Streetwise Professor

My OpEd on oil speculation ran in Friday’s (7/11) Wall Street Journal.

Index funds and pension funds are the most recent bêtes noir in the commodity speculation debate. These participants are primarily long, are supposedly relatively insensitive to price (which is an assertion, rather than something for which reliable evidence has been produced), and hence according to critics are driving up prices of oil and grain. And by “prices,” critics mean the prices of physical commodities that consumers buy.

These arguments fail to grasp important aspects of the operation of derivative and commodity markets, and ignore the benefits these market participants can reap from trading in the commodity markets.

The main error in the argument is that it does not recognize that there are multiple markets for commodities, some of which are markets for the physical commodity proper, and some of which are for commodity price risks. Derivatives markets serve the latter purpose, and fund investors almost exclusively restrict their activities to those markets, and hence affect only the prices for commodity price risks rather than the prices of commodities themselves.

Virtually all index investors and pension funds do not participate in any way in the physical market. If they are in futures, they roll their positions prior to delivery. If they gain commodity exposure through swaps, they are pure price takers, and even if their counterparties hedge some of the index exposure through the futures markets, these firms also roll prior to delivery and hence do not contribute any demand for physical commodities. Hence, they cannot affect—or in particular, elevate—the price of any physical commodity.

But, the critics reply, since these funds are buying, they HAVE TO make prices higher than they would otherwise be. In addressing this criticism, it is necessary to be precise and ask: what price? Clearly, all else equal, with more buying interest, the futures price will be higher than it would be without it (unless the supply of offsetting positions is perfectly elastic, as may be the case). But it is important to recognize that this buying raises the futures price relative to the expected spot price. Since index traders and index funds are likely uninformed, their buying does not systematically convey bullish information to the market, and hence does not affect the expected spot price; and if these trades have any information content, they should have an impact on prices, and this impact is beneficial.

By moving the futures price relative to the expected spot price, index/fund trading (a) does not elevate the prices consumers pay for physical commodities; and (b) affects the RISK PREMIUM embedded in futures prices, and hence the trend in the futures price for a particular contract up to the expiration date. In other words, the price that fund traders affect is the price of risk, not the spot price of oil or gas or corn.

In a Keynesian “normal backwardation” type model, in which speculators are not diversified and hence idiosyncratic risk affects futures prices, and hedgers are net short, the addition of new long speculators causes the futures price to rise relative to the expected spot price, reducing the discount in the futures price and the upward trend in the price. Their entry also displaces some other long speculators who find that the greater competition from the index/fund investors reduces the profits they earn from their trading. In this model, these other longs only participate if the futures price is below the expected spot price. Hence, as long as any of these traders remain, the futures price must remain below the expected spot price, but by a smaller amount. All that the entry of index funds does is replace one set of long speculators with another that bears the commodity price risk at lower cost, reduces the risk adjustment in futures prices, and therefore makes the net short hedgers better off. This is not Pareto improving—the displaced long speculators and some long hedgers are made worse off—but overall surplus rises because risk is borne at a lower cost. So, what’s the problem? None that I can see.

It is theoretically possible that that long index/fund participation can be so great that it completely displaces other long speculators. That is, fund trading causes the futures price to rise above the expected spot price, meaning that all other long speculators leave the market. Again, though—so what? This hurts those speculators and some long hedgers, but benefits short hedgers even more. (I should also add there is no evidence that this has in fact happened. There are still long speculators in the markets other than the index funds, so evidently they have not all been displaced.)

The theoretical possibility that participation of index/fund investors causes the sign of the risk premium to flip also points out that it is dubious to call these folks “speculators” in any event. They are really hedgers, in the very real sense that they are buying futures to reduce risk exposure. They are buying futures for diversification reasons—that is a risk reducing trade, and hence it is legitimately referred to as a hedge. They are not traditional hedgers, to be sure, but again—so what? Investors are people too. Why should they be denied the opportunity to use the commodity markets to reduce their risks? Why should they be considered inferior to other long hedgers who just happen to participate in the physical markets? Suspicion of these non-physical long hedgers seems to be an example of what Thomas Sowell once termed “the physical fallacy” in his excellent book Knowledge and Decisions.

Indeed, the presence of index/fund investors in the commodity markets serves to integrate the financial and commodity markets. This integration ensures that risks are priced consistently across the two markets. Indeed, the flow of funds from portfolio investors (who may include hedge funds too) from traditional equity and fixed income investments to commodity markets is likely a reflection of a mispricing of risks across these markets. In essence, this flow is serving to arbitrage away a differential in risk prices across previously segmented markets. Again—this is a feature, not a bug.

My work (with Martin Jermakyan) on electricity prices shows that incomplete integration can impose very large costs on hedgers. Electricity is probably an extreme case, but due to incomplete integration forward prices are substantially above expected spot prices. This is a symptom of inefficient risk pricing and risk allocation.

If all the markets are completely integrated, risk premia in commodity prices will be driven purely by the covariation between those prices and the market pricing kernel. The composition of market participants would be completely irrelevant. Barring one group from participating in the market would just open up a profit opportunity for somebody else without having the slightest effect on risk prices.

However, restricting the participation of portfolio investors may impede integration of the commodity, stock, and bond markets. In this case, risks will be priced inefficiently and risks and capital will be allocated inefficiently. Why is that considered desirable?

The main things to remember in this debate are: (a) since fund investors do not participate in the delivery market, they cannot be influencing physical market prices, except to the extent that by improving risk allocation they are making hedging more efficient and thereby beneficially affecting investment and stockholding decisions, and (b) the main effect of index/fund participation is to affect risk premia in futures prices (i.e., the relation between futures and expected spot prices), and in a way that improves the efficiency of risk allocation. Index/fund participation facilitates the integration of commodity and financial markets. This helps rationalize the pricing of risk. Again—a good thing.

The entire debate over speculation in commodity markets, at least the political side of that debate, is largely devoid of good economic reasoning. This goes in spades for the debate over the role of index funds and pension funds in the market. The “they buy therefore they drive up prices therefore they should be banned” syllogism is completely bogus. It is bogus because fund buying does not in the first instance drive up physical prices, and hence does not affect the price that we all pay at the pump. It is bogus because fund participation affects risk premia—the relation between futures prices and expected spot prices rather than spot prices or expected spot prices. It is bogus because it affects risk premia in a good way. It ensures consistent pricing of risk across markets and the efficient allocation of risks across markets.

Some people may be hurt by this flow of capital—but it is not the people that politicians are allegedly defending, such as individual consumers. Traditional speculators who earned rents in less-integrated markets are hurt. Long hedgers in markets dominated by short hedgers may be hurt, but their losses are more than offset by the gains of short hedgers and the fund investors themselves.

More generally, I have yet to hear anyone—anyone—present a credible case that there is a true (rather than pecuniary) externality that results from the entry of a new class of participants into the commodity markets. Absent such an externality, the free flow of capital across markets will have a beneficial effect, rather than a baleful one. Index and pension fund investors participate in the commodity markets because it improves their risk-return tradeoffs. This is a bad thing? Competition and the free flow of capital facilitates the efficient pricing of risk. This is a bad thing? These flows do not affect, let alone distort, the physical markets except insofar as improving the allocation of risk improves the efficiency of investment and inventory decisions. So this is a bad thing?

When one understands the very basic finance of index/fund participation in commodity derivatives, it is evident that restrictions on their participation in the market, either through position limits or (in the extreme) banning them altogether are extremely misguided. Extremely. Their participation should be encouraged, not limited. Derivatives markets are first and foremost markets for risk, and index/fund investors in commodities are just using those markets for the very purpose of managing risk. By doing so, they are improving the allocation of risk and its pricing across all markets—stocks, bonds, real estate, and commodities. They bear commodity price risk at a lower cost than others. This is unambiguously a good. Unambiguously. Will Congress understand this? Sadly, there is considerable room for doubt.

Over my extended European sojourn, the Antitrust Division of the USDOJ gave its approval to the CME’s acquisition of NYMEX. During the height of the kerfuffle over the Antitrust Division’s letter on exchange ownership of clearing, it was widely conjectured that this signaled that the Division would fight the deal. I disagreed, arguing that the Division would have to approve it if it wanted to maintain even a shred of dignity. There is no way it could approve the CME-CBT tie up in June ’07 and turn around in June ’08 and disapprove CME-NYMEX. And approve it did. One curious thing. There is no announcement of the decision on the Anti Trust Division website, even though there was such an announcement when it approved the CBT deal. Now, that’s interesting.

James Hamilton is a world-class econometrician who has done pathbreaking work on the relations between oil prices and the real economy. Recently, he has blogged extensively about the potential contribution of speculation to the price of oil. Although he argues that most of the runup is fundamentals-driven, he is open to the suggestion that the increase in price since January is not primarily the result of fundamentals, but is instead speculative in origin. He is sensitive to the objection that a speculative distortion in prices should also manifest itself in increases in stocks. He attempts to counter this criticism with an example:

A much more important way in which the spot price of crude would affect the refiner’s demand for the product is through an intertemporal calculation. Given my customers’ demand, I’m going to need to buy the product sooner or later. If you charge me a lower price today than you’re going to charge me next month, I’d choose to buy more today to put it into inventory. If you charge me a higher price today, I’d rather run down my inventory and buy the oil next month, and of course the futures market allows me an opportunity to lock in a price for doing just that. Thus by far the most important factor in refiner’s demand for July oil will be the August futures price. If my production plans left me willing to buy July oil for $124.25/barrel when August oil was selling for $124/barrel, I’ll probably want to buy July oil for $126.25/barrel now that I’m forced to pay $126/barrel for August oil. Thus to a first approximation, the spot price would move by exactly the same amount as the near-term futures price. A $1 increase in the August futures price would shift the demand curve for July spot oil up by $1. In this fashion, an ever-increasing volume of speculative purchases of the near-term futures contracts would drive the spot price up with them.

There are two fundamental problems with this example, one logical the other empirical.

With regards to the logical problem. The premise of the hypothetical reminds me of the old Steve Martin routine “How to make a million dollars without paying taxes! First, make a million dollars.” That is, James pulls the $1 increase in the August price out of a hat, like a magician producing a rabbit. But why would an increase in speculative futures purchases lead to a dollar increase in the price of the August contract? Setting aside that the speculators might be informed–in which case, the price response is likely rational and efficient–why would other market participants believe that an (uninformed) speculator’s purchase should lead to an increase in the price of oil in August? Perhaps they anticipate that the August contract will be offset, but the speculator will buy even more for September delivery. This just kicks the can down the road a bit. Due to the ultimate connection between the futures price and the price of physical oil (that results from the delivery mechanism) the only way an uninformed speculative purchase will lead to a price increase is if market participants anticipate that some portion of the speculator’s purchase will not be offset. That instead, the speculator will take delivery of oil, and USE THAT OIL INEFFICIENTLY.

Inefficient use can occur as a result of a corner or squeeze. The speculators could squeeze some future contract, causing distortions in the production and transportation of oil. (A squeezer demands excessive deliveries, and essentially forces the delivery market up the supply curve to outputs beyond the competitive equilibrium point.) The problem here is that many speculators are unlikely to execute a squeeze, although A Speculator might do so. Multiple speculators may collectively have the ability to squeeze the contract, but they also face a collective action problem. Each one reasons: if everybody else is going to take to many deliveries to drive up prices, why should I go along? Why don’t I just liquidate my entire position at the artificially high price, and let everybody else bury the corpse (i.e., dispose of the excessive deliveries at a depressed post-squeeze price.) Individual rationality of the speculators results in a non-cooperative equilibrium where no squeeze takes place. Thus, given that myriad hedge funds, pension funds, investment banks, etc., make up the speculative crowd, unless one or two of them possess market power it is highly unlikely that anticipation of a squeeze could cause the price to rise in response to an increase in speculative purchases.

Another story is that somewhere along the line, speculators will take excessive deliveries, and just hoard the oil, keeping it off the market to enhance the price. This scenario also faces the prisoners’ dilemma issue, and another problem as well. Even for an individual speculator, it is difficult–and arguably impossible–to make a credible commitment to carry out this inefficient action. This is analogous to the Coase durable goods monopoly problem. (My 1993 Journal of Business paper discusses this issue in detail in the section titled “Pure Monopoly Manipulation.”)

That is, once he takes delivery and liquidates his futures position (at a high price), why should he just hold onto the commodity he received via delivery, reducing consumption below its efficient level and elevating price going forward? He would rationally sell the good, driving down its price to the efficient competitive level. But, forward looking counterparties, recognizing the speculator’s inability to precommit to the inefficient policy, would conjecture that he will not carry through on his threat, and hence are willing to sell the future at the competitive price today. The long would like to precommit to holding supplies off the market, but this is problematic, not to say impossible.

In a nutshell: distortion in the futures price today via the mechanism of speculative purchases requires an anticipation that the speculators will somehow take actions (a corner or hoarding) that reduce consumption below its efficient level in the future. There is no credible reason to believe that a large number of speculators can do this. Index funds that roll all their positions deterministically definitely cannot do this–they are effectively precommited NOT to take delivery. Ditto for those rading cash settled instruments, such as ICE WTI futures, or swaps (although the holders of such instruments could have an incentive to distort the physical market to enhance the value of their derivatives position.)

James’s example also poses other difficulties. The expectation that speculators will somehow take actions in the physical market that reduce supplies in the future (and such an expectation is a necessary condition for the price to move today, per the hypothetical) will induce immediate real responses. An anticipated increase in the demand for oil in the future will induce, at the margin, a decline in current consumption and an increase in current output, and an increase in stocks, in order to meet the anticipated future demand. That is, it is unrealistic to argue, as James’s example suggests, that an increase in future demand for the physical product will not lead to an increase in current inventories.

The empirical difficulty relates to the prediction inherent in the example: that there is a one-for-one relationship between the change in the spot and futures prices, especially when the market is in backwardation (as James deliberately specifies in the example, as he explains in his responses to comments). I have produced empirical evidence for industrial metals (J. of Bus., 1994) and oil (J. Futures Markets, 1996) that shows that when the market is in backwardation: (a) the correlation between spot and futures is well below one, and (b) the spot volatility is higher than the futures volatility. This implies that if one regresses the futures price change against the spot price change, the coefficient on the latter will be less than one–and often substantially so (e.g., on the order of .75 or .8). (Of course, if the regression is run the other way, the coefficient could be bigger or less than one, but in practice the coefficient is still less than one because the correlation effect dominates.)

Futures and spot move one-for-one when the market is in full carry (or nearly so)–but only because inventories (which are large when the market is in a carry) provides an intertemporal connection between spot and futures prices. This link is attenuated when the market is in backwardation. (I’ve also demonstrated this theoretically/numerically in solving dynamic storage models.) But when the market is in backwardation, the one-to-one relationship between spot and futures moves is unlikely to be observed in practice. Thus, if one treats the example seriously, as a source of empirical predictions about comovements of spot and futures prices, it is refuted by the data.

While musing about contango and backwardation, it is interesting to note that back in 2005-2006 those blaming speculation for distorting prices pointed to the strong contango as evidence that funds trading progressively more in the back end of the curve were distorting prices. These voices were notably silent when the market returned to backwardation last July. If anything, it appears that more activity is moving to the back end of the curve–so why did the contango go away? Moreover, although the price runup post-Katrina was accompanied by an increase in inventories–which is it at least superficially consistent with the price distortion story–the recent price runup was not accompanied by a jump in stocks. (And, as I said in my “Dance the Contango” post that is so loved by spam commentors, and in my recent working paper formalizing that intuition, in a world with stochastic fundamental volatility a positive co-movement in stocks and prices can occur in a rational expectations equilibrium, and hence is not necessarily a smoking gun of speculative distortion.)

In conclusion, I find James’s example unpersuasive. Although an increase in stocks that accompanies an increase in prices does not necessarily indicate speculative distortion, it is hard to imagine how the speculators could force prices above the competitive level without having to get their wingtips dirty with holdings of the gooey black stuff.

The words are, of course, Mark Twain’s. And almost a century after rumors of his death were no longer exaggerations, Congress daily works assiduously to bring his joke to life. Especially with regards to energy policy. Case in point: Rep. Maurice Hinchey (D for do you even need to ask, NY) has called for nationalization of US oil refineries. Methinks that even that ultimate cynic Twain would be amazed at such gobsmacking stupidity.

Another case in point; the mindless blather about energy speculation, and the various vacuous proposals to curb it. I’ve blogged on this subject many times, and will return to it again soon, but here I will limit myself to repeating a point I’ve made before: these assertions are based on bad economics and no evidence–always a great basis for effective policy.

On Econbrowser, the University of Illinois’ Scott Irwin presents an interesting analysis of the remarkable developments in the grain/oilseed basis (the difference between the cash price and the futures price) in the past couple of years. Scott (reporting work done with colleagues Darrel Good, Phil Garcia, and Gene Kunda) shows that the basis has widened dramatically in recent years, and considers various explanations.

One he entertains, but does not strongly endorse, is that the entry of speculative interests, most notably long only funds, has driven this development. I am extremely skeptical that speculators can cause the basis to become abnormally wide during the delivery period. In particular, long only funds almost invariably roll their positions forward prior to the delivery month. (As an example, the GSCI Index rolls forward contracts that are about to expire the month prior to the delivery month.) Funds that roll forward prior to the delivery month obviously cannot be inflating prices during the delivery month.

So what is causing the periodic basis blowouts? Squeezes are one possibility. But, squeezes would be associated with (a) sharp drops in cash prices immediately following contract expiration, (b) very large deliveries, (c) a dramatic narrowing in the deferred basis (i.e., the difference between the cash price and the next-to-expire futures price), and (d) a widening of spreads between delivery locations (e.g., on the Illinois River) and non-delivery locations (e.g., central Iowa). The Irwin piece doesn’t mention whether these things have occurred.

As some of the Econbrowser commentors note, absent a squeeze, the wide basis would seem to represent a substantial profit opportunity to those operating the regular warehouses and shipping stations (the facilities where delivery actually occurs.) These firms, which include agbiz giants such as ADM and Cargill, could buy cash grain, sell futures, make delivery, and capture the basis. So why don’t they do so?

In essence, commodity trading is the business of making transformations in form, location, and time. The operators of river shipping stations regular for delivery against CBT soybean and corn contracts are in the business of transforming these products in space–from the farm to the barge on its way to the Gulf for export, primarily to Asia.

Of course firms incur costs to make this transformation. The question is: is the marginal cost of delivery so large that it equals the inflated basis? Irwin is skeptical.

Absent the exercise of market power by those who operate regular delivery facilities, however, the basis measures the marginal cost of making delivery. (By reducing throughput through their facilities to less than the competitive amount, the facilities operators would depress cash prices, elevate futures prices, and thereby cause the basis to widen to a level in excess of marginal cost. This would, however, likely require collusion among them.) So, absent evidence of manipulation or collusion, or some other exercise of market power, the basis will equal the marginal cost of the transformation from farm to barge; if the basis is above the marginal cost, competitive firms would sell futures, make delivery, and buy cash grain, thereby driving up the cash, driving down the futures, and narrowing the basis.

It should also be noted that there is somebody willing to pay the futures price and stand for delivery to obtain a shipping receipt. If the taker was not receiving something of value commensurate with the futures price, he would sell futures. (And I am very highly confident that it is not long only funds, or even hedge funds, that are standing on delivery.)

What could cause the marginal cost (and marginal value) of delivery to be so high? Here’s one conjecture that is worth some investigation. Consider corn and soybeans. These contracts are satisfied via delivery of shipping receipts. (I was on the committee that helped design these contracts in 1997.) The contract rules state that the owner of the facility issuing the shipping receipt give priority to the holders of these receipts in determining whose barges get loaded. That is, by issuing a shipping receipt, the owner of a shipping station on the Illinois River (which could be Cargill, ADM, Louis Dreyfus, Zen-Noh or one of a couple of other firms) gives up control of its facility. Put differently, by making delivery, the owner of a facility gives the taker of delivery the option to control the shipping receipt issuer’s facility. The taker has the option to choose the timing to load out the grain. The taker will behave so as to maximize the value of this option. That is, he will exercise the option to use the facility to load out grain when it is most valuable to do so–which is just when it is most costly for the operator of the facility to give up control. That is, the owner of the shipping receipt has the option to transform grain from farm to barge when that marketing opportunity is most valuable–which is just when the owner of the delivery facility would find it valuable too, but cannot exploit it because he has shorted a call on his facility by issuing a shipping receipt.

This option is valuable to the taker of delivery, and costly to the maker of delivery. Therefore, the regular firm that can issue shipping receipts will do so only if the futures price compensates it for the value of the option it provides to the taker of delivery. Asset and infrastructure owners in all commodity markets are becoming increasingly aware of the inherent optionality in physical assets used to transform commodities in space, time, and form. They are explicitly valuing these options, and making trading, investment, and resource allocation decisions based on these valuations. Thus, I would expect that operators of regular facilities take option values into account when making delivery decisions. Similarly, takers of delivery surely take these values into account.

Are option values sufficiently high to explain the wide basis? Skepticism is warranted, to be sure. It must be said that it has often been the case that “real options” theory has been used to rationalize wildly inflated valuations (see energy trading, circa 2000.) Nonetheless, it is possible that optionality has contributed to the level of, and variations in, the basis. If optionality is important, the basis should fluctuate with changes in volatility. Volatility of what? Volatility in the value and cost of making the transformation from farm to barge. Thus, higher volatility in export demand and higher volatility in domestic demand for processing should contribute to higher option values and higher basis levels. A spike in domestic processing demand (driven, e.g., by an increased demand for ethanol) reduces the derived demand for barge loading facilities; a drop in domestic processing demand increases the derived demand for these facilities. Export shocks have similar effects. Transportation cost shocks also matter. Changes in fuel prices that change the costs of shipping grain also affect the derived demand for these facilities. Variability in all these shocks, and the correlations between them, contribute to the volatility that can create option value.

Spreads–such as the basis–price bottlenecks in the transformation process. Therefore, bottlenecks are the first thing to look for when trying to explain anomalously large spreads. Sometimes these bottlenecks can be created through the opportunistic, strategic behavior of traders (as in a squeeze). Sometimes they result from unusually high demand, or disruptions in supply. The analysis presented herein suggests when there is uncertainty, spreads can price in contingent bottlenecks. Speculators will affect spreads only to the extent that they exacerbate or mitigate bottlenecks; given that most commodity funds do not participate in the delivery process, they cannot be contributing to the price of a delivery month bottleneck.

I would mention one historical case that comes to mind; it was discussed in Chapter 2 of my book (with Roger Kormendi and Phil Meguire), Grain Futures Markets: An Economic Appraisal. The cash futures delivery month basis became very wide in July, 1988 for corn, wheat, and soybeans. This was the time of a historic drought, and the operators of Chicago elevators brought in massive quantities of old crop grain in order to protect their hedges, knowing that they would not be able to attract large quantities after a shrunken 1988 harvest. Delivery warehouses were chock-full, and the Chicago cash-futures basis became very wide. In this case, the basis was pricing a bottleneck in storage space.

According to Bloomberg’s Matt Leising (story not yet online), the CME’s would be competitor ELX is in discussions with The Clearing Corporation (the clearinghouse formerly known as BOTCC) to obtain clearing services. Immediately following the announcement of the formation of the new exchange in December, I surmised that the then-unnamed CME competitor would clear through the Clearing Corp due to the fact that several of the nascent exchange’s founders had just bought stakes in the once and former BOTCC. Although the Options Clearing Corp and ICE Clear have submitted proposals to ELX, I predict that at the end of the day Clearing Corp will prevail.

Although this will not be formally a vertical relationship, as ELX and CC are formally separate organizations, given the overlaps in ownership it will functionally integrate execution and clearing. Indeed, that is almost certainly one of the virtues of the arrangement to ELX, although I imagine they will not be too vocal about this as that would contradict their criticism of CME’s ownership of its clearinghouse.

This would also represent another move in the direction of more integration in clearing. The trend is clear (no pun intended): SWX, ICE, and LIFFE have already moved decisively in this direction, and LSE has also mooted the possibility. Regulators on both sides of the Atlantic view this with alarm, due to their fixations on the purportedly anti-competitive effects of integration (a fixation derived from bad economics), and their steadfast refusal even to contemplate the potential efficiency benefits of integration. You’d think that such a trend would spark at least a little doubt and reflection among European regulators and USDOJ, but you’d be wrong.

Treasury Secretary Paulson made a big splash with his announcement of a “plan” to reform US financial markets. In fact, it is much sound and fury signifying nothing, with virtually no chance of being implemented. Moreover, it is completely non-responsive to the current travails in the credit markets.

The biggest headline was that the recommendation for the merger of the SEC and the CFTC. This puts in me in mind of two quotes. The first is by Churchill: “A fanatic is one who can’t change his mind and won’t change the subject.” Whenever anything happens in the financial markets, the cry immediately goes up to merge the SEC and the CFTC. Many people are apparently fanatical, because they never change about their minds about the desirability of the merger, and the subject always seems to return to it.

The second quote is by somebody slightly–well, a lot actually–less famous; that would be me. In a 2001 Regulation Magazine piece on the Clinton regulatory legacy, I wrote that the SEC-CFTC combination was a solution in search of a problem.

I am always somewhat mystified by the substance of the arguments for the merger. The most commonly mentioned benefit is a harmonization of margins between stocks and stock index futures. What, it’s not possible to harmonize without going merging the two bodies? Moreover, given the myriad other more important issues facing the two agencies, this seems like a very thin reed on which to rest a major reshaping of the regulatory structure.

In reality, there is very little overlap between the regulatory responsibilities of the two agencies. What’s more, there are huge swathes of the trading landscape that fall outside the jurisdiction of either agency. So merger will hardly reduce that much duplicative or contradictory regulation, and will not fill any regulatory gaps. So what’s the point?

Indeed, there are many sources of potential danger in a merger. One, very underappreciated in my view, is that it sacrifices the advantages of specialization. There are issues unique to securities markets and derivatives markets. Specialized agencies can develop the expertise needed for each market space. Of course the staff at a merged agency could specialize, but major policy, rulemaking, and interpretive decisions are made at the commissioner level. Right now SEC commissioners, for example, need to deal with arcane issues of accounting, disclosure, securities intermediation, and securities trading practices in stock, option, and fixed income markets. This is an already daunting task. Adding new areas of responsibility involving different markets and different instruments with different issues will further tax the already limited expertise of the commissioners of the merged agency.

The inevitable outcome of this dilution of expertise and specialization will be to enhance the power of staff, and degrade the quality of commission decision making. Neither outcome is desirable.

Indeed, I would argue that the SEC is already underspecialized. The agency operates subject to three statutes, the Securities Act of 1933, the Exchange Act of 1934, which focus on primary and secondary markets for securities, respectively; and the Investment Company Act of 1940, which focuses on mutual funds and the like. The agency has responsibility over the issuers of securities, and the markets and intermediaries that trade securities. There is little overlap between these areas. Issues of disclosure and accounting can be conceptually and operationally distinguished from issues of market structure and organization.

A second area of concern is that a unified agency will provide a mechanism to reduce and distort competition between different sectors of the financial markets. There are many on Wall Street that would love to throttle the futures exchanges in order to reduce competition for the securities business. (The margin issue is a perfect example of this. The securities firms would love to force an increase in margins on futures to drive some business from the futures exchanges to the stock market.) The regulatory autonomy of the CFTC has largely precluded such an outcome. The SEC has indeed tried in the past to impede the development and introduction of futures products that compete closely with securities markets but has largely failed in these endeavors because it does not have the necessary authority or jurisdiction.

Now, of course, a merger would change agency politics. Under the current framework, the SEC is largely responsive to securities firms and exchanges, and the CFTC is responsive to the futures exchanges and the FCMs. A merged entity would be responsive to the interests of all of these parties. But that is not necessarily a good thing, as one very likely outcome is that the merged entity would implement regulations that would reduce competition between the varying constituencies.

A more sensible, but still problematic, regulatory reorganization would involve (1) stripping out the primary market, accounting, and disclosure responsibilities from the SEC and putting them in a separate agency focusing on these corporate finance issues, and (2) creating a separate agency responsible for trading and market structure issues in securities and derivatives markets. This second agency, call it the “Commission for Financial Trading and Markets” (“CFTM”) would focus on issues relating to manipulation; fraud; the financial adequacy of intermediaries (securities and derivatives brokerages); and facilitating competitive market structures in financial markets. Arguably the manipulation, fraud and competition responsibilities should give the CFTM some authority in the OTC markets.

This approach would be far preferable to mashing together two disparate agencies with very different histories and cultures in the hope that something beneficial will come out of the unnatural coupling. It would permit the development of some specialization, and many issues of fraud, manipulation, and market structure are common across securities and derivatives markets, so the specialization could be applied to a variety of related markets. This alternative is still problematic, however, because the CFTM could easily become a mechanism for stifling competition between different methods of allocating risks and discovering prices.

All that said, there is little likelihood that the merger (or the creation of a CFTM) will come to pass in any event. The idea has been around for decades, and has never even come close to implementation. This is no surprise. There are powerful political forces in the way. Most notably, the futures exchanges, their members, and the FCMs have fought the SEC’s loving embrace vociferously, and found vocal support in Congress. Moreover, whereas the SEC falls under the congressional banking committees (e.g., the Senate Banking Committee and the Securities, Insurance and Investment Subcomittee), the CFTC is under the ag committees. Neither is about to readily cede jurisdiction over a large, well-heeled, and generous industry.

There is another strange aspect of the Paulson initiative. The ostensible reason for the urgency of financial reform is to address systemic risks. The most recent event stoking this urgency is the near failure of an investment bank and the resulting bailout (call it what you will, but by any other name it would still stink.) But what financial institutions are almost wholly absent from Paulson’s “blueprint”?–well, investment banks. Now, presumably, they would be subject to the Fed’s “supercop” authority if they posed a threat to financial stability, but what is striking is that the specificity of the proposals for commercial banks, insurance companies, the SEC, the CFTC, and mortgage intermediaries is not matched by specific proposals for changes in the regulation of investment banks.

Don’t get me wrong, I am not advocating expansive new regulations of IBs. I just find the contrast somewhat jarring.

I also think that the blueprint shockingly fails to mention, let alone address, a major source of the current ongoing tumult in the credit markets, and what could be the source of worse problems in the future: the lack of transparency in the valuation of many products in bank and investment bank portfolios.

One reason for Bear-Stearn’s liquidity crisis was that potential lenders and counterparties had no way of ascertaining the value of the complex products in its portfolio. Even if Bear had opened the kimono (as the phrase goes) and told everybody what was in its portfolio, nobody would have been able to put a value on it. The complexity of many of the products, and the lack of pricing data make the task of valuation impossible.

I wish I could say I had a canned answer to this last problem. I don’t. Neither does anybody else. However, Treasury and the SEC have already made tentative moves to engage the NYSE in launching a pricing service. There are some existing precedents, albeit dealing with simpler tasks–the Municipal Securities Rulemaking Board and NASD have created price reporting services for municipal and corporate bonds, respectively, for example. Getting accurate valuations of much more complex structured products will be far more daunting, but before this difficult problem can be tackled, it must be raised. Paulson did not do so.

In my view, all of the things that Paulson actually addressed are small beer compared to the thing he left out–improving price discovery, valuation accuracy, and transparency in the vast markets for structured credit and mortgage products. These products are the source of the current problems in the credit markets, and are the most likely source of future problems. The lack of good information about the valuation of these products is what makes the credit markets most vulnerable to seizing up; who will finance intermediaries when nobody knows what they are really worth?

As I said, this is a hard problem. But it is a problem of first order importance–something which cannot be said of other things in the Paulson initiative, the SEC-CFTC merger most notably. it would be far better had the Treasury secretary identified this problem as a priority, and at least outlined a proposal to tackle it.

According to the FT, the UK’s Office of Fair Trading (the British antitrust authority) has apparently caught a case of the stupids from the USDOJ:

In the row over the ICE, which is planning to move clearing in-house and away from LCH, the matter is under review by the UK Office of Fair Trading. There are signs that the OFT, which has long been troubled by the competition issues raised by exchanges owning clearers, is studying the application closely. Two weeks ago, it sent out questionnaires to market participants querying the level of competition for the mostly widely traded ICE contracts in London.

If ICE forces customers to use only its own clearer, bankers say they will press the Commission to block the deal. Last week, in a separate initiative, Nymex launched a suite of products in direct competition with ICE that will clear through LCH.

Meanwhile, customers are also threatening to bring LCH to the attention of European authorities over a deal it tentatively struck with Liffe last week that would see the exchange take some of its clearing in-house but stop short of forming its own in-house operation and ending its relationship with LCH.

It would be nice, if just once, somebody, somewhere in some antitrust authority would actually step back and do a thorough analysis of economics of vertical integration in clearing and execution. The monomaniacal focus on (likely chimerical) anti-competitive effects, to the complete exclusion of any consideration of the possibility that vertical integration, might, just might, have some efficiency rationales will inevitably lead to bad policy. As I have said before, this is throwback antitrust analysis–BC, as in before Chicago.

One simple question for the OFT: if exchange control of clearing is the big obstacle to competition in execution, why hasn’t LIFFE faced competition in its products? And for that matter, why hasn’t LSE? (Okay, that’s two questions.) And who owns a big chunk of LCH? (Okay–three.) It wouldn’t happen to be the banks that are complaining about LIFFE moving clearing in-house, would it? (I know.)

On that last point, before one canonizes the poor, martyred banks who suffer at the hands of those cursed exchanges, consider the following story by the excellent Natasha (may I call you dahlink) de Terán:

LCH.Clearnet has operated SwapClear, a much used and admired swap clearing service, for nearly a decade. SwapClear has its critics and limitations but the one that could prove to be most damaging is its membership criterion.

A self-qualifying circle of dealers, OTCDerivNet, guard SwapClear’s gates. The buyside and other smaller dealer firms are kept outside. LCH.Clearnet might have wanted to roll out a similar service to that of the CME. But it has been hamstrung by OTCDerivNet.

Imagine that, a cooperative that restricts entry! Never heard of that before. (Yeah, well, except for the NYSE and pretty much every traditional US derivatives exchange and many overseas exchanges.) Think that such entry restrictions might well enhance the profitability of the members that are on the inside looking out? That certainly was the case with exchanges, as my 1999 J. Financial Markets paper showed.

Thus, perhaps the European Commission and OFT should take a break from obsessing about exchange vertical integration, and take a gander at some other possible competition issues in clearing. As I wrote in my clearing paper, disintegration combined with the formation of a cooperative clearing venture is no guarantee that a thousand competitive flowers will bloom. Execution venues that discover prices are likely to remain monopolies after disintegration; even cooperative clearers can exercise market power by restricting entry or supercompetitive pricing (and don’t be fooled by big rebates to members–that can be perfectly consistent with the exercise of market power); and the parallel operation of an exchange and a clearer both with market power can lead to inefficiencies in the form of double marginalization and higher transactions costs.

In my earlier posts on the DOJ’s jeremiad on clearing, I questioned whether its analysis of US options markets was apposite. I have finally had a little time to research the issue, and the answer is a resounding “NO!”

In my original post pointed out a couple of possible important issues–intermarket linkages and payment for order flow–that could mean that the survival of multiple options exchanges does not imply that network effects are immaterial in financial trading. Indeed, as several SEC studies document, both features are very relevant in US options markets.

As part of the exchanges’ antitrust settlement with the government, the exchanges adopted an intermarket linkage plan and agreed to adhere to order handling rules. Though not as streamlined as those eventually adopted for the equity markets under RegNMS, these measures provided considerable linkage between the different option markets. That is, though they did not go as far as creating a central limit order book (“CLOB”), the rules did go a long way towards creating a central price discovery venue. That is, options exchanges are not competing price discovery venues; they are competing portals to a central price discovery mechanism. Linkages and order handling rules sharply reduce the centripetal forces that would otherwise induce trading to “tip” to one exchange

Moreover, the SEC studies report that a very large fraction of order flow served by the options exchanges is purchased. As I have written in my academic work, purchased order flow is typically uninformed order flow that does not contribute to price discovery. Moreover, as I have also shown in that work, multiple “cream skimming” venues servicing uninformed order flow can coexist. That is, segmented uninformed order flow does not tip. The survival of multiple exchanges servicing uninformed traders via payment-for-order-flow and internalization arrangements in no way contradicts the tipping/natural monopoly of price discovery framework.

Thus, the survival of multiple exchanges in options is not attributable solely to the fact that the industry operates a cooperative clearing “utility” as the DOJ claims. Rather, this survival reflects the facts that (a) linkage and order handling rules have effectively socialized order flow and created a central price discovery venue, and (b) much of the uninformed order flow is “skimmed” and segmented, and thus not susceptible to tipping.

This implies that creation of a clearing cooperative is NOT sufficient to lead to competition in execution, and the survival of multiple, competing price discovery venues as the DOJ letter asserts. Much more radical steps are required. Specifically, no execution venue can be allowed to own and control its order flow. Absent any obligation to redirect order flow to another market offering a better price, and the creation of technological linkages that make this redirection quick and efficient, trading activity will tip to the market that offers the best expected terms of trade. This becomes a self-fulfilling process, resulting in the survival of a single market.

Now, there is an argument to be made that such rules and linkages are efficient; in fact, I’ve made it in my JLEO article “Security Market Macrostructure.” But the DOJ does not make that argument–or even provide any inkling that it even understands the issue. It merrily suggests that cutting the baby in half–splitting execution and clearing–alone will allow the proliferation of many competing execution venues. Wrong. Wrong. Wrong. Look at the history of equity trading 1975-2005 for abundant proof of that. If the formation of a clearing cooperative was sufficient to create competition in execution, why did the SEC feel it necessary to push ahead with RegNMS and its socialization of order flow decades after the creation of a securities clearing cooperative?

Indeed, if followed, the DOJ’s prescription could be very damaging, leading to no improvement in competition in exchanges, but resulting in reductions in efficiency due to double marginalization, and higher transactions costs. Without measures to break the network effect–to socialize order flow through mandated market linkages and order handling rules, or the creation of a CLOB–shearing clearinghouses from exchanges will do nothing–zip, nada, zero–to increase in competition in execution, but it will lead to wasteful “friction” at the interface between the independent clearer and exchange. All pain. No gain.

It is also interesting to note something that the DOJ ignores altogether. Not only is exchange ownership of futures clearinghouses the standard worldwide, it is actually increasing in importance. ICE has brought its clearing in-house in the US, and is endeavoring to do so in the UK, though that is running into some obstacles–regulatory and in implementation. As another example, LIFFE, which had historically secured clearing from LCH (and subsequently LCH.Clearnet) is now moving to integrate clearing. This is quite consistent with the transactions costs arguments I have advanced.

There are two stark choices: either keep the status quo, or undertake a thorough remaking of the regulatory structure in futures markets along the lines of what has been done in equity (and latterly options) markets in the past 30 plus years. The DOJ’s nostrum either goes too far, or not far enough. Since there has been absolutely no debate regarding the organization and regulation of futures markets along the lines of that which has roiled the securities markets for decades, it is highly unlikely that the more radical alternative is in prospect any time soon. I only fear that the pressure to do “something” leads Congress and the regulators to take the DOJ’s middle ground–to the detriment of the markets and their users.