Streetwise Professor

CFTC Chairman Gary Gensler and Commissioner Bart Chilton have mooted the idea of replacing the CFTC’s specific intent standard in manipulation cases with the SEC’s weaker recklessness standard:

Gensler asked securities and commodities experts whether it would be appropriate for the CFTC to use the SEC’s less stringent “recklessness” standard for evaluating manipulation cases, rather than the CFTC’s “specific intent” standard. He noted that the CFTC has only once in its 35-year history successfully won a manipulation case in court.

Other CFTC commissioners also are interested in exploring the issue. CFTC Commissioner Bart Chilton said, “I like the SEC’s manipulation standard. For them, it just has to be reckless (to investigate). We have to prove an intent to manipulate.”

The CFTC’s record in manipulation cases is, not to put too fine a point on it, a mess.  To prove manipulation, it is necessary to prove: (a) the existence of an artificial price, (b) the accused had the ability to cause an artificial price, (c) the accused did cause the artificial price, and (d) the accused had the specific intent to cause an artificial price.  The “specific intent” standard means that the artificial price was more than a foreseeable consequence of actions intended to achieve some other objective (e.g., a firm takes delivery pursuant to a marketing program, and as a result of this action the price is distorted).  Instead, under the specific intent standard, the accused must have deliberately intended to create the artificial price and profit therefrom.

As I wrote about 15 years ago in an article in the Washington & Lee Law Review, these criteria for manipulation are in fact sensible.  It’s the Commission’s application and interpretation of these criteria that have been woeful, not to say idiotic.  The silliest Commission decisions were in re Cox & Frey, and especially in re Indiana Farm Bureau.  Both cases are monuments to economic ignorance, for reasons too numerous to detail here.  (The law review article was upwards of 50 single spaced pages.)

Indiana Farm Bureau is the worst offender.  In this case, a split Commission spelled out its interpretation of specific intent, and made a complete hash of it.  Again I’ll spare you the details, but the most important error the Commission made was to make the accused trader’s intent at the time he initiated a position decisive in determining intent.  Unfortunately, in a corner (the most common and important form of manipulation), it is a trader’s actions when he liquidates a position that are crucial.  A cornerer liquidates too few positions and takes too many deliveries; the latter action distorts prices by forcing the market up the supply curve.

So, under IFB, a trader can enter in a position as a hedge or speculation, and then as the contract nears expiration, squeeze the hell out it if the opportunity presents itself, and escape scott-free.

So, it’s not specific intent that is objectionable.  It is the Commission’s boneheaded interpretation of the concept that needs fixing.  The Commission needs to focus on intent at the time the price distortion takes place, not long before.

As currently interpreted, the Commission essentially gives traders a manipulation option.  Enter into a position for any legitimate commercial purpose (e.g., hedging or speculation) and you have the option to squeeze later on.  It’s like saying that murder is OK, as long as you don’t plan it too far in advance, but just take advantage of any opportunity to knock off somebody who bugs you when it comes up.

A recklessness standard is, in my view, too loose, and too subject to abuse by regulators.  A coherent specific intent standard, rather than the current incoherent one, is preferable.

Gensler raised the possibility of going to Congress to get additional authority:

“It may well be that we can do something within our current authority” to boost enforcement against fraud and manipulation, Gensler said. “It may be that we recommend some changes to Congress.”

That would be advisable.  In my 1996 book on manipulation (#2,217,310 on Amazon!  Available in Kindle format!) I laid primary responsibility for the pathetic state of manipulation jurisprudence squarely on Congress’s shoulders for its failure to define manipulation with sufficient clarity, and failing to set out more specific standards/criteria to prove manipulation.  In its desire to create a statute so broad as to encompass every type of manipulation, Congress created one so vague that it was incapable of being used to combat the most serious forms of this conduct, most notably market power manipulations.  (I made a similar suggestion to Sen. Richard Lugar when he was chairman of the Senate Ag Committee in 1996.)

The sad part about all this is that the effects of manipulation are quite distinct, and the kinds of conduct that can cause these effects are very straightforward.  By failing to apply some basic economic reasoning, Congress and the Commission have made things far harder than they need to be.

So, it is indeed about time for the Commission to get serious about addressing its past failures–and getting Congress to address its failings as well.

Gensler and Chilton spoke glowingly of the SEC’s manipulation standards.  I should point out, though, that the SEC has hardly been that successful in prosecuting manipulation, even given its weaker recklessness standard.

And speaking of reckless, one suggestion made at the CFTC-SEC meeting by Columbia Law Professor John Coffee was to make insider trading illegal in commodity futures markets, as it is in securities markets:

Fraud in the derivatives market may be reduced if the CFTC had SEC-like powers to enforce insider-trading and market- manipulation cases, Columbia University securities law professor John Coffee said in prepared remarks to be delivered today.

The CFTC “needs legislation prohibiting insider trading on commodities and transactions within its jurisdiction” and should be able to impose financial penalties in cases of violations. The SEC “is armed with a greater enforcement club” and can impose penalties without going to court, Coffee said.

“The bottom line here is that it would make sense to harmonize these penalty levels so that both agencies had equivalent powers,” he said.

This suggestion, and the reasoning behind it, are inane. There are substantial differences between securities and commodities markets.  Sanford Grossman summarized the key issue in the Journal of Business in 1986:

In securities law, which regulates insider trading, an insider is a corporate employee or some other person with a fiduciary responsibility to the shareholders of the corporation.  The mere possession of valuable private information by a person who owes no fiduciary duty to the shareholders of a company does not make the person an insider under the securities law.

. . . .

It is important to realize that securities law prohibitions against insider trading are not prohibitions against informed trading . . . These laws are designed to prevent corporate officers from violating their fiduciary responsibility to shareholders, for example, by preventing trade by an insider that increases the wealth of the insider at the expense of shareholders.  A futures contract is not a “security” issued by a commercial trader.  The commercial trader is not under any fiduciary obligation. . . . Hence the rationale for regulating insider trading is absent in the case of futures markets.

In the absence of fiduciary duty as the guiding principle behind any regulation of insider trading by a market with no “insiders” as defined in securities markets, it is likely that any inside trading regulation in commodities markets would attempt to restrict some kinds of informed trading.  This would be a disaster.  It would wreak havoc with the price discovery process, deter some market participants from participating, and create a game of regulatory Russian roulette because any attempts to draw lines between “good” informed trading and “bad” informed trading would be inherently arbitrary.

What was Coffee thinking?  I have no idea, but I must say it’s not the first time I have asked myself that question.  It seems that he’s a guy who knows a lot about securities, and virtually nothing about derivatives, but assumes that they are effectively the same even though there are important differences.  A foolish consistency, Mr. Coffee . . . [And no, I’m not talking about Joe Dimaggio.]

The joint CFTC-SEC meeting about how the two agencies can play better together has spurred numerous suggestions that the agencies merge, or better yet, that the government create an uber-regulator responsible for all aspects of regulation of financial markets and financial firms.

I’ve written before that this is a very bad idea, and in light of the return of attention to this issue, thought it worthwhile to explain again why I think that’s so.  I’ll also lay out an alternative regulatory scheme that I think makes sense than either the existing system, or the uber-regulator alternative.

The argument against a regulator with myriad responsibilities for myriad firms rests in economic theory, notably agency theory.  Avinash Dixit has laid out the argument in a nice book that is somewhat accessible to a non-professional audience, so I’ll just hit the high points.

The idea here is that a regulator is an agent.  Who is the principal?  Well, Congress is the primary principal.  Thus, fundamental mechanism design issues that arise in the context of agency theory as typically applied to a firm (principal) trying to motivate and control its employees (agents) apply to the Congress-regulator relationship too.

Dixit notes that Congress designs regulators.  Moreover, Congress, both through the statutes it passes establishing and governing the regulators, and through the oversight process, provides regulators with incentives.  In particular, Congress can subject a regulator to very strong, “high powered” incentives, or very weak “low powered” incentives.  Agency theory tells us that the power of the incentives will depend on the nature of the organization/regulator.

Specifically, agency theory implies that low powered incentives are generally desirable when an agent has to perform multiple tasks.  The more tasks, typically, the weaker the incentives.  If you provide really high powered incentives, unless it is possible to measure everything the agent does with high and roughly equal precision, the agent will have an incentive to game the incentive system and do the things that provide very high rewards, and neglect the tasks that don’t.  As an example, let’s say you let cops keep a portion of the stolen goods or drugs that they seize.  You can bet that the cops would spend all their time looking for thieves and drug dealers, and have very little incentive to solve murders or intervene in domestic disputes: where’s the money in that?  Moreover, it’s hard to measure the effort or effectiveness or benefit of murder solving or separating Mr. and Mrs. Smith, so it’s hard to design an incentive to reward what you can’t measure.  So, when that 911 call comes from the Smith residence, don’t expect much of a response: the cops will be out looking for the dealers.

The resulting allocation of effort can be very perverse.  To give an incentive for the agents to do things that are hard to measure, you have to provide low powered incentives.  You can’t reward drug seizures, because that would induce the cops to spend all their time looking for drugs, and little time policing other kinds of (less remunerative to them) crimes.  Thus, low powered incentives are necessary to induce an optimal allocation of effort across tasks.

The more alternative things that the agent can do–the more tasks he performs–the more possibility for gaming high-powered incentive systems, and typically the weaker the incentives have to be.  Therefore, it is typically optimal to subject an agent that is  responsible for many tasks with lower powered incentives.

If the agent has many principals, the problem gets even worse.  Each principal has an incentive to get the agent to do what that principal wants, at the expense of the other principals.  So, it may be optimal to subject an agent working on a single task to weak incentives (fixed salary, no bonus, 9-5 hours) if he works for many principals.

Put these problems together, and you usually have to impose extremely weak incentives in order to reduce opportunistic gaming of the incentive system.  A multi-tasking agent working for many principals should typically be subject to very weak incentives.  And having very weak incentives, he is unlikely to work either hard or smart.  That may seem bad, but it’s less bad than having the agent work hard and smart to game a high-powered incentive system.

This means that a big, uber-regulator responsible for regulating everything in the financial space would be a disaster if Congress subjected it to strong incentives.  The uber-regulator would have many, many tasks to perform: oversight over security issuance, disclosure, bank capital and risk taking, derivatives trading practices, and on and on.  Moreover, it would have many principals.  It might seem there is only one–Congress–but Congress is not a unitary body.  It has numerous committees, many of which would have a piece of the responsibility for overseeing the agency.  Moreover, on a given committee, there are multiple Congressmen, each of whom is responsive to distinct interests unique to his district or state.

So, Congress would likely respond to this by providing the regulator with very weak incentives.

Thus, the alternative outcomes with an uber-regulator: an out of control body gaming high powered incentives, or a slothful, inefficient organization subject to weak incentives.  The likely outcome would be the latter, a living illustration of Eugene McCarthy’s statement that “the only thing that saves us from bureaucracy is its inefficiency.”

So what do I propose instead?  A more functional division of regulatory responsibilities, and one that mitigates the multi-tasking/multi-principal problems.  In a nutshell:

• Split off the primary market, accounting, and disclosure parts of the SEC into a separate organization.  Call it the “Securities Commission” or the “Corporate Financial Information Commission.”  This agency would police fraud in the issuance of securities, and fraudulent disclosures and accounting practices.
• Combine the market operation parts of the SEC and the CFTC into a Trading and Markets Commission.  This body would have responsibility for overseeing the operation of exchange and OTC trading mechanisms.  It would essentially be a “microstructure” regulator responsible for secondary market structure issues in securities and derivatives, manipulation and fraud in securities and derivatives trading, and the policing of agents who execute transactions for principals (e.g., stock brokers).  Under this system, there wouldn’t be the turf battles over the regulation of different kinds of financial products, or attempts to design products in order to have their trading overseen by one regulator or the other.  All trading would be under one regulator.  These trading-related matters are largely distinct from the information/disclosure related issues, and there is no good reason to combine all under one regulator.
• Create a prudential regulator with the responsibility of regulating the risks of financial institutions.  This regulator would cover major financial intermediaries, regardless of corporate form, that potentially pose a systemic risk.  Thus, banks, investment banks, large insurance companies, and other levered institutions whose failure would pose a risk to the financial system would be subject to this prudential regulator

This division of authority along more functional lines would mitigate the multi-tasking and multi-principal problems that an uber-regulator would pose.  Of course, there would still be multiple principal and multiple task problems under this allocation of responsibilities, but the organizations would be more focused, and could be provided with stronger incentives to do their jobs than would be the case under a single, overarching regulator.

Is this likely to happen?  Surely not.  But hopefully people will start to awake to the fact that the seeming elegance and simplicity of one-stop regulatory shopping is actually a recipe for the next crisis.  Think that regulators failed last time?  Just wait until you have only one, and you’ll see a real failure.  Just like businesses are subject to diseconomies of scale and scope, regulators are too.  Sure, securities issuance and securities trading are related.  So are steel manufacture and automobile manufacture.  But it proved very inefficient to combine steel and car production in a single firm, and in my view it is very inefficient to combine all of the many aspects of financial market regulation in a single agency or commission.

Exchange Traded Funds (“ETFs”) are attracting a lot of attention given (a) the CFTC’s clear signaling of its intention to impose limits on these funds, and (b) the reactions of fund issuers to this signal, most notably Deutsche Bank’s announcement that it was closing down some ETFs altogether rather than operate under the anticipated position limit regime.

So what’s the big deal?  As with most discussions of the issues surrounding speculation in commodities, the critics of ETFs are maddeningly vague in their criticisms, and don’t provide any evidence of a demonstrable deleterious effect.  The arguments seem to be that big must be bad.

Case in point.  On CNBC this morning I heard an oil trader say that the UNG fund (which trades natural gas futures) is a problem because it holds 30 percent of the nearby contract; routinely liquidates that position as expiration approaches; and that the liquidation of such a big position must be disruptive.

Call me Alfred E. Newman, but in response, I’m thinking: “What?  Me worry?”  This seems like something that the market is perfectly capable of diagnosing and addressing without any meat cleaver regulatory restrictions.

First, note that the operators of funds have strong incentives to minimize their disruptive effect.  If their liquidations are distorting prices, that is costing the funds money.  They would be moving prices against them–inflating the prices of what they buy and deflating the prices of what they sell.  They have an incentive to trade to minimize that impact.  After all, they have to compete for investor funds, not just with other ETFs, but an immense array of other investment vehicles.  If they become so big, or trade so badly, that their execution costs balloon, their performance relative to that of alternative investments will decline, and they will have trouble attracting investment.  So, they have an incentive to mitigate their price impact.

Second, and relatedly, to the extent that a given fund becomes so big that despite its best efforts its liquidations are messy and its execution costs are high as a result, that will serve as a natural constraint on growth.  Put differently, if these execution cost-related problems create diseconomies of scale, again in a highly competitive investment marketplace, the size of these entities will be limited naturally.  It means they have an efficient scale, and competition will constrain their ability to expand beyond that efficient scale.

All sorts of markets for all sorts of things have natural mechanisms for ensuring that firms operate at efficient scale.  Why should financial markets in general, or ETFs be any different?

Third, the CNBC critic and others who point to the large liquidations of big ETFs fail to recognize that there is a natural set of traders who are ready, willing, and able to buy what the ETFs want to sell when they roll: these are the traders who sold short in the first place in order to allow the ETFs to buy.  They almost certainly don’t want to make delivery, and are looking to liquidate/cover their expiring shorts just as the ETFs are looking to liquidate/cover their expiring longs.  That is, the ETF doesn’t need to find a new set of buyers to take its positions.  There is a natural set of buyers out there; the people who sold to them in the first place.  And wouldcha know it, they just happen to want to buy the exact same amount of stuff that the ETF wants to sell.  A match made in heaven.

The main potential problem is how to coordinate the activities of the ETFs and those they want to sell to at expiration.  If the ETF starts to sell when the natural buyers aren’t around, there can be a temporary price impact as liquidity suppliers must bridge the gap until the natural buyers turn up, and the liquidity suppliers demand compensation for the risks that they bear as a result.

But markets have myriad ways to facilitate this coordination.  Indeed, coordination is what markets are all about.

One way to facilitate coordination would be through block trading facilities.  These have been around in equity markets for a long, long time.  They have started to make inroads into futures markets, but exchange rules and government regulations have been less favorable to block trading in futures than in equity markets.  So, one response would be to put rules and regulations in place that make block trades easier.

Another way is through sunshine trading.  It’s been known for a long time (basically, since the mid-1980s when portfolio insurers used the strategy to reduce their execution costs) that a large, uninformed trader who is buying or selling for liquidity-related reasons, rather than because he has private information, can reduce execution costs by announcing his purchases or sales in advance.  If potential counterparties believe that the trader making the announcement is indeed uninformed, then (a) they will not charge transaction cost (in the form of price impact) to compensate for the possibility of trading with somebody with better information, and (b) they can make sure that they are there to take the other side of the announced trade, thereby ensuring that there’s a lot of liquidity available.

Yet another way is to develop crossing networks that don’t contribute to price discovery, but merely cross offsetting positions at some price taken from an exchange, e.g., the settlement price of NYMEX NG futures. Crossing networks are another way that uninformed traders can credibly signal that they are trading for liquidity reasons, and don’t want to have a price impact.  Stock crossing networks have been around for decades.

An alternative to a crossing network is a call market, which is essentially a one shot auction.  So, for instance, NYMEX could set up a call market in the expiring nat gas or WTI contracts.  The ETFs would submit offers to sell, and knowing that the ETF would be there, its natural counterparties could submit offers to buy.  (Since the ETFs look to roll positions, and hence want to buy the next month when selling the expiring contract, it might be desirable to have a call market in spreads.)

Still another way is to use cash settled contracts.  These contracts use “derivative pricing”–they take the price from another market, such as NYMEX, to determine the final value of the contract.  These contracts are essentially “self liquidating”; they don’t require a trade to close out the position.  The position closes out automatically by reference to another market price.

Indeed, UNG has already moved in this direction, using cash settled nat gas swaps as well as nat gas futures to achieve its exposure to natural gas.

In sum, there are many ways to mitigate price impact even of big funds.  Even if a fund controls 30 percent of the open interest in a contract and wants to liquidate, well, damn close to 100 percent of the opposite side of that open interest wants to liquidate too.  There is an almost perfect double coincidence of wants.  It’s just a matter of coordinating those traders.  There are many market mechanisms to do that, and market participants have the incentive to find the efficient mechanism–or more likely, the efficient combination of mechanisms, including efficiently scaled funds, the use of cash settled contracts, crossing networks/call auctions, block trading and sunshine trading, and stuff I haven’t thought of–to achieve this coordination and mitigate price impact.

The key thing to remember is that somebody internalizes the costs of these alleged liquidation-related disruptions.  As a result, that somebody has the incentive to use mechanisms that minimize that impact, and entrepreneurs have incentives to devise new mechanisms that further reduce the impact–if regulations or legal impediments don’t prevent that from happening.

One last thing.  The market share numbers, e.g., the 30 percent number mentioned by the CNBC talking head, don’t bother me in this context.  A big percentage translates into a big position which could pose a manipulative threat if–IF–the party holding it DOESN’T liquidate enough positions, but demands excessive deliveries.  That is, a big trader that liquidates his entire position–which is a big ETF in a nutshell–does not pose a manipulative threat.

So, let the market develop and employ the mechanisms that facilitate the accumulation and liquidation of large positions that individual investors obviously want to hold.  (Note that they are willing to pay premiums to get into some big ETFs.)  The challenge posed by ETFs is nothing new, and markets have figured out ways to address such challenges efficiently for years.   There’s no real need for the regulators to worry their pretty little heads over this one.

I’m sure that no one would be surprised that CFTC Commissioner Bart Chilton was not pleased by my recent post that lambasted his equation of the activities of ETFs with manipulation.  Well, the sarcasm was arguably overdone (that NEVER happens, I’m sure you’re saying), but I stand foursquare by the substance.

Well, now Commissioner Chilton penned an editorial in the Des Moines Register that lays out his argument for the need to restrict speculation.  It is a very weak argument indeed, and it would be a tragedy if anything like it is the basis for major changes in the regulation of derivatives markets.

He starts with a wild mischaracterization of history:

For a hundred years, farmers in Iowa and around the nation have been able to hedge their business risks in the futures markets. The entire endeavor has worked well for farmers, futures exchanges and our economy. In the last few years, however, things have changed. New “non-traditional” speculators, such as hedge funds, index funds, pension funds and endowments, have all entered the futures markets, bringing with them massive new liquidity but also some very real concerns. Unlike commercial speculators – for example, farmers, processors and refiners who actually do business in the underlying commodity, be it corn or beans, natural gas or crude oil – the new speculators have no such similar interests. The new speculators are only interested in one thing: increasing long-term profits in their investment portfolios. Therefore, their trading strategy differs significantly from the commercial traders who move in and out of the markets on a regular basis, depending upon many market-based factors.

This is to suggest that speculators looking only to make money, without “do[ing] business in the underlying commodity” are a new phenomenon.  I’m sure that readers of the Register in 1909 or 1899 or 1889 would have begged to differ.  Moreover, speculators of whatever age “have moved in and out the markets on a regular basis, depending on many market-based factors.”

This argument seems to make motive the primary criterion for determining whether somebody is eligible to trade a futures market.  This is truly disturbing.  It also suggests that Commissioner Chilton believes that commodities should be fenced off from other financial markets.  This is bad finance, and actually harms market users by interfering with the efficient transfer of risk.

Chilton also says: “The new speculators buy into the markets for years, and stay there.”  And we are to conclude . . . ?  And again, there have been many speculators that have made it their living for long periods.

Additional remark (9/2/2009): I find this criticism of Chilton’s ironic that the classical criticism of speculators is that they are quick buck artists that have no long term stake in any market or company, and hence trade on meaningless short term information.  Now, we have a class of speculators that are not short term, quick-buck traders, but are instead patient investors in the market for a long haul–but that’s bad too.  Damned if you do, damned if you don’t.

As for evidence, Commissioner Chilton relies on one of the least creditable tropes: the “some suggest” argument:

Due to the influence some suggest the new speculators may be having on prices, however, there may be some changes on the horizon for these new players.

I (and others) suggest otherwise.  So where does that leave us?

Then he pulls out the “it’s possible” justification:

Just as the tide raises all boats, it is possible that this massive influx of capital helped to raise commodity prices beyond what the simple forces of supply and demand would dictate. The crude oil “commodity bubble” is a good example. To date this year, crude oil is trading at roughly $70 a barrel. While that is a far cry from the incredible (and some say irrational) high of $147 last summer, the current price is still up over 60 percent from the beginning of this year. Does that make sense?

A lot of things are possible.  Some evidence would be helpful.  The role of evidence is to help sort out what’s probable from what’s possible.  You can’t make policy on the possible, since so much of the possible is contradictory.  X may be possible.  Not X may be possible too.  We’re right where we started.  Reasonable analysis requires effort to determine which of these possible outcomes is more likely, and to estimate the costs of incorrect conclusions.  Identifying the possible is the beginning of an inquiry.  It clearly cannot be the end.

And note the second helping of the “some say” trope: “incredible (and some say irrational) . . .”

In fact, economists have known for a long time that commodities can exhibit substantial variability, and that in particular, in models where only fundamentals drive prices, prices spike and crash with regularity.  That’s exactly what you’d expect in a market for a commodity like oil.  There’s no reason to invoke the “bubble” word to explain big moves in commodity prices.

Indeed, the reason speculators are attracted to commodities is the volatility.  That’s a lot more plausible statement than to say that the speculators cause the volatility.

Now we get to the punchline:

Supply is at a 10-year high and demand is at a 10-year low. You do the math; prices should be lower. And if the cause was uneconomic speculative activity (that is, not caused by the forces of supply and demand), then regulators have a responsibility to act.

There is no doubt that the current commodities market is more puzzling on the surface than what happened in 2008 or early 2009.  But speculation by financial players in the US or the UK is hardly the first thing that bears scrutiny.  Indeed it should be about the last.  In all major commodities, the big buyers have been China, China, and China.  China has engaged in a stimulus that beggars the imagination, and probably in part to reduce its exposure to the dollar, a lot of that money has gone into commodities from aluminum to zinc.  The CFTC–with considerable Congressional cheerleading–is on a snipe hunt, and ignoring major factors in the market.  If Commissioner Chilton is puzzled, he needs to read more.

And note the tricky segue in the argument: “if the cause was uneconomic speculation . . . then regulators have the responsibility to act.”  But the “if” remains just that.  Chilton certainly has not provided a scintilla of evidence to support that contention.  He mentions the CFTC hearings on position limits, which generated zip, zero, nada in terms of anything that would pass the laugh test in terms of evidence.

And Commissioner Chilton then fails to man up and take a stand himself, instead invoking the “some say” argument yet again (for the third time!):  he describes the hearings as a step in a process “to address what many call ‘excessive speculation’ in our futures markets.”  Again.  Many say it ain’t.  “Some say”–even “many say”–is hardly a legitimate basis for any major policy initiative.

Amazingly, Commissioner Chilton repeats the “unintentional manipulation” gaffe:

The clear message is that physical commodities – like those in the agricultural, energy and metals arenas –  are too important to our nation to allow even the possibility of price manipulation, intentional or unintentional.

He will undoubtedly say that he is using the word “manipulation” in some common-sense use of the term to mean the actions of traders that affect prices.

That doesn’t cut it, for at least three reasons.

First.  There is no common-sense use of the term.  That’s been a problem for a long time–and is exactly why I quoted the Texas cotton broker in my original post.  Or to quote my book on manipulation, if Ambrose Bierce was writing the Devil’s Dictionary of Finance, I would define manipulation as anything that causes me to lose money.

Second, this is sort of the immaculate conception theory of prices.  If trading activity doesn’t affect prices, what does?  Surely public information releases (e.g., a crop report) have an effect, but people still interpret those releases differently and trade on their interpretation.  Moreover, some traders have private information, and trading on that information moves prices.  That tends to make prices more informative.  That’s a good thing.  It’s called price discovery.  How can you have price discovery if trades don’t affect prices?  I should also note that hedgers’ trades can affect prices.  Putting on a big hedge may require a move in price to find somebody willing to take the risk.  Here the market is discovering the price of risk, and consenting adults will negotiate a mutually agreeable price.  And such a price will almost certainly be different than if no such trade had taken place. Thus, hedgers can have a price impact.  Are they manipulators too? (And, I might add, hedgers will have a bigger price impact if speculation is constrained.  So, if trades that impact price are manipulative, and hedgers have a bigger price impact when speculation is constrained, wouldn’t that make the party that constrains the speculation an accessory in the manipulation?  That question is only half in jest.)

In other words, defining manipulation to mean any trade that has a price impact is complete non-sense, not common sense.  Such markets exist in textbooks, and nowhere else.

Additional remark (9/2/2009): Price impact may be a necessary condition for concluding that regulatory intervention is needed.  It is definitely not a sufficient condition as Chilton suggests.  A regulatory intervention should require a showing that a certain kind of trading moves prices away from competitive values.  Even if a price impact is demonstrated, it is absolutely wrong to conclude that this is inefficient.

Third, and most importantly, Commissioner Chilton is one of those responsible for enforcing the anti-manipulation laws.  These laws make manipulation a felony.  They also subject manipulators to the prospect of heavy fines, and great reputational damage.  As a result, no CFTC Commissioner should use this term imprecisely, or make statements using words that have legal meaning in such a cavalier way.  In other words,  I don’t believe that someone in the position of enforcing the law has the luxury of making such implicit distinctions on matters of potential legal import.

The term is provocative, and its use suggests that the markets have been manipulated.  People believe that manipulation is wrong, and many know that manipulation is a crime.  This creates a presumption that there is something wrong–manipulated–in the markets that need correction.

I would also suggest that this could lead to serious difficulties for the Commission, and for Commissioner Chilton, if the Commission ever has to rule on a manipulation case.  I can see a defendant appealing an adverse Commission decision on manipulation by saying that one of the Commissioners had written in a way that could suggest ignorance of the law, and/or a prejudicial view of the activities of speculators, and/or is inclined to see a manipulator lurking behind every trade.

It seems to me that Commissioner Chilton is attempting to have it both ways: to insinuate that the markets have been manipulated to persuade people of the need to regulate more aggressively and intrusively, while avoiding having to provide evidence to support his insinuation, escaping instead with evasions about how he’s not using the term in the legal sense, just in some “common sense” way.  But if the activities aren’t illegal, then what is the justification for the regulation?  And if there is a justification other than manipulation as legally defined, why use such an inflammatory term that has a specific legal meaning, rather than explain precisely what that justification is?  Why not set out in plain terms exactly what he thinks is wrong with the activity of speculators, and their effect on prices, and let people analyze that contention without waving the bloody shirt of manipulation to inflame passions?  And maybe, just maybe, provide some reliable evidence in the bargain, rather than relying on the “some say” evasion.

I don’t think that’s too much to ask of those responsible for the regulation of markets with huge sums on the line.  In fact, I think it’s far too little to ask.  But I’ll take it as a start.

In an apparent attempt to make Michael Masters look good, Rice University’s Baker Institute has released a report on oil speculation, that concludes that increasing volumes of speculation have caused oil prices to be higher than they would otherwise be, and in a novel twist, have caused a higher correlation between the dollar and the price of oil.  It also lays blame on everybody’s favorite whipping boy, the Commodity Futures Modernization Act of 2000.

In a nutshell, this report is bilge.  It relies on no rigorous economic analysis to support its contentions.  Moreover, it is unscientific, eschewing any serious statistical analysis.

The report first sets out its evidence that speculation has increased, and that this increase is due to the CFMA.  It attempts to argue that speculation increased 15-fold, while commercial trading only doubled, by adding non-commercial outright futures, options, and spread positions, as measured by the CFTC Commitment of Traders Reports.  The vast bulk of the increase in speculation is attributable to spread positions.

But it is odd indeed to argue that a massive increase in speculation caused higher oil prices when the bulk of this increase in speculation occurred in spread positions.  Such positions, which involve the purchase and sale of oil for different delivery dates, are speculations on the shape of the oil forward curve, not on the absolute price level.  Indeed, it is very difficult to imagine how such spread positions would cause prices to rise since they involve purchases and sales in equal magnitude.  Certainly the authors of the Baker study provide no rigorous justification for any such connection.  For that matter, they don’t provide any non-rigorous justification either.

Tying the massive increase in speculation as they measure it to CFMA is particularly bizarre.  As they note, the main provisions of the CFMA eased restrictions on trading on the OTC market, and in non-US markets.  As a result, if anything, the CFMA favored these other markets over NYMEX.  But all of the data in the “study” pertain to NYMEX futures markets.  How can you attribute a rise in trading on NYMEX, and a change in the composition of that trading, to regulatory changes that would tend to shift trading to venues not covered by the data?  (You could make an argument that the increase in off-exchange activity lifted NYMEX volumes due to arbitrage, or to the use of futures to hedge OTC positions.  But the Baker boy and girl don’t do that.  And if some non-commercial NYMEX positions are actually hedges of OTC positions, you can’t conclude the futures positions are speculative without knowing about the related OTC positions).

In other words, report authors Ken Medlock and Amy Jaffee play the drunk looking for a wallet under the lamppost.  The COT data is the only data relating to speculation that they can get their hands on, and they use it even though it is peripherally related to what they want to demonstrate, namely, that a set of regulatory changes that mainly benefitted non-NYMEX markets led to a dramatic increase in speculation.

This is the crudest post hoc, propter hoc reasoning.  CFMA happened in 2000.  Speculative futures positions increased, especially post-2003.  Therefore, the former caused the latter.  (Why the big lag?  Don’t bother looking for answers in the report.  You won’t get one.)  This is about as weak as it gets.

When they get to analyzing the effects of speculation on prices, the spreaders are out the window, and Medlock and Jaffee focus on net non-commercial positions.  (This could be viewed as a tacit admission that there is no basis to believe that spreaders could have an effect on price levels.)

Do the study authors utilize statistical techniques, like Granger Causality or the like, to document such a connection?  Surely you jest.

They use a much more sophisticated diagnostic instrument.  Their eyeballs.

Seriously.

They present a graph of net non-commercial positions overlaid on prices, and say:

Generally, movements in price over the last few years have coincided with trends in open interest by noncommercial traders.  We can see that during periods where [sic] speculators have been net short, prices typically declined, even if only slightly.  When speculators are net long, the general shift in the market has been upwards, in some cases to a dramatic extend.  Some exceptions have occurred when speculators were generally in a net long position, but were moving to liquidate positions.  In this case, such as the late spring/early summer 2008, prices responded by moving sharply lower.

Well, when I look at their Figure 5 with my eyeballs, I note numerous instances when the changes in net non-commercial positions were of a similar magnitude to what occurred in spring-summer 2008, and the price movements were nowhere as large as in the late-summer/fall of 2008.  I see other periods (fall, 2008) when net long positions spiked, but prices fell.

I just wonder: think the financial crisis might have had something to do with the collapse in prices?  What financial crisis you might ask, after reading the report: if this was the only information you had, you’d never know there was a financial crisis.

Also, why the asymmetry?  Why do net shorts often result in “slight declines” while net longs can lead to big spikes?  It is not obvious a prior that this should be the case, and Medlock and Jaffee certainly provide no explanation.

There is no way in hell that such a casual, visual analysis of that Figure can provide a basis for their grandiose conclusions.  To say that this is unscientific is far too kind.  It would be too kind to call it junk science.  It’s just junk.

Medlock and Jaffe also interpret the data, uhm, flexibly, in order to make their case.  On the one hand, they claim, prior to 2006 “the open interest of noncommercial players” was a “lagging indicator” of prices.  (If it lags, how can it cause?)  But then, in a “striking” development, it becomes a “leading indicator of price around January 2006.”

Do they present a rigorous test of this assertion?  No.

Do they provide a coherent explanation as to why it would go from a lagger to a leader?  They provide an explanation, but it is not coherent.  It is in effect the story of a perpetual motion machine.  Speculators buy so prices go up so people think prices will go up and so they buy and force up prices more yadda yadda.  This is, at best, ex post rationalization, fitting their story to the data rather than coming up with a rigorous hypothesis without peeking at the data and then testing it.

How do they address the problem that if COT data is really a leader, and leads by months (according to their eyeballs, anyways), why did all of these greedy speculators leave money on the table?  As soon as they recognized that COT data lead oil prices, they would trade on the COT data, and voila!, the relationship would disappear.

Again, the more obvious answer: there is no causal relationship between COT numbers and prices.

A more reasonable explanation is there is no connection between movements in net noncommercial positions and prices.  Sometimes positions lead price, then sometimes the reverse is true, but there is no causal connection, just chance in action.  This makes Jaffee and Medlock look like fools for randomness.

The asserted connection between oil and the dollar resulting from increased speculation is bizarre.  For starters, I contest their statistical results, such as they are.  They report a correlation between the dollar and the price of oil of -.82.  I can reproduce that number by calculating the correlation between the levels of the dollar index and the price of oil.  However, since both time series have unit roots, such high correlations are extremely suspect: highly persistent time series can be highly correlated even if, in fact, there is no economic relation between them.  This is the spurious regression problem.

A more reasonable method is to look at correlations between percentage price changes.  This number is much smaller (in absolute value) for 2001-2009: only -.22.  It is bigger than observed in 1986-2000, but so what?  What’s more, that -.22 isn’t nearly as eye-popping as -.8, is it?

And what theory do these people advance to explain why an increase in speculation would increase the correlation?  They tell a story–and it’s no more than that–about speculation causing high oil prices causing higher trade deficits causing a lower dollar.  There is no evidence supporting any one of these alleged causal connections.  And considering the trade deficit–like, have these two heard of China?  Or any other factor that might have influenced the trade deficit?  This is more post hoc, propter hoc mumbo jumbo, with myriad omitted variables.  A serious study would (a) estimate the relation between the trade deficit and the dollar index, controlling for other factors that could affect the dollar; (b) estimate the effect of the price of oil on the deficit, and combine this with (a) to get an effect of the oil price movements on movements in the dollar, and (c) estimate the effect of speculation on the price of oil, and combine with (a) and (b) to get an estimate of the contribution of speculation to changes in the value of the dollar.  Or include oil speculation as an explanatory variable in a model of the dollar that also includes other relevant explanatory variables.

But that would be, as I say, a serious study.  This one is a joke.

There’s also a serious issue regarding the direction of causality.  Why should it go from oil prices to the dollar?  A decline in the dollar represents a fall in its value relative to other currencies.  The factors that lead to such a fall (e.g., a US monetary policy that is looser than the monetary policies of other nations) also plausibly lead to a decline its value relative to goods, including oil.  A decline in the purchasing power of a dollar means that the prices of goods, including oil, rise in nominal terms.

Here’s a final, telling example of the level of rigor in the report: “While correlation does not imply causation [really?], the trends evident in the open interest data are impossible to ignore.”

Is that so?  Just watch me.

Historically, the CFTC has not been an overly intrusive regulator.  It has not attempted to push its jurisdiction to its limits, and in most areas it compares favorably to other federal regulatory agencies.  Under pressure from Congress, and exploiting the opportunities presented by the financial crisis, however, the CFTC is becoming much more aggressive and ambitious.

The most recent cases in point: its actions to clamp down on index funds, and now exchange traded funds (“ETFs”).  Last week, the agency revoked position limit exemptions for two ETFs offered by Deutsche Bank.  Seeing the threat from restrictions on the ability of ETFs to hold positions, several sellers of the funds, such as Barclays and the UNG fund, have announced that they will not issue new shares, even though these shares are selling at a premium.

Just what is the theoretical or empirical basis for these restrictions on commodity ETFs?  Beats me.  It is possible that these funds affect prices when they roll from an expiring contract into the next one, but there is a self-correcting mechanism that would mitigate these effects: the funds demand for liquidity is known, both in its approximate magnitude and certainly its timing.  This permits the flow of additional capital into the market during roll periods to mitigate the price impacts.   Moreover, to the extent that ETFs affect prices during the roll, they tend to move prices against them.  That is, their price impact raises their cost and reduces their performance.  Since the funds have to compete with other investment vehicles for funds, if these costs become too large and thus impair performance sufficiently, the flow of money to the funds will decline.

But I don’t think it’s the roll issue that exercises certain CFTC commissioners.  I think that they really believe that these ETFs distort prices.  The basis for that belief escapes me.  The Commission surely has produced no reliable evidence of such an effect, nor have I seen any reputable academic studies documenting such an effect.  Moreover, although many of these funds are “long only,” leading some to claim that they inflate prices, there are also funds that profit when prices go down, meaning that there is no necessary structural bias towards purchases.

Before interfering with the ability of investors to allocate capital across alternative vehicles, a government regulator should have a very strong logical and empirical basis to conclude that free choices are inefficient, and are distorting prices.  It should identify a market failure, and provide empirical evidence that this market failure is resulting in a material distortion in prices and resource allocations.  Moreover, it should analyze rigorously the effect of its actions: How will investors respond to the regulation?  If the flow of funds is distorting market X, will limiting the flow into X just divert monies into markets A, B, and C, distorting those prices?  Or, will investors respond to constraints on the size of a given fund by splitting investments across multiple funds, thereby sacrificing management scale economies and inflating costs?

The CFTC has done none of these things.  None.  It just justifies them with vacuities such as:

Cutting out individual investors isn’t the goal, said Bart Chilton, a CFTC commissioner, in an email. “The Commission has never said ‘You aren’t tall enough to ride,’  ” Mr. Chilton said. “I don’t want to limit liquidity, but above all else, I want to ensure that prices for consumers are fair and that there is no manipulation — intentional or otherwise.”

The CFTC seems hell-bent on segmenting commodity and financial markets, apparently viewing the commodity markets as some kind of ghetto, or insufficiently responsive to normal economic forces to be largely self-regulating.  This is bad finance.  The goal of public policy should be to encourage the integration of financial markets to ensure the efficient allocation of risk across investors and market participants, and the consistent pricing of risk across these markets.

Chilton’s statement is shocking for another reason.  Consider the last sentence: “I want to ensure that . . .  there is no manipulation — intentional or otherwise.”  Now, note that as a CFTC commissioner, Chilton may have to rule on manipulation cases.  Therefore, although it would be nice if he knew economics, it is imperative that he at least know the law.  But Bart Chilton apparently does not, or is in the habit of speaking so carelessly as to give the impression that he does not.  In fact, under existing case law, including CFTC decisions, to find someone guilty of manipulation under the Commodity Exchange Act, four conditions must be met.  One of these conditions is that the accused have a specific intent to cause an artificial price.  (See especially the Commission’s decision in the in re Indiana Farm Bureau case.)

In other words, “unintentional manipulation” is a legal oxymoron, at least so far as the CEA is concerned.

So, here we have one of the commissioners with responsibility for enforcing Federal anti-manipulation laws who apparently does not know the law.

Rather than speaking carefully, and expressing views that are consistent with the laws and precedents that he is charged to enforce, Chilton appears to be the poster child for the arch comment of a Texas cotton trader testifying before the Senate in 1928:  “The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

ETFs apparently do not suit Bart Chilton.  God knows why.  But to justify his dislike of them, he throws around the very, very heavily freighted word “manipulation” in a way that is inconsistent with its meaning under the laws that he is responsible for enforcing.  That is very disturbing.  Very.  If you use that word, you better have a high degree of confidence that you have the law, the economics, and the facts on your side.  On that score, Chilton strikes out.  Ignorance of the economics is, alas, pretty common.  Ignorance of the law is inexcusable.

Yesterday I wrote about the German financial regulator Bafin seeing no evil in what the data strongly suggest was one of the largest manipulations in history.  Today I write about a US regulator who sees manipulations where there is no evidence that they exist.

Keep this in mind when anybody–a Congressman, a regulator, or a talking head–tries to convince you that more regulation is the key to reducing the prevalence of misconduct in financial markets, and ensuring that these markets work more efficiently.  Regulators can make both Type I and Type II errors: false positives (Chilton) and false negatives (Bafin).  I would suggest that the rates for both type of error is extremely high, especially when policies are predicated on as little logic and evidence as the crackdown on commodity ETFs.  I would further suggest that the costs of these errors are very high, and importantly, those that make the errors do not incur the costs–which would tend to explain why they make so many of them.

The CFTC is getting vast new powers, and asking for even more (cf. Chairman Gensler’s letter to the Congressional Agriculture committees regarding the Administration’s draft OTC regulation bill).  It does not inspire confidence that at least one of the commissioners who will exercise these powers does not even know one of the very fundamental tenets of the law governing the powers he already has.

The Treasury Department has released its draft OTC derivatives regulation bill, “The Improvements to Regulation of Over-the-Counter Derivatives Act.”  The actual language of the 115 page proposal follows quite closely what Geithner has been floating for several months–a clearing mandate for standardized derivatives, attempts to force OTC derivatives trading onto execution facilities, differential margin and capital requirements for cleared and non-cleared products.

My initial reactions:

First, there’s a whole lot of delegatin’ goin’ on.  A good part of the bill sets out the haziest general objectives, and then directs the CFTC, SEC, and “the Prudential Regulator” (either the Fed, the Office of the Comptroller of the Currency, or the FDIC, depending on a bank’s charter status) to come up with specific rules on what constitutes a standardized derivative, capital and margin requirements, position limits and so on.  There is an aggressive timeline for most of these rules–180 days.  Given the depth and breadth of the issues, and their contentious nature, and the needs to coordinate among disparate agencies, this will be very difficult to do at all, and extremely difficult to do well.

Second, the Treasury has finessed the jurisdictional issues by giving multiple regulators authority over OTC derivatives markets, with the injunction that everybody share and play well together.  Many of the provisions require that the CFTC and SEC issue rules jointly, with the proviso that if they cannot, the Treasury will prescribe them.

Given the delegation-heavy aspect of the proposal, there are few specifics to analyze.  But there are some aspects of the proposed bill that are spelled out with sufficient detail that deserve comment.

I’ve beaten the clearing mandate horse repeatedly before, so I won’t do more than repeat my previous conclusion that the mandate approach is wrongheaded, and ignores crucial economic issues.  The proposal does not require clearing when “one of the counterparties to the swap— (i) is not a swap dealer or major swap participant; and  (ii) does not meet the eligibility requirements of any derivatives  clearing organization that clears the swap.”  This would seem to permit an end user (e.g., a gas producer) to enter into a swap with a dealer without triggering the clearing mandate.

This is a desirable feature, and would permit end-users to enter into swaps without having to clear them; this could be especially important for end users concerned about the cash flow and liquidity risks associated with daily mark-to-market.  However, there are some peculiarities as to what constitutes a swap dealer or major swap participant that confuse me, and create ambiguity in the application of this exemption from the clearing requirement.  For instance:

The term ‘swap dealer’ means any person engaged in  the business of buying and selling swaps for such person’s own account, through a  broker or otherwise.

“(B) EXCEPTION.—The term ‘swap dealer’ does not include a person that  buys or sells swaps for such person’s own account, either individually or in a  fiduciary capacity, but not as a part of a regular business.”

“As part of a regular business”?  As opposed to what?  An irregular business?  A hobby?  I think most involved in this industry have a pretty good idea of what a swap dealer is, but would have a hard time recognizing one from the language just quoted.  A dealer is a firm that stands willing to quote prices at which it is willing to buy and sell products–a market maker.   The dealers/market makers usually enter into large numbers of off-setting positions.  Those features are totally absent from the bill’s definition of dealer.

Here’s the definition of a “major swap participant”:

The term ‘major swap participant’ means any  person who is not a swap dealer and who maintains a substantial net position in  outstanding swaps, other than to create and maintain an effective hedge under generally  accepted accounting principles, as the Commission and the Securities and Exchange  Commission may further jointly define by rule or regulation.

It seems the key phrases here are “substantial net position” for a purpose “other than to create and maintain an effective hedge.”  So, they’re not hedgers, and they have a substantial net position.  The addition of the “net position” language would seem to mean that swap dealers often don’t have net positions, which is true.

So, it would seem that what Treasury is trying to say is that a major swap participant is not a dealer and not a hedger, so that would suggest speculator.  But what about a hedge fund that is basis trading, or spreading between some cash instrument or commodity and a derivative?  A lot of speculators do just that.  Are they hedgers?  You could argue that the derivative is hedging the cash position, and under that interpretation any deal involving a hedge fund engaging in this strategy would be exempt from the clearing mandate.  I doubt that’s what Treasury means, but their drafting leaves a lot to be desired.  This imprecision will become a litigation magnet if it makes its way into law.

This is true not just because the clearing mandate turns on the classification of the counterparties, but because the execution facility mandate does so as well:

Except as provided in paragraph (8), a swap that is  standardized shall be traded on a board of trade designated as a contract market under  section 5 or on an alternative swap execution facility registered under section 5h.

“(8) EXCEPTIONS.—The requirements of subsection (j)(1) and (7) do not apply to  a swap if—  “(A) no derivatives clearing organization registered under this Act will  accept the swap for clearing; or

“(B) one of the counterparties to the swap—

“(i) is not a swap dealer or major swap participant; and

“(ii) does not meet the eligibility requirements of any derivatives  clearing organization that clears the swap.”.

So, if our hypothetical hedge fund doing a basis trade is deemed a hedger, any trade it does needn’t be executed on an alternative swap execution system (e.g., an electronic trading platform) that is subject to various requirements and obligations similar to those imposed on exchanges.

This whole regulatory schema is based on creating distinct classes of market participants, with different rights and obligations.  Given that the mandates in the proposal turn on the classifications of both parties to a trade, and that there is notable ambiguity in the definitions of the classifications, this will likely lead to some legal disputes.

The proposal also addresses the “standardization” issue, but again in an unsatisfactory way.  This is also crucial because the clearing and trading mandates also turn on standardization.  Most of the specifics are punted to CFTC and SEC, but the proposal does set out some criteria that the agencies should take into consideration when determining whether something is standardized.  These criteria include whether trade terms (including prices) are distributed, or relied on in determining the prices of other deals, and the volume of trade.  Unfortunately, however, most of the other criteria refer to the “terms” of the swap as the criteria by which CFTC and SEC assess standardization.  Are the terms of swap A like those of swap B that is cleared?  Are the differences in terms economically significant?

But it’s not just the terms that matter in determining suitability for clearing.  The risk characteristics of the instrument, and the availability of pricing information are also relevant.  Two deals with very similar terms may differ along these economic dimensions in ways that make one efficient to clear, and the other not.  (The volume of trading requirement is a crude way of assessing the price information availability issue.)  Moreover, these economically relevant factors may vary over time.  Is a CFTC/SEC determination permanent?  This would be problematic.  It should also be noted that due to economic differences, and variations of these economic conditions over time, that clearinghouses may not price risks appropriately, and that as a result the mandate could discourage mutually beneficial trades that parties would be willing to enter bilaterally because it is cheaper to do that than to clear.

The proposal also sets out rules for capital requirements and margins on non-cleared deals, but these aren’t that helpful:

BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—In setting  capital requirements under this subsection, the Prudential Regulators shall  impose:

“(i) a capital requirement that is greater than zero for swaps that  are cleared by a derivatives clearing organization; and

“(ii) to offset the greater risk to the swap dealer or major swap  participant and to the financial system arising from the use of swaps that  are not centrally cleared, higher capital requirements for swaps that are not  cleared by a registered derivatives clearing organization than for swaps  that are centrally cleared.

“(B) NON–BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—Capital  requirements set by the Commission and the Securities and Exchange  Commission under this subsection shall be as strict as or stricter than the capital  requirements set by the Prudential Regulators under this subsection.

So, capital requirements on cleared deals are positive, and requirements on cleared deals are higher than that.  That’s a huge help, guys.  This will touch off huge efforts to influence the determination of these requirements, and regulators will quite honestly not have the knowledge or information to set them efficiently.  I foresee reliance on crude proxies for risk, such as . . . wait for it . . . credit ratings.  Heaven help us.

Margin requirements are similarly fuzzy:

Prudential Regulators shall impose both initial and variation margin requirements  under this subsection on all swaps that are not cleared by a registered derivatives  clearing organization, except that the Prudential Regulators may, but are not  required to, impose margin requirements with respect to swaps in which one of  the counterparties is—

“(i) neither a swap dealer, major swap participant, security-based  swap dealer nor a major security-based swap participant;

“(ii) using the swap as part of an effective hedge under generally  accepted accounting principles; and

“(iii) predominantly engaged in activities that are not financial in  nature, as defined in section 4(k) of the Bank Holding Company Act of  1956 (12 U.S.C. 1843(k)).

“(B) NON–BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—Margin  requirements for swaps set by the Commission and the Securities and Exchange  Commission under this subsection shall be as strict as or stricter than margin  requirements for swaps set by the Prudential Regulators.

So, again: virtually no guidance on the principles regulators shall use to set margins, the counterparty classification issue, and the need to get numerous regulators to play nicely.

The proposal also opens the way for the vast expansion of position limits.  Swap execution facilities are required to set accountability or position limits, which means that the reach of these limits is extended to the swap market.  Moreover, Section 723 states:

The Commission may, by rule or regulation,  establish limits (including related hedge exemption provisions) on the aggregate number  or amount of positions in contracts based upon the same underlying commodity (as  defined by the Commission) that may be held by any person, including any group or class  of traders, for each month across—

“(A) contracts listed by designated contract markets;

“(B) contracts traded on a foreign board of trade that provides members or  other participants located in the United States with direct access to its electronic  trading and order matching system; and

“(C) swap contracts that perform or affect a significant price discovery  function with respect to regulated markets.

The definition of “significant price discovery function” is very broad:

SIGNIFICANT PRICE DISCOVERY FUNCTION.—In making a determination  whether a swap performs or affects a significant price discovery function with respect to  regulated markets, the Commission shall consider, as appropriate:

“(A) PRICE LINKAGE.—The extent to which the swap uses or otherwise  relies on a daily or final settlement price, or other major price parameter, of  another contract traded on a regulated market based upon the same underlying  commodity, to value a position, transfer or convert a position, financially settle a  position, or close out a position;

“(B) ARBITRAGE.—The extent to which the price for the swap is  sufficiently related to the price of another contract traded on a regulated market  based upon the same underlying commodity so as to permit market participants to  effectively arbitrage between the markets by simultaneously maintaining positions  or executing trades in the swaps on a frequent and recurring basis;

“(C) MATERIAL PRICE REFERENCE.—The extent to which, on a frequent  and recurring basis, bids, offers, or transactions in a contract traded on a regulated  market are directly based on, or are determined by referencing, the price  generated by the swap;

“(D) MATERIAL LIQUIDITY.—The extent to which the volume of swaps  being traded in the commodity is sufficient to have a material effect on another  contract traded on a regulated market;

These criteria would apply to most important, heavily traded OTC products.  Thus, the bill would give the CFTC tremendous power to impose position limits on combined OTC and exchange-traded positions.  Given the contentiousness of the position limit issue in energy alone, one can only imagine the difficulties that await when the CFTC’s powers to set limits extend to everything.

Overall, I think that it is a travesty to call this the “Improvements to regulation” act.  All of the substantive elements–the clearing mandate, the trading mandate, the setting of capital and margin requirements by relatively uninformed regulators subject to influence and pressure, the position limits–have no solid economic justification.  Indeed, the stronger justifications cut the other way in virtually every case.  Moreover, the ambiguities in the definition of key terms that determine the reach of the mandates are a recipe for trouble later on.  The delegation of virtually all implementation details to regulators, the rapid time frame for the formulation of specific rules, the need for coordination across regulators, and the lack of anything more than the haziest guidance will create immense implementation problems and lead to enormous influence activities.

All in all, therefore, this would be better titled “The (further) Bollixing of the Regulation of Over-the-Counter Derivatives Act.”

The Federal Trade Commission issued its final rule on market manipulation, as authorized by Congress under the Energy Independence and Security Act of 2007:

The  final Rule prohibits any person, directly or indirectly, in connection with the purchase or sale of crude oil, gasoline, or petroleum distillates at wholesale, from (a) knowingly engaging in any act, practice, or course of business – including the making of any untrue statement of material fact – that operates or would operate as a fraud or deceit upon any person, or (b) intentionally failing to state a material fact that under the circumstances renders a statement made by such person misleading, provided that such omission distorts or is likely to distort market conditions for any such product.

The rule, and the enabling legislation, are patterned on the anti-manipulation provisions of the securities laws, rather than the commodity laws.  And therein lies a problem, and renders the rule another monument to Congressional cluelessness on commodity market manipulation.

The emphasis on “fraud and deceit” makes some sense in securities markets.  Securities values are information-driven, and hence manipulative schemes in such markets frequently rely on fraud and deceit to distort investors’ information sets, and thereby distort securities values.

Things are quite different in commodity markets.  Although some manipulative schemes do rely on making untrue statements (e.g., false price reporting), by far the most important type of manipulation in commodity markets–including oil markets–involves the exercise of market power.  It is nigh on to impossible to wrench the concept of “fraud and deceit” to cover genuinely manipulative exercises of market power in the oil markets.  So, one of two things will happen.  Either the rule will prove completely useless, because it does not touch the most troublesome form of conduct in commodity markets; or the FTC will play legal Twister to try to interpret a rule written to attack information-based manipulations in order to take action against market power manipulations.

I would bet that the latter alternative is the more likely outcome, for a several reasons.  First, it is in the nature of regulator agencies to extend their power as far as possible, and stretch the rules to the breaking point to do that.  Second, the FTC will be under pressure from Congress to act in the event somebody does try to execute a market power manipulation.

I spoke with a group of FTC staffers while the rule was being drafted.  It was discouraging in the extreme to hear, that when I told them that the rule did not touch the most important form of manipulative conduct in commodity markets, that they were completely unaware that there was such a thing as market power manipulation.  I participated in a workshop on the rule that the Commission held in November, and hammered home the issues of market power manipulation.  But to no avail.  As stated in the final rule:

Some commenters argued that the final Rule should extend to conduct such as speculative activity or the unilateral exercise of market power, because in their view such conduct is inherently manipulative.   See, e.g., CFA at 8 (arguing that the Commission “could have considered the exercise of market power and excessive speculation as manipulation” because they “have no economic justification”); Greenberger at 1 (opining that the proposed Rule could offer a tough enforcement mechanism against speculative activity); Senator Cantwell at 2-3 (asserting that Congress intended for the FTC’s rule to reach a broad range of conduct, including the withholding of supply); Pirrong, NPRM, at 2 (arguing that the proposed Rule should not focus on fraud or deceit, but rather on the exercise of market power).   However, the rulemaking record does not support extending the final Rule to cover such conduct, except to the extent that the practices used are part of a course of conduct that otherwise violates the final Rule.

Whatever that means.  Translation: we had already released a Notice of Proposed Rulemaking that was totally silent on the issue of market power manipulation, so the train had already left the station and we weren’t about to look like fools and start over.

Actually, the FTC doesn’t bear the primary culpability.  Congress is the one that put the train on the wrong track.  It wrote the “fraud and deceit language” in the statute.  It was the one that had no clue about what manipulation in a commodity market really involves.

Sadly, it’s not the first time that Congress made the same mistake.  The law giving FERC anti-manipulation powers does as well, and as a result, FERC’s rule is also fundamentally flawed.

The Congressional cluelessness on all things derivative does not stop with manipulation.  It is pervasive.  It is on display daily in the myriad efforts to completely reshape derivatives regulation.  The ACES (Waxman-Markey) climate change bill contains several sections that would take derivatives regulation back to the days of rumble seats and the Charleston.  Other regulatory proposals bouncing around Capitol Hill would do the same.

What’s their motto?  “Today we screw up the energy markets! Tomorrow, the world!”?  It would fit.

The controversy over high frequency trading and flash orders and dark pools does pose one very serious puzzle that is encapsulated in this article from Bloomberg:

The U.S. Securities and Exchange Commission’s move to ban so-called flash orders may help  NYSE Euronext take back market share of U.S. stock trading at the expense of three-year-old rival Direct Edge Holdings LLC.

Senator  Charles Schumer said yesterday the SEC will seek to stop the practice in which some brokers get a split-second advantage in viewing requests to buy and sell stock, after discussing the issue with Chairman  Mary Schapiro. NYSE Euronext, the only one of the top four U.S. exchanges that doesn’t use flash orders, has seen its portion of the nation’s share trading slip to 30.3 percent in the second quarter from 35.5 percent a year earlier, while Direct Edge’s doubled since November.

. . . .

Direct Edge, based in Jersey City, New Jersey, used its early lead in flash trading to take business from rivals. The company is the fastest-growing equity market in the U.S., helped by its three-year-old  Enhanced Liquidity Provider program, which handles the most flash trades.

Even excluding flash orders,  Direct Edge matched 11.2 percent of U.S. stock trades in July, making it the third- largest U.S. equity market by volume, according to data compiled by Bloomberg. That may help fuel growth if regulators start a broader review of off-exchange trading, Chief Executive Officer  William O’Brien said in an interview yesterday.

If these practices are so deleterious, then how come Direct Edge and other platforms that facilitate HFT, particularly through the use of flash orders, have been gaining market share?  Why would more and more market users submit orders to venues, which if the complaints about these practices are to be believed, allow them to be raped by HFTs?  Are they suckers?  Given that these are institutional investors for the most part, methinks not.

This is an interesting tidbit:

Flash systems trace their roots as far back as 1978 to efforts by exchanges to electronically replicate how a trader might yell an order to floor brokers before entering it into the system that displays all bids and offers.  Markets have evolved since the days of floor brokers’ dominance, with computer algorithms now buying and selling shares 1,000 times faster than the blink of an eye.

That is, on the floor, a broker holding a limit order (an order to buy or sell at a particular price or better) could first attempt to execute the order by soliciting interest in the trading crowd.  If someone in the trading crowd was willing to trade a price at the limit or better, the deal would get done.  If not, the order would go into the specialists book.  That is, the floor broker first “flashed” the order to the trading crowd to see if he could get the customer a better execution.

The hysterics about HFT in general, and flash trading in particular, could represent special pleading by the NYSE to hobble competitors.  So, I treat a lot of the criticism with a very critical eye.

And generally, although competitive success does not necessarily indicate the provision of a better value, it usually does.  So when a particular system gains market share, the presumption should be that is providing value.  Show me otherwise.  I’m open minded.

One last thing on HFT.  Krugman said that it’s bad in part because only those who invest in the technology can compete.  (Looking for the link).  Which is true of, oh, I don’t know, computers, cars, software, flea collars, and just about anything you can name.  You know, it’s called competition.  It’s in all the textbooks.  You can look it up.

The relevant question is whether the technology is used to create value, or to extract a rent.  Both things are possible, but you serious analysis is required to figure out which.  There are some aspects of HFT that do suggest rent seeking, others that suggest value creation.  Krugman needs to work a lot harder to make a persuasive case to show that it’s the former, and not the latter.

The SEC letter granting ICE Trust the exemptions necessary to clear CDS transactions provides a perfect illustration of the extraordinary shallowness that characterizes policy analysis of the subject of clearing:

The Commission believes that using well-regulated CCPs to clear transactions in CDS would help promote efficiency and reduce risk in the CDS market and among its participants. These benefits could be particularly significant in times of market stress, as CCPs would mitigate the potential for a market participant’s failure to destabilize other market participants, and reduce the effects of misinformation and rumors. CCP-maintained records of CDS transactions would also aid the Commission’s efforts to prevent and detect fraud and other abusive market practices.

A well-regulated CCP also would address concerns about counterparty risk by substituting the creditworthiness and liquidity of the CCP for the creditworthiness and liquidity of the counterparties to a CDS. In the absence of a CCP, participants in the OTC CDS market must carefully manage their counterparty risks because the default by a counterparty can render worthless, and payment delay can reduce the usefulness of, the credit protection that has been bought by a CDS purchaser. CDS participants currently attempt to manage counterparty risk by carefully selecting and monitoring their counterparties, entering into legal agreements that permit them to net gains and losses across contracts with a defaulting counterparty, and often requiring counterparty exposures to be collateralized.11 A CCP could allow participants to avoid these risks specific to individual counterparties because a CCP “novates” bilateral trades by entering into separate contractual arrangements with both counterparties – becoming buyer to one and seller to the other.12 Through novation, it is the CCP that assumes counterparty risks. For this reason, a CCP for CDS would contribute generally to the goal of market stability.

As part of its risk management, a CCP may subject novated contracts to initial and variation margin requirements and establish a clearing fund. The CCP also may implement a loss-sharing arrangement among its participants to respond to a participant insolvency or default.

Stop right there.   So, in a bilateral market firms

“carefully manage their counterparty risks because the default by a counterparty can render worthless, and payment delay can reduce the usefulness of, the credit protection that has been bought by a CDS purchaser. CDS participants currently attempt to manage counterparty risk by carefully selecting and monitoring their counterparties, entering into legal agreements that permit them to net gains and losses across contracts with a defaulting counterparty, and often requiring counterparty exposures to be collateralized”

but once things are cleared, it’s apparently: “No worries!   The CCP takes care of everything!”   These sentences represent one of the greatest logical leaps–that is to say, non sequiturs–that I have read in a long time: “Through novation, it is the CCP that assumes counterparty risks. For this reason, a CCP for CDS would contribute generally to the goal of market stability.”

Uhm, yes, the CCP assumes counterparty risks.   But they don’t disappear.   Given the size of trading positions, the total losses resulting from a particular default result in the same size of loss in bilateral or cleared markets; clearing just changes the allocation.   Indeed, it can make this allocation worse, not better.   Moreover, a CCP concentrates counterparty exposure, meaning that there is a concentrated point of potential failure.   That hardly contributes to market stability.

Note too that the SEC completely ignores any incentive issues.   It recognizes that bilateral counterparties spend considerable resources to manage counterparty risk because they bear the loss in the event of a default.   The letter is completely silent on the incentive of the CCP (compared to bilateral counterparties) to manage this risk.   It is also completely silent on the information available to the CCP as compared to bilateral traders to evaluate, manage, and price counterparty risk. The letter is also silent on the potential moral hazard problem that mutualization of performance risk through a clearinghouse creates.

Thus, in expressing a preference for one way to manage performance risk over another, the SEC makes not the slightest effort to analyze the incentives or abilities of agents to perform this task under alternative arrangements.   It just makes conclusory statements with no logical, factual, or analytical basis.

To put it bluntly, the mere fact that a CCP “assumes” counterparty risk in no way implies that it improves market stability.   The chasm between one the conclusion (clearing improves market stability) and the alleged basis for that conclusion (the mere fact that a CCP assumes performance risk) is wider than the Grand Canyon.   Assumption of risk is not the same as making that risk disappear.   Given the incentive and information issues, it is quite possible that it makes the risk worse.

The SEC then falls back on the other main justification for clearing:

A CCP would also reduce CDS risks through multilateral netting of trades.13 Trades cleared through a CCP would permit market participants to accept the best bid or offer from a dealer in the OTC market with very brief exposure to the creditworthiness of the dealer. In addition, by allowing netting of positions in similar instruments, and netting of gains and losses across different instruments, a CCP would reduce redundant notional exposures and promote the more efficient use of resources for monitoring and managing CDS positions. Through uniform margining and other risk controls, including controls on market-wide concentrations that cannot be implemented effectively when counterparty risk management is decentralized, a CCP can help prevent a single market participant’s failure from destabilizing other market participants and, ultimately, the broader financial system.

Most of the benefits of netting mentioned are private benefits.   If they are so large, market participants would have been incentivized to capture them long ago.   Instead, they are only forming CCPs under the threat of even more draconian government intervention.

Sadly, this letter is representative of virtually every regulator’s and legislator’s advocacy of clearing.   That includes the US Treasury, CFTC, various legislators (e.g., Barney Frank and Colin Peterson), and the EC.   Based on such shallow justification, said powers are about to re-engineer the largest and most sophisticated financial markets in the world.