Streetwise Professor

I was quoted extensively in this article on energy speculation by Isabelle Cleary. The photo is not, shall we say, representative of my current appearance. Whether that is a good thing or a bad thing is a matter of some dispute in certain quarters, most notably in chez Pirrong.

Substantively, Isabelle’s article is a good and thorough one, which is not surprising because she is a knowledgeable reporter. (I say this not just because she quotes me now and again, but because it’s true.) At the very least, it’s nice to see a balanced presentation of the issues regarding speculation and manipulation in the energy markets.

From a New York Times article on the fading away of floor trading in Chicago:

Equal access to the markets has made trading more challenging for pit traders. “We’re trading against machines” all over the world, said Jeffrey Levant, 53, who has been at the exchange for 29 years, and recently left the Nasdaq pit to learn electronic trading. “Sometimes it feels like we’re John Henry going up against the steam hammer.”

Well said. In the past I’ve compared floor traders to the Polish cavalry charging German tanks in 1939, but Mr. Levant’s metaphor is much more colorful and evocative. It is particularly evocative when one listens to “John Henry” by acoustic blues performer Furry Lewis: “I’m gonna die with this hammer in my hand.”

It is somewhat ironic to see how things have changed in a short decade. Even in late-1997 it was widely believed that the floor was inherently superior to the machine. Then, in early-1998, Eurex wrested the Bund contract from LIFFE, and the momentum changed. I had been an early advocate of electronic trading, and had taken some flack for that advocacy. Hence, it was somewhat gratifying to see my predictions borne out. Nonetheless, even an apostle of the steam hammer can feel for John Henry, and it is with mixed emotions as I see the floor and its vibrant culture fade away.

I was quoted on a Marketplace story on the energy market regulation changes I blogged about yesterday. Nice to get the last word.

The CFTC is supporting Congressional efforts led by Sen. Levin of MI to pass legislation that would allow it to impose position limits and obtain position information on energy derivatives traded on ICE (and presumably other electronic OTC trading platforms) in order to prevent energy price manipulation:

The CFTC is seeking mandatory daily reporting to the agency of large ICE trades, limits on the number of ICE energy contracts a single trader could control and exchange rules to force a trader to unwind large contract positions.

To recycle a line I’ve used before, they want to reduce manipulation in the worst way–and they’ve found it. Position limits and position reporting are inefficient ways to reduce the frequency of manipulation, as compared to readily available alternatives. There are so many defects in these remedies, it’s hard to know where to begin.

For one thing, position limits must be set based using very crude information about the market conditions that will prevail when the position limits are in effect. Sometimes the limits will be too large to constrain much manipulative behavior. Other times, the limits will be smaller than necessary to combat manipulation, and will be so small that they constrain the legitimate activities of market participants.

This last effect is very important. It is economically efficient for some traders to accumulate large speculative positions. These speculators absorb risk from hedgers. Position limits constrain speculators’ ability to take on risk, meaning that hedgers will find it costlier to transfer risk to speculators. They will hedge less as a result. That’s a real cost.

I have just completed a paper that shows that even if position limits constrain manipulation, they reduce overall welfare because of they interfere with the efficient allocation of risk. In essence, position limits throw out the baby with the bath. Sure, they constrain the rent seeking, manipulative activities of speculators, but they also constrain speculators’ efficiency enhancing risk bearing function too. In the standard mean-variance/Anderson-Danthine hedging/speculation equilibrium model of my paper, the latter effect outweighs the former, and position limits reduce welfare. Thus, even if they are successful in reducing manipulation, that doesn’t mean that they’re good public policy.

This possibility has been totally ignored in the debate, such as it is, over position limits in energy. This reflects a general ignorance of the socially beneficial effects of speculation, and indeed, the hostility to speculation that has dominated the Congressional and regulatory intellect for decades (stretching back into the 19th century.) Risk transfer is a primary function of derivatives markets, and position limits interfere with this primary function. This is a real cost, but one that is too often ignored.

Position reporting wins no prizes for efficiency either. Presumably the theory is that the ability to monitor positions gives regulators the ability to identify incipient manipulations, and intervene before things get out of hand. Now let’s deal with the reality.

The first reality is that how big is big–i.e., how big a position must be before it poses a manipulative threat–depends on variable market conditions, and how the trader acts. Just seeing that somebody holds a big position tells you absolutely bupkus. As a result, regulators will start to scrutinize big positions only when price distortions become manifest in the marketplace. Well, by the time this happens, a lot of the damage is already done. Maybe the regulators can keep things from getting worse, but the idea of preventing manipulation before it affects prices is a pipe dream. Even when armed with position information, regulators only become engaged when price distortions become apparent.

And even when they intervene, there is no guarantee that they will succeed. They can jawbone, but sometimes regulators can be fooled, persuaded–or intimidated–into inaction by manipulators. Think that doesn’t happen? Want to buy a bridge?

Regulators can also be wrong, and it is important to remember that when attempting to intervene during an alleged manipulation regulators necessarily have worse information than is available after things play out. The manipulative “end game” (as I call it in my ’93 JOB piece on manipulation) often provides the most powerful information on whether a manipulation in fact occurred. For one thing, the price movements post-manipulation–the “burying the corpse” effect–often provide the strongest evidence that prices were distorted. (After a corner ends, the manipulated price collapses relative to other prices as the excess deliveries are dumped on the market. These deliveries are the “corpse” of the corner, and disposing of them is referred to in the biz as “burying the corpse.”) (And to reiterate, Bill, I didn’t make up that phrase. P. D. Armour did. Sorry for the inside humor, folks, but I couldn’t resist–although I did restrain myself from making a really cutting remark.) Also, the alleged manipulator’s behavior–whether he takes deliveries at prices that appear uneconomic–provides the strongest evidence on his motives and intent.

Errors are important. Regulators can intervene and force liquidations of large positions when there is really no manipulation, or they can fail to intervene when a manipulation is actually in progress. Both kinds of errors are costly. Given the lack of crucial information before things play out, for a given probability of one type of error, the other type of error is higher when regulators try to intervene before the fact than afterwards. As I’ll discuss momentarily, civil (or even criminal) sanctions imposed after the fact can utilize better information, reduce the frequency of one or both kinds of error, and reduce the frequency and severity more efficiently than early intervention.

Reporting is wasteful for other reasons too. It is costly to collect this information, most of which will never be needed to detect or prevent a manipulation.

Moreover, traders can avoid position limits and reporting by moving their activities into the non-electronic OTC market, using voice brokers or just bilateral deals with other traders. To the extent that it is more efficient to execute transactions electronically on a platform like ICE, this displacement of trading activity is inefficient (though it is a boon to voice brokers.)

So what is better? Dropping the hammer on manipulators after the fact, that’s what. Law and Economics scholars (notably Steve Shavell) have identified conditions under which deterrence through the imposition of sanctions ex post is more efficient than ex ante prevention. Most importantly, deterrence is efficient (relative to prevention) when the offense is detected with high probability, and malfeasors are not judgment proof.

Both conditions characterize manipulation in derivatives markets. As Judge Frank Easterbrook once wrote, an undetected manipulation is an unsuccessful manipulation. A successful manipulation distorts prices–and everybody in the market can observe it. Moreover, most manipulators are well heeled, and can pay legal judgments levied against them.

By waiting to act until after a putative manipulation runs its course, regulatory or judicial authorities–or private plaintiffs harmed by the manipulation–can rely on the best information available on the price impact of the manipulation–including the “burying the corpse” effect–and on the alleged manipulator’s actions. Thus, there should be fewer errors (incorrect convictions, or incorrect acquittals) after the fact than when regulators attempt to intervene during a suspected manipulation.

Litigation is expensive, to be sure. But the expenditures can be targeted, and only incurred when the harm occurs. Position information need only be collected via discovery when the evidence of a manipulation is manifest, and from the likely culprits (who can be identified pretty easily, as there is a lot of information about who is doing what is floating around the markets, and some manipulative behavior is hard to miss, e.g., who ends up owning all the deliverable supply.) This is cheaper than collecting information from everybody (virtually all of whom are completely innocent of anything) all the time (when usually nothing amiss is happening).

So, in a nutshell, deterrence rules, and position limits/reporting are for fools. And guess which way Congress and the CFTC are moving? Draw your own inferences, people; do I have to draw a map?

Ironically, the news about the Levin bill and the CFTC advocacy thereof comes almost simultaneously with the announcement that BP has agreed to pay $300 million(!) (subscription required) to settle civil charges that it manipulated the propane market in 2004, and that four BP traders are facing criminal charges (ditto) arising out of the same incident. I have mixed feelings about the criminal aspect of this case, but the imposition on a hefty fine on BP is the way to go as a way to deter this sort of conduct going forward. Three hundred large large is some major change–especially considering that the alleged (and I guess now admitted) BP corner attempt was apparently unprofitable because the company ended up with a much bigger corpse to bury than it had anticipated. Surely any trader contemplating cornering, squeezing, or hugging a market in the future will think once, twice, and a few more times, before squeezing the next time. It should also be noted that all this activity took place in the OTC market, and that it did not take place on ICE, or to my knowledge, any electronic trading platform. Nonetheless, the manipulation was identified, the culprit fingered, and the hammer brought down. No need for watching everybody all the time, most of said watching effort being completely unnecessary because much of the time manipulation isn’t a serious worry.

For those of you with way too much time on your hands, I have a much expanded analysis of the deterrence vs. prevention debate in my book The Economics, Law, and Public Policy of Market Power Manipulation. (Shameless plug! Now up to #1,302,119 on Amazon! Only 3 copies left! Order soon!) I also presented some rigorous numerical analysis of the power of detection ex post vs. ex ante in the working paper version of what eventually turned into my 2004 ALER article on the Ferruzzi squeeze. I think that version is still posted on my UH web page.

One last comment. I find the obsession with energy market manipulation to be somewhat curious. The US government has manipulation problems much closer to home–the US Treasury securities market. Manipulation problems in this market became so chronic in the early-2000s that two high ranking Treasury officials raised the subject in public speeches, and the FRBNY called bond market heavyweights to a Come-to-Jesus meeting, where the assembled congregation was sternly warned to go away and sin (that is, manipulate) no more. Despite the importance of the Treasury markets, and their size, Congressional interest in this problem seems de minimus as compared to the constant hyperventilating over energy market manipulation. Presumably this has to do with the fact that energy prices affect pretty much everybody, whereas the Treasury markets (especially the repo market) are pretty much inside baseball; Congress has to be seen Doing Something about energy prices even though there is little if any connection between persistently high energy prices and the kinds of manipulation that are allegedly the targets of legislation, and even though (as discussed above) the legislation is an inefficient way to reduce those kinds of manipulation.

I was thinking of inserting an apposite Mark Twain quote here (you probably know the one I’m thinking of), but won’t gild the lily. Like Mom says, if you can’t say anything nice . . . I know I’ve broken that rule a lot already in this post, but I’ll follow it just this once.

Correction. I wrote that to my knowledge, none of BP’s propane transactions were consummated on an electronic system. I took another look at the CFTC’s civil complaint against BP, and noticed that market participants utilized an electronic trading platform called Chalkboard to trade propane. I don’t know the breakdown of volume between voice brokers and Chalkboard.

Crain’s Chicago Business reports that several analysts are touting a potential CME-NYMEX merger. Crain’s cautions that it has no indications that talks are underway, and both exchanges declined comment. Nonetheless, it is clear that the compelling economics of the transaction, which I have been pointing out since early-2006, are becoming widely understood.

Interestingly, NYMEX’s stock price has been relatively flat in recent months, while CME’s has appreciated dramatically to all time highs–up $40/share since early August, and rallying over $80/share since late September after a sell-off earlier in the month. The CME’s warchest is therefore bulging, and CME is more than able to swallow NYMEX. Antitrust considerations would most likely stymie CME’s nemesis in the CBT merger–ICE–in its pursuit of NYMEX. Thus, CME’s most likely competition would be NYSE/Euronext, and Thain is desperate to get into derivatives, but I still give CME the leg up due to the fact that NYMEX contracts already trade on CME’s Globex.

The article also suggests that CME is looking abroad–to exchanges like Brazil’s BM&F. Given CME’s financial heft and management, in my opinion the exchange can do both. So, my guess is that in early ’08 we’ll see CME make a bid for NYMEX, and perhaps BM&F as well. NYMEX is the prize, though, and I expect the CME to focus there first.

This WSJ article (subscription required) warns about Russia’s creation of an oil exchange that will “shift energy business away from existing global financial centers.” St. Petersburg’s historic Greek Revival Bourse building is being restored to house it. Author Judy Shelton says that this is just one effort among many by Putin to challenge America’s (and to a lesser degree Europe’s) global financial primacy.

My fearless prediction: within months of its opening, you will hear crickets chirping on the trading floor. I base my prediction on two factors, one common to all attempts to start new exchanges, one specific to Russia and other nations that do not respect property rights and which are dominated by lawless governments.

The universal problem is liquidity. It is notoriously difficult to start a new market, or to launch a new contract, especially in competition with existing markets. This is due to the difficulty of attracting liquidity. As a result of the Catch-22 nature of liquidity, nobody wants to enter a market where no one else is trading. Potential traders are like Alphonse and Gaston, each waiting for the other to go first.

There is an excellent example of this right now in the very oil market that Russia hopes to enter. The world’s oil supply is increasingly sour and heavy, but both major pricing benchmarks—Brent and WTI—are sweet and light. Thus, oil traders, producers, consumers, and marketers have been seeking a viable sour/heavy price benchmark and hedging vehicle. Both ICE and the Dubai Commodity Exchange (“DCE”) launched Middle East crude contracts (tied to Omani crude) that would meet these needs. After the typical initial flurry of activity, volume in both contracts has declined dramatically, and ICE has pulled its contract. These problems follow the pattern of earlier failed attempts to launch a heavy/sour contract (NYMEX tried back in the 1990s.)

Both ICE and DCE are excellent exchanges operating under secure legal and contractual regimes. Both have spent a lot of money designing, developing, and marketing their contracts. Despite these efforts, both contracts have withered, and I have little faith that this trend will be reversed.

The specifically Russian problem? That should be problems, plural. Futures and commodity markets are markets for promises. If there is even a modicum of doubt that contractual promises will be honored, a futures market cannot develop. Russia’s lack of a rule of law, and its recent flouting of laws and contracts, creates a something well beyond a modicum of doubt regarding the sanctity of contractual commitments.

One can easily imagine scenarios in which contracts are abrogated or undermined. Let’s say that a politically connected individual or firm (a member of the siloviki, for instance, or Rosneft or Gazprom) takes a big position that loses a lot of money. The loser raises a hue and cry that the market has been manipulated, and a sympathetic government (which may include people with a direct financial interest in the losing company, or who can be “persuaded” with a well-placed gratuity) brings its investigative and police powers to bear. It finds manipulation, and either explicitly abrogates the contracts, or exerts pressure that leads to a “negotiated” settlement that makes the loser whole—and maybe even more than whole. This outcome is particularly likely if the party on the right side of the market happens to be a foreigner.

If you think this is far-fetched, you obviously haven’t been paying attention to the way that Putinworld works, cf. Yukos, Rusoil, Ukrainian gas, Sakhalin II, BP/TNK, maybe Sakhalin I, etc.

And speaking of manipulation, let’s turn the example on its head. A playah—a Rosneft or a Gazprom—has incredible leverage through its control of physical assets to manipulate prices. Consider this very real possibility: Remember that pipeline that is the source of deliveries against the futures contract? Well, it just sprung a leak, and darn it, we really don’t know how long it will take to fix. So deliverable supply has just gone to zero. And wouldn’t you know it, we just happen to be long. Sorry about that, suckers . . . we mean shorts. Better luck next time. Or a connected a firm can just run the tried-and-true squeeze play.

In either instance, is there any reason to believe—any at all—that the Russian authorities would intervene, or impose penalties on the connected malefactor?

As a quick example, I read some months ago how Gazprom was using its market power to hammer the Russian electricity behemoth EES. (I also read another article that specifically discussed a gas auction which resulted in EES paying much higher prices. There were allegations that Gazprom withheld output from the auction. It’s in my clip files–I’ll try to dig it out.) Were there consequences? Surely you jest.

Moreover, although the Russian government is no doubt happy now that oil markets are establishing high prices, but will it be so happy if (and I should actually say “when”) the worm turns, and prices move lower? The government’s temptation to interfere with the market, or to shut it down, will be very great. Shooting the messenger is not unknown in Russia (and unfortunately, the shooting is arguably not just metaphorical.) The government may like the market’s message now, but will not like it nearly so much in the event of a price decline, and in my view it is highly likely to act aggressively in that event. This is another major political risk that will impede the development of an open oil trading market in Russia.

Vertical integration is another obstacle to a successful Russian energy futures market. Vertical integration impedes the development of a viable futures market. There are fewer arms-length transactions that need to be priced and hedged in a highly integrated chain, as opposed to a dis-integrated one. Energy trading is all about identifying and pricing transformations in space, time, and product. These transformations are internalized in an integrated structure, and hence there are fewer trading opportunities.

The Russian energy infrastructure is already highly integrated, and becoming even more so as the result of conscious political decisions, rather than economic forces. The “power vertical” in the energy industry means that vertical integration is the dominant form of organization in Russian energy. Indeed, Russia is trying to integrate extensively into marketing, distribution, transportation, and refining outside of Russia. This integration will impede the development of a Russian energy exchange.

Information asymmetry is another impediment to the development of a liquid market. The notorious lack of transparency in Russia aggravates information asymmetries. And there is incredible opacity obscuring the kinds of information that are particularly important in Russia—such as political information and operational information relating to the Russian energy infrastructure. Energy has been identified as a primary pillar of Russian state security, and the aggressive use of state secrecy and espionage laws that has characterized Russia in recent years strongly suggests that these laws could readily be directed against those attempting to ferret out price-relevant information in the energy market. Indeed, since information advantages would tend to redound to the politically connected in Russia, there is a direct economic incentive to use the state’s powers to preserve those information advantages.

In sum, launching a new exchange is hard enough in a country subject to the rule of law, with independent enforcers and a tort system available to crack down on manipulators, a culture of transparency, and a relatively unintegrated market structure. The fundamental defects of Russia’s political, regulatory, and economic structure make the prospects for an energy exchange dim indeed. Inside a cave at midnight dim. And this is true in spades for Iran, another country that has made noises about starting an oil bourse to undermine American economic hegemony.

So, it’s nice and all that a historic building with ties to Russia’s financial past is being refurbished. It is a nice symbol of the demise of communism, and of the fact that Russia is at least paying lip service to markets. But don’t expect much of consequence beyond the architectural preservation/revitalization. A la the military posing I analyzed in an earlier post, this seems just another Potemkin moment. Viable markets need the appropriate institutional and legal infrastructure, and those are woefully underdeveloped in modern Russia–when, indeed, they are not actively undermined by the actions of the state and politically connected companies.

It’s a bummer (grew up in the 70s? who? me?) to have to read about the approval of the CBT-CME merger from distant China, where I am teaching until mid-July. But it’s good news nonetheless. Things played out pretty well as I forecast, with CME bumping its bid at the last minute, and ICE folding because it just couldn’t afford to overcome the CME’s efficiency advantages. Congratulations to the managements of both exchanges, and to their owner-members.

Although this brings down the curtain on the longest running act in the derivatives business (at least as an independent venture) it is a smart move. Due to mis-steps in the 90s (born out of a futile hope that they could stave off the electronic era by failing to create a viable electronic system and building a huge new trading floor–sorry guys, but Econ 1o1 says sunk costs are sunk), the CBT has been living on borrowed time for years. It never owned its clearing operation, and due to its failure to create and own its own technology, it was inevitable that it would be snapped up post-demutualization by somebody who owned both. And who better than the CME, with a first class clearing operation and arguably the best trading system in the business. The CBT-CME combination was clearly the most efficient way to go.

As I noted in an earlier post, things will develop quickly, and the remaining independent exchanges will soon cease to be such. NYMEX and ICE will soon be the next to go–and for quite handsome prices, thank you. The FT surmises that NYSE-EuroNext will try to snap up NYMEX to break up the CME-NYMEX strategic partnership. I doubt it. That partnership has worked very well, so why should NYMEX migrate to a new platform only months after moving to Globex? Moreover, the clearing efficiencies would be large. As I have said for well over a year, I expect NYMEX to end up in the CME Group ASAP. The natural thing is for NYSE-EuroNext to buy ICE.

That pretty much leaves CBOE, and various small fry, at least in the US. (LSE is another matter altogether). One could see a rationale for CBOE combining with CME, but I think that (a) the CME’s reluctance to suffer any more SEC oversight than it has to, and (b) the lingering rancor over the CBT-CBOE trading rights will make that a difficult deal to do. (Although a marriage might be one way of dealing with that troublesome issue.) So I see CBOE going with NYSE too, although that’s going to have to wait resolution of the trading rights issue.

But those are tomorrow’s stories. Now it is appropriate to reflect on the glorious and colorful–though often contentious–history of the Chicago Board of Trade. Truly a pioneer, the derivatives business as we know it would not exist if it hadn’t blazed the trail for almost a century and a half. In some respects, however, that very historical legacy–the traditions and habits and interests that grow like barnacles on venerable institutions–impaired its ability to lead the industry in the 21st century. Its management made the wise choice of partnering with a younger, more dynamic, and lately more innovative exchange. I fully expect that this partnership will blaze yet more trails, and thereby enhance the efficiency of the financial markets in the 21st century and beyond.

CME CEO Craig Donahue sent on some thoughtful remarks on the evolution of financial market structure that he gave at an International Monetary Conference that merit some comment.

A crucial point he makes is how demutualization has changed the nature of the relationship between exchanges and intermediaries, notably the large FCMs. Whereas the FCMs were once exchange members, and hence owners, and exchange efforts were devoted in part to enhancing their profits, now exchanges are focused on maximizing returns to shareholders. This, as Donahue puts it, creates a tension between “value chain players” with exchanges and intermediaries both chasing dollars from ultimate customers. Although this is not a zero sum game, exchanges can profit at intermediaries’ expense, and vice versa. Exchanges and intermediaries provide complementary services, and each is striving to get the biggest piece of what customers are willing to pay to execute and clear a trade.

This is not to say that these conflicts never existed. Donahue notes that non-profit exchanges were “inefficient member-run utilities.” In large part, that inefficiency was a feature, not a bug. Inefficient, committee-dominated, deliberative decision processes were in large part a way of managing tensions and conflicts and rent seeking between different types of exchange members, such as FCMs, floor brokers, and locals, all of whom were “value chain players,” and each of whom had an incentive to seek rents from other parts of the value chain. Thus, the tensions between exchanges and intermediaries are just now more out in the open. They used to be all in the exchange member family, as it were, but we all know that intra-family disputes can sometimes be very intense indeed. (I saw some of these battles up close when I worked with the Chicago Board of Trade to redesign its grain futures contracts, first in the early 1990s, then in 1997. I saw short hedgers pitted against long hedgers, Locals pitted against brokers, etc. Committee gridlock was intended in part to ensure that nobody could do anything to drastically change the status quo, and hence reallocate profits from one group of members to another.)

Donahue also notes that in the demutualized world, exchanges are venturing into the intermediaries’ space (e.g., the CME FXMarket Space and Swapstream) and intermediaries are striving to execute trades, either through internalization or the creation of execution platforms. He pays particular attention to the issue of “dark pools,” a subject that Clara Furse has been quite outspoken on as well.

Dark pools are off-exchange execution vehicles. Importantly, they typically do NOT contribute to price discovery, instead allowing large traders to execute orders at prices derived from those established on the exchanges where price discovery does occur.

Donahue (and Furse as well) raise concerns about the impact of this fragmentation on price discovery and the liquidity of exchange markets. The basic idea–which has been understood for quite awhile–is that dark pools (once called “third markets”) siphon off uninformed traders who provide liquidity from exchanges. This exacerbates the adverse selection problem on the central exchange market, leading to wider spreads and lower depth. The dark pools free ride off of exchange price discovery, and actually impair the quality of that price discovery by reducing the amount of trading activity that occurs on exchanges where the price discovery actually takes place.

It is quite correct that fragmentation impairs liquidity on central exchanges where price discovery occurs. It may be going to far, however, to conclude that this is inefficient, at least relative to the alternative of discouraging the formation of dark pools/third markets. Third markets may be second best, as I argued in a paper with a similar title, and in an article published in JLEO in 2002.

The argument is that central exchanges are likely to possess market power due to the network effects of liquidity. The existence of exchange market power means that we are not in a first best world, and hence the theory of the second best implies that an externality (such as free riding off of exchange prices) does not necessarily reduce welfare relative to what it would be if the externality was eliminated. (If absent the externality the exchange would supply the optimal level of output, the externality would reduce surplus.)

In the formal model in these papers the dark pools/third markets actually increase total surplus because they result in increased trading activity–trading activity that would be too small in the absence of the third market due to the output-restricting policies of exchanges with market power. The defection of some traders to third markets indeed reduces liquidity on the central locus of price discovery, making the traders on the central exchange worse off, but in the model the defecting traders reduce their trading costs (price impact costs) by an amount that is larger than the increase in trading costs on the exchange.

Thus, theoretical models do not support a blanket conclusion that fragmentation and free riding on exchange price discovery is a bad thing. I acknowledge that these results are dependent on the assumptions underlying the model, and that different results might obtain with different assumptions. The models do serve to caution us, however, that fragmentation is not necessarily a bad thing if competition between exchanges is imperfect, as is almost certainly the case due to the centripetal force of liquidity that tends to make price discovery a natural monopoly.

In my view, the dizzying pace of change in market structure in derivatives and securities trading is a very complex phenomenon. Moreover, it is very difficult to draw hard and fast conclusions about the desirability of various alternative arrangements because network effects and the information-intensive nature of trading mean that the “perfect competition” benchmark of textbook economics is not achievable in financial markets. All alternatives involve trade offs, and arguments over which arrangement is second best, third best, fourth best . . . . The devil is truly in the details, and it is very important to understand the microfoundations of trading. Different formulations of those microfoundations can lead to very different conclusions. The formulation of the microfoundations in my models leads to one conclusion–other formulations might lead to opposite implications.

In such an environment, it is important to have vigorous–and thoughtful–debate so that the relevant issues and trade-offs can be identified and evaluated. Craig Donahue’s speech is a fine example of such a thoughtful contribution, and I encourage anyone interested in the evolution of financial markets to read it when it is published (as I understand it will be soon.) In the meantime, it has reinvigorated my interest in these issues, and I will devote some effort to pushing the theoretical envelope to help gain a better understanding of how fragmentation affects welfare under alternative assumptions about microfoundations. My earlier work was inspired by mutualized exchanges that exercised market power by limiting membership rather than by charging supercompetitive prices for their services. Things may be different in a demutualized world where exchanges have an incentive to encourage entry of liquidity suppliers, and exercise market power by charging higher prices rather than by limiting access. The key thing will be to come up with models of such exchanges that predict that dark pools will form in equilibrium (as is clearly the case), and then to see how trading costs and trader surplus depends on policies affecting the operations of third markets. So many interesting problems, so little time!

In Whither NYMEX and Merc+Merc I surmised that NYMEX would not survive long as an independent entity. Earlier this week, that conjecture came much closer to reality. The exchange’s Chairman, Jim Newsome, made remarks that put NYMEX in play. Then Bloomberg’s Matthew Leising broke a story saying that NYMEX was in preliminary talks about a sale with three exchanges–Deutsche Borse, the NYSE, and CME.

NYMEX has strengths–its energy futures franchise–and weaknesses–notably the fact that it does not own its electronic trading platform. Each of the named suitors can fix the latter problem.

Who is going to prevail? I would put DB a distant third. Its activist shareholders (e.g., Atticus Capital) have been sharply critical of the exchange’s run at the LSE, and its offer to purchase the ISE. If they are furious with the $2.8 billion offer for ISE, I imagine they would be apoplectic over shelling out $14 billion or so for NYMEX.

CME is the most natural fit. NYMEX contracts already trade on GLOBEX (with 80 percent of crude contracts traded electronically on that platform.) This would dramatically reduce the integration problems. Moreover, a combination with CME would generate additional scope economies in clearing.

The NYSE’s John Thain has made it abundantly clear that he wants to buy his way into the derivatives market. Given the increasingly competitive environment in equities post RegNMS, and the continued spiraling growth in derivatives, this is very wise. NYMEX would be a good–but very pricey–way to do that. NYSE has the dough to deal. There could be some decent clearing economies via LCH.Clearnet. The integration might be somewhat dicier than with CME, but probably not an insuperable obstacle. But I think the main thing is that NYSE is going to do what is necessary to buy a big derivatives exchange–including overpaying for one. I get the sense that CME is not going to overpay just to do a deal, so the NYSE’s intense desire to get into futures could be decisive.

So, this could turn into an interesting battle between two heavyweights–NYSE and CME. How will it turn out? Here are my thoughts.

First, things will get very interesting after July 9, when the CBT and CME shareholders vote on the merger. This will resolve a lot of the uncertainty that makes prognostication difficult. If, as I expect, the shareholders approve, CME could well turn its sights on NYMEX. This could set off the battle with NYSE. Or, more likely in my view, NYSE will turn its gaze to ICE. Thus, the most likely scenario in my view is that there will be a CME/CBT/NYMEX combo and a NYSE/ICE pairing.

Second, things could get crazy if CBT shareholders reject the CME offer. If ICE gets CBT (no certainty), CME could turn immediately to NYMEX, or CME could try to swallow ICE. Or NYSE could go after ICE. I still think that the advantages of a CME-CBT combination are so compelling that one way or the other that the CME will get CBT, perhaps with ICE in the bargain. If that happens, NYSE would likely end up with NYMEX.

Third, after July 9th, it is likely that CBOE’s status will become clearer. Once the issue of CBT member trading rights on CBOE is resolved, CBOE will be in play. I think that it will end up with NYSE.

Fourth, once NYSE buys a US futures exchange–whether it’s NYMEX or ICE–it will be interesting to see how that changes the regulatory dynamic in the US. Securities exchanges and derivatives exchanges have always been at loggerheads over regulatory issues. Futures exchanges have wanted to stay away from anything that would put them under SEC oversight. Indeed, this is one reason why CME has disavowed any interest in CBOE. Once the NYSE gets a futures exchange, it will be interesting to see whether their attitude towards the SEC, and their support of a single regulator of stock and futures markets, will change. I imagine that it very well may. This is a very complicated issue, and there is no way that I would venture bold predictions. Suffice it to say that the consolidation of exchanges, and specifically the convergence/consolidation of derivatives and securities exchanges, will have major effects on US regulation.

In sum, we are nearing the culmination of the restructuring of US exchange markets. The weeks and months following July 9 will see a profound, and in my view rapid, reorganization of these markets. Moreover, the Road to the Final Two (exchanges) will run through Chicago because a major likely acquirer–CME–and a major likely target–CBOE–are there. (Yeah, I know it will run through New York too because major acquirers and targets are there too, but I gotta give props to my home town.) My bet is that when the dust clears, we’ll see CME+CBT+NYMEX and NYSE+ICE+CBOE.

[One aside. What about the two remaining US futures exchanges, MGE and KCBOT? They’ve done pretty well lately, but on purely economic grounds, in an electronic era it doesn’t really make sense that they remain independent entities. But their survival was always something of an anomaly anyways. CBT could have probably put both out of business by offering competing wheat contracts any time it chose. But it didn’t. Why not? Politics is a likely explanation. The value of the MGE and KCBOT to the CBT as political allies with influence on the Minnesota and Missouri congressional delegations far outweighed any value that the Chicago exchange would have gained by taking away volume from their relatively small wheat contracts. That might change once NYSE gets into futures. That would transform the NYSE from a political adversary of the Chicago exchanges to a frequent political ally. With the NYSE’s clout added to Chicago’s clout, the political value of the Minneapolis and KC exchanges will decline precipitously. If my political economy explanation for their survival to this point is correct, I would expect their days as independent exchanges to end soon after NYSE gets into futures in a big way, and sees its future growth coming more from derivatives than equities.]

One of my first posts on SWP (in January 06) discussed exchange capacity limits. A recent WaPo article states that this issue is increasingly a concern of market participants who worry that during times of market stress exchange message processing capacity will be overwhelmed, leading to (or exacerbating) market disruptions.

My post discussed the point that the nub of the issue was that messages (i.e., bids, asks, cancels) were unpriced resources, and that as a result customers send too many of them. This has apparently dawned on some important folks. The article quotes the NYSE’s John Thain as saying: “We don’t get paid for messages, we get paid for trades,” Thain said. “So nobody has infinite message traffic capacity.”

Well, yeah, dude, but that sort of begs the question–is it optimal (or even sane) to have unpriced messages? Similarly, it begs the question–how do you know the right amount of message traffic capacity to invest in if there is no market for it? It is ironic (or something) that businesses that are in the business of facilitating price discovery haven’t thought more seriously about discovering some prices for their most important resource.

As noted in the original post, it is not a trivial matter to devise a capacity pricing system. As Coase noted long ago, there are costs to using prices to allocate resources. But there can be costs of not using them too. And there has to be some means of allocating a scarce resource (capacity) even if one doesn’t use prices. The article suggests that the costs of inefficient utilization of, and investment in, capacity may be very large. It mentions October 87, when capacity limits nearly caused a catastrophe in US markets. The TSE’s recent embarrassment is another illustration. I therefore think it is past time for exchanges to think seriously about capacity allocation mechanisms, including pricing mechanisms.