery of gold to the buyers’ offices in exchange for cash.  This, of course, resulted in robberies, sticky-fingered messengers, etc.  So the Gold Exchange adopted rules permitting delivery of bank certificates signifying ownership of gold in vaults.  That resulted in the a fraud scandal in which a trader counterfeited gold certificates (shades of the CO2 market, circa 2009-2010!).

As a result, in 1866, a Gold Exchange Bank was chartered in New York.  The Bank operated a clearing division.  Each day, traders submitted settlement statements to the Bank.  The bank calculated net pays and net owes in cash and gold.  Traders delivered their net obligation to the clearinghouse, in exchange for net payments owed them.

The Gold Exchange Bank was not a mutual organization, like a modern CCP.  But it did back trades out of its capital.  The Gold Exchange absorbed any losses attributable to the failure of any broker, and made whole those who were owed money on the daily settlements.  Thus, like a modern CCP, it insured against default risk.

The system worked like a charm from its inception in late-1866 until Black Friday.  But on that day, clearances were many times larger than usual: the usual day saw about $80 million in clearances, but (incomplete) records for the 24th indicated clearances of about $350 million.  More importantly, several important brokers–namely those who traded for Fisk–didn’t submit reports, and didn’t pay anything into the clearinghouse.

Chaos ensued.  Those owed money were clamoring for their funds.  But there was a huge whole in the Bank’s accounts.  It owed money to those who profited from the price collapse, but hadn’t received the funds from those who had lost.  It tried to finesse the situation by paying out partial settlements to those owed money.  But a trader filed an injunction stopping the Bank from doing this, and appointing a receiver to handle the settlements.  The Bank was closed for some days while the receiver unwound the tangled mess of obligations.  The Bank ended up losing close to $500,000.

The failure of the clearinghouse brought the New York financial market to a near standstill.  Liquidity dried up, as vast sums sat in the Bank’s vaults awaiting resolution of its obligations: short term money was only available at a rate of 1 percent per day.   The freeze-up of the financial markets brought foreign trade to a standstill as importers and exporters could not obtain the typical finance.

There are other interesting aspects to the story.  For instance, the Bank’s (state) regulators were overwhelmed by the situation.

In a nutshell: a big price move makes some big traders unable to meet their obligations to the clearinghouse.  The clearinghouse has insufficient capital to make up the shortfall, and shuts down.  There are serious, broader market spillovers and impacts on the real economy: that is, the clearinghouse was deeply interconnected with the broader financial markets, and consequently, with the real economy.

An old example, yes, but an illustration that clearinghouses can fail in times of market stress, and that these failures can lead to substantial market dislocations.

The episode also provides some other cautionary lessons.  For instance, collateralization–margining–was common on gold trades.  Indeed, not only was there daily variation margining, traders often posted initial margins (“independent amounts” in current OTC market parlance).  So margining was not sufficient to prevent defaults in the face of large market moves.

In the gold market of the 1860s, the clearinghouse did not collect margins: they were collected by individual traders.  This would differentiate a modern CCP from the Gold Exchange Bank.  However, the episode demonstrates that collection of margins was not sufficient to prevent default, either by deterring default-risky speculation, or by effectively eliminating the credit in any derivatives trade.  (If the net settlements paid and received by the Gold Bank took the margins already collected by the individual traders into account, the fact that the Bank did not collect the margins itself would be immaterial.  In this case, the Bank would be on the hook for default losses in excess of margins–exactly as is the case with a modern CCP.  The historical record that I have examined is not specific on this point.)

In brief: Clearing does not preclude the possibility of Black Days, with defaults and metastasizing financial chaos.

The best primary source on the episode is testimony taken by Rep. James A. Garfield’s House Committee on Banking and Currency in its Gold Panic Investigation.  That document is available on Google Books.  There’s a lot of tedious stuff, a lot of tendentious stuff, but a few (ahem) nuggets that make the read worthwhile, especially using GB’s search capabilities.

One last thing.  In conjunction with more recent events, Congress’s investigation reveals government’s love-hate relationship with clearing.  In the recent Frank-N-Dodd legislation, clearing intended to be the panacea to prevent systemic crises.  In 1925, acting under authority granted by the Grain Futures Act, the Secretary of Agriculture forced the Chicago Board of Trade to adopt clearing in order to clamp down on excess speculation.

In the Garfield investigation, in stark contrast, clearing was routinely damned by many Congressmen as the cause of excessive speculation and a systemic crisis.  As the minority report put it:

We have no doubt that the clearing-house, which is a nuisance to legitimate traffic and commerce, and the Gold Exchange Bank, which was an instrument used for the certification of fabulous amounts not represented by money (the “phantom gold,” which played so conspicuous a part in the drama,) are obnoxious to the sweeping criticisms of the majority report.  The clearing-house gave great facilities for gambling.  Seventy millions a day was its general average, and not half of it legitimate business.

“You can,” says Mr. Fisk, “make more transactions through the clearinghouse with $5,000 than with $100,000 without it.”  Men without means are by it enabled to deal in immense sums of gold, or phantom gold. . . . The gambling hells of Hamburg are Monaco are not more pernicious as temptations.  Their evils are few compared to those inflicted upon all our country and its business by this time and labor saving machine [a description given of clearing by one witness] to facilitate gold gambling.

The majority resolved to tax the clearing system out of business:

That the Committee of Ways and Means be instructed to inquire into the expediency of reporting a bill to levy such a tax on such transactions as those of the Gold Exchange and the Gold Exchange clearing-house, as, in their judgment the interests of the country shall require.

So, depending on when you ask, clearing is either: (a) the savior of the financial system and a deterrent to destabilizing speculation, or (b) a catalyst of destabilizing speculation that threatens the stability of the financial system.  Damned if you do: Damned if you don’t.

The truth is, of course, it is neither.  Which all suggests that considerable caution is warranted in believing financial morality tales spun by Congressmen in high dudgeon, the heroes and villains of which are interchangeable from episode to episode.

Frank-N-Dodd mandates that all cleared swaps trade on either a contract market (i.e., an exchange) or a “swap execution facility.”  There’s been a lot of uncertainty about just what a swap execution facility (“SEF”) is, but the bill provides enough clues to get a pretty good idea.

The short answer: a lot like an exchange.  A whole lot.

Some key points:

• An SEF must permit multiple participants to trade by accepting bids and offers made by multiple participants.  This means that an SEF must be a “many-to-many” execution platform.  A “many-to-one” platform, such as an electronic system in which a bank or broker-dealer posts bids and offers that customers can execute against wouldn’t qualify.
• They must permit “impartial access,” although that term is not defined.  But it suggests a mechanism in which no one can be excluded.  (Here the link to clearing is important.  If anybody is allowed to enter bids and offers that others can execute against, they must be effectively equivalent as potential counterparties.  Clearing standardizes–homogenizes–credit risk across counterparties.)
• The bill specifies that the goal of the section on SEFs is to promote pre-trade transparency.
• SEFs must establish and enforce rules to deter trade abuses.  They must have the capacity to investigate to detect rule violations.
• Relatedly, they must collect information that can be used to establish whether rule violations have occurred.
• They must permit trading only in non-manipulable swaps.
• They must monitor trading to ensure that rules are adhered to.  In particular, they must engage in real time monitoring of trading, and have systems to permit accurate and comprehensive trade reconstructions.
• SEFs must monitor trading in swaps markets to prevent manipulation.
• The bill states that SEFs “shall” impose position or accountability limits.
• SEFs are required to adopt rules to provide for the exercise of emergency authority.
• They are to make public “timely” information on price and trading volume and other trading data, as prescribed by the CFTC or the SEC (for security-based swaps). That is, they must offer “timely” post-trade transparency, but just what constitutes “timely” is an open question.  (Yet another thing on regulators’ plates.)

If you compare this list to the obligations imposed on contract markets (i.e., futures exchanges), you’ll see that SEFs are subject to almost all of the same obligations as contract markets.

In essence, SEFs must be a many-to-many execution platform that is also self-regulating entity that polices for trade practice violations and manipulation.  The combination of many-to-many with “impartial access” and extensive pre-trade and post-trade transparency effectively requires the creation of a public exchange; the mandated link between clearing and SEF execution is also very (futures) exchange-like.

It seems unlikely that “dark pool” like structures would meet these requirements; these are often not many-to-many, frequently don’t permit the making or executing against bids/offers (e.g., crossing networks), and offer limited pre- and post-trade transparency (hence the “dark” in “dark market”).  Traditional dealer-client execution wouldn’t cut it either: that’s not many-to-many.  Moreover, the real time trade monitoring and the ability to engage in accurate and comprehensive trade reconstructions seems to be an insuperable obstacle for voice brokers, meaning that effectively the bill requires the creation of electronic exchanges.

This suggests that (a) market participants will have a very limited choice of methods for executing transactions in swaps, and (b) these choices are far different than market participants have opted for currently.  Congress, in its infinite wisdom, is forcing pretty close to a one-size-fits-all trade execution system on the market.

The lack of diversity in execution methods compatible with the SEF mandate contrasts sharply with the incredible diversity of market participants.  It is well known that these diverse participants would like to have access to a variety of execution methods compatible with their particular needs.  For instance, those wanting to trade in very large quantities often prefer–and often strongly prefer–not to trade on many-to-many exchange-type markets because of information leakage, price impact, front running, etc.  The incredible array of execution platforms in equity markets testifies to this, as does the variety of derivatives execution methods, which range from order driven exchange markets to voice brokered markets to electronic dealing systems to telephone markets.

What is the rationale for restricting choice in execution?  The only hint of a justification is the desire for greater transparency.  But it is well known that  transparency has costs as well as benefits.  Mandating a high level of pre- and post-trade transparency just begs the question of why market participants would systematically choose the wrong level of transparency (i.e., a level that does not maximize the difference between costs and benefits), and why even if some market participants might profit from a sub-optimal level of transparency, competitive forces don’t prevail in overcoming the self-interest of a subset of participants.  Moreover, transparency isn’t the only thing that matters to market participants.  Other aspects of execution affect their costs and benefits as well.  A myopic focus on transparency alone ignores these other relevant dimensions.

The clash between the diversity of market participants and the my-way-or-the-highway SEF rules will result in chronic conflict in coming years.  There will be a demand, and likely a very strong demand, for the creation of alternative execution mechanisms to accommodate diverse trader needs.  There will be conflicts with regulators, and litigation, over whether these alternative mechanisms fall afoul of the SEF requirements.  There will be lobbying for exemptions, exceptions, and new laws permitting the creation of new kinds of facilities.

In 2005, I wrote that there was a 30 years war over securities market structure that was effectively started by the Securities Act Amendments’ mandate of a National Market System in 1975: that is now on its way to becoming a hundred years war (with the fallout from the Flash Crash just being the catalyst for another intense battle in that war).  The SEF mandate will spark a long running battle in derivatives market structure as well.  This is not the end of battles over derivatives market structure: this is the beginning.

The SEF rule is a Procrustean bed: an “arbitrary standard to which exact conformity is forced,” “a scheme or pattern into which someone or something is arbitrarily forced.”  Just why such conformity is optimal in a market with a wide range of buyers and sellers of different sizes, different trading objectives, different demands for immediacy and liquidity, etc., is hard to comprehend.  I understand that the nature of trading markets makes it that they are unlikely to be highly competitive (and I’ve written about that extensively in my academic work), and that as a result some inefficiencies (notably market power) can persist.  But competitive forces do exist, and especially given modern electronic trading technologies, it is possible for these competitive forces to respond to, and accommodate, diverse transacting preferences.

But rather than let market forces work, albeit imperfectly, Congress would rather play Procrustes, forcing traders large and small onto the same type of trading platform.

Where’s Theseus when you need him?

Patrick Pearson is head of market infrastructure for the EC’s financial market regulator.  He apparently hasn’t read the memo declaring that clearing mandates will usher in the era of the Big Rock Candy Mountain:

Central clearing  . . . is a concept so dear to regulators [sic] hearts that it has become something of a mantra — particularly since the demise of Lehman Brothers and the counterparty risks that were brutally revealed by that event.  So when Patrick Pearson . . . stood up to address an ABS conference in London on June 15 his words took some in the audience by surprise.  “Clearing houses don’t reduce counterparty risk,” he stated.  “They simply redistribute it.  Central counterparties (CCPs) can act as a channel for risk.  Their failure s far more dangerous than the failure of one single counterparty.”

. . . .

“If we shift massive amounts of OTC derivatives onto an exchange–are they safe enough to manage the risk? . . . . We don’t know.  There are 13 clearing houses in Europe.  If one defaulted there would likely be multiple defaults of clearing houses across the region.  Just imagine how the markets would react.”

Hallelujah.  How long have I been waiting for a regulator or legislator recognize those basic facts.

The author of this piece, Louise Bowman, recognizes that Pearson has gone off the happy talk reservation and committed the dire sin of telling the truth:

Hang on!  The market has long worked on the assumption that central counterparty clearing will be mandated in Europe — it is just a matter of when . . . . The question is therefore what the highly eloquent Pearson was trying to say.  In addition to questioning whether central clearing reduces counterparty risk he suggested that exchange trading of OTC derivatives might not be adopted in Europe–something that has also been seen as almost inevitable given the regulators’ drive for transparency in this market.

It is encouraging that not everyone in a position of regulatory responsibility has drunk deep the Klearing KoolAid.  It will be interesting to see how things develop in Europe.  It will be especially interesting to see whether an extended debate over clearing and exchange trading mandates lead to rather testy interactions between US and European officials, as alas, KoolAid seems to be the only thing served on Capitol Hill, Pennsylvania Avenue, and 21st St.

Pearson is, so far, pretty much a voice in the wilderness.  One hopes, however, that he catalyzes a more constructive debate on these issues.  There is a growing group of clearing skeptics among academics and practitioners.  Pearson’s outspokeness raises the possibility that the skeptics’ arguments might actually receive a serious hearing at least somewhere it matters.