Streetwise Professor

Historically, oil prices and stock prices were negatively correlated, or exhibited a close to zero correlation.  During the financial crisis, the equity-oil correlation spiked.  In recent weeks, it has plunged, and become sharply negative.

Some people try too hard to explain this pattern.  To me it has little to do with QEII, and the explanation is relatively simple.  It depends on what are the important shocks at any particular time.  When macro demand shocks predominate, correlations will be positive; when oil supply shocks are important, correlations will be negative.

During the financial crisis, there was slack oil production capacity, and price movements were demand driven.  Prices plummeted when demand crashed in the post-Lehman days.  Prices rebounded when economies around the world started to recover.  The economic crash and recovery drove stock prices lower then higher.  So during the crisis and recovery period, the state of the macroeconomy drove oil demand, and drove stock prices and oil prices in the same direction.

In contrast, the Mideast turmoil has generated oil supply shocks.  Declines in oil output, and increased likelihood of greater future output declines cause oil prices to go up.  These output declines also tend to reduce economic growth, and if severe enough, can tip economies into recession.  Thus, these adverse output shocks tend to cause stock price declines  because stock prices reflect the health of the broader economy.

In brief, the historically high positive correlation between oil and stock prices during the late-2008-early-2010 period reflected the fact that the primary shocks driving both markets during that period were macro shocks that influenced the demand for oil.  The negative correlation we observe now is due to the fact that the predominant shocks are oil supply shocks that will adversely affect the real economy.

The title of the FTAlphaville piece I linked to asks whether the correlation breakdown is “permanent.”  I permanently wonder why people have a tendency to believe that the most recent change will last forever.  No, the correlation shift is not permanent.  When supply shocks abate, and when (macro) demand shocks intensify, the correlation will tack again.

Ben Bernanke really worries me when he says things like this:

When Rep. Jeb Hensarling (R-Texas) asked yesterday about the spike in prices for gold, oil, wheat, and other commodities , Fed chief Ben Bernanke—whose expansion of the money supply over the past three years amounts to a highly confident gamble on the Fed’s ability to control the devaluation of the dollar—dismissed the idea that this inflation was related to Fed policy, noting that “commodity prices have risen just about as much in other currencies as they have in terms of the dollars. So while I take those commodity price increases very seriously I don’t think they’re primarily a dollar phenomenon.”

This is disturbing for at least two reasons  First, it stretches the limits of the meaning of the phrase “just about as much.”  Since September, 2010, as measured by US dollar index futures, the US dollar has fallen by about 7.5 percent.  There was a rally into the first part of 2011, but then the decline resumed: it has fallen nearly 5 percent from the end of 2010.  This means that commodity prices in non-dollar currencies have risen by about 7.5 percent less than dollar prices in the period that commodity prices have risen substantially.  That doesn’t seem “just about as much” to me.  If 7.5 percent is close enough for government work as far as Bernanke goes, that’s grounds for serious concern.

Second, it is disingenuous in a way similar to other, earlier Bernanke statements.  It is not honest to say that one cannot attribute rises in commodity prices denominated in other currencies to an expansion in the stock of dollars.  Foreign central banks don’t want to see a dramatic strengthening of their currencies relative to the dollar.  They therefore respond to US monetary expansion by expanding their own money supplies.  In a fixed exchange rate world, inflation rates will be equal in all currencies, and a US monetary expansion would lead to world inflation as to maintain the fixed rate foreigners have to expand their money supplies to match the US expansion.  Exchange rates aren’t fixed today, but they are not passively floating either.  To the extent that foreign central banks attempt to fight appreciation of their currencies, they import some American inflation.  Thus, the fact that commodity prices are rising in other currencies does not mean that commodity inflation is not a dollar phenomenon, and it is disingenuous of Bernanke to claim otherwise.  The initiating shock is the US monetary expansion: the channel of transmission is the monetary policies of other countries attempting to avoid a sharp appreciation of their currencies.

To the extent that Bernanke and the rest of the Fed governors truly believe that sharply rising commodity prices are not a harbinger of inflation, and hence ignore danger signals from the commodities markets, there is a real danger that inflation in other prices can spurt quickly, before the Fed can act.

The monetary base has expanded dramatically.  It is common to downplay the importance of this phenomenon by pointing to the fact that most of the reserves that constitute the vast bulk of the expanded base are held as deposits at the Fed, and that as a result, velocity has plunged.  That raises two questions: (a) if the expanded money base is just sitting around, how is it doing anything to generate a rise in real output?, and (b) what happens if velocity ticks up, even modestly?  Question (a) casts doubt upon the benefits of a dramatic expansion in the monetary base.  Question (b) raises serious concerns about its dangers.

Here’s an analogy.  There’s a huge amount of dry kindling lying around.  It’s not doing anything damaging at present, but it’s not doing any good either.  It represents a fire hazard, but it’s not burning now, so the fire marshal calmly states that nobody should worry, and he can readily douse any flames, so there’s no reason to clear the kindling.

Somehow, that’s not very comforting.  What’s the upside for having huge amounts of fuel lying around, doing nothing?  The downside is clear: it could explode into a major conflagration.  The calming words of the fire marshal don’t inspire true confidence, especially when he tells everybody to ignore smoke rising from a part of the woodpile.

The reserves are the kindling; Bernanke is the fire marshal; and the rising smoke is the rise in commodity prices.  The risk of an inflationary conflagration breaking out–a big one–seems very real to me.

The US currency says “In God We Trust.”  The problem is, when it comes to avoiding a substantial inflationary spurt, we have to trust in Ben.  But Ben ain’t God, and that’s cause for worry–especially when he gives such dubious justifications for his policies and its effects.

John Parsons of MIT takes issue with my post arguing that CFTC Chairman engages in magical thinking on clearing.  John claims that my criticism is based on a (non-existent) “conservation of risk” principle.  I respectfully disagree.  I am criticizing the arguments that Gensler has in fact advanced, whereas John is generously attributing to him arguments as to how changing rules (including clearing rules) can reduce risk that I have not seen Gensler make.

In contrast, I have written extensively that clearing affects both the allocation of risk for given economic decisions, and the amount of risk through its effects on myriad decision margins; I do so explicitly in “Do You Believe in Magic?”  From the very beginning of my writing on clearing mandates, dating back to late-2008 when the issue became a salient one, I have made that point repeatedly.  Indeed, my analysis of AIG–Exhibit A-to-Z in many pro-clearing mandate arguments–has emphasized this point.  See here, here,  and here, and my piece in the Journal of Applied Corporate Finance; I also raised it in an exchange with Jeffrey Gordon of Columbia Law School in my presentation on clearing that you can view here.  This working paper, written in the fall of 2008, details a variety of ways in which clearing (via its effects on margining, netting, monitoring, and risk sharing) affects both the amount of risk exposures and the allocation of these exposures.  I could go on and cite additional papers and presentations: suffice it to say, most of what I have written about clearing focuses on how clearing affects incentives and information, as compared to bilateral mechanisms, and how these changes affect the amount of risk in the system and the way that risk is allocated.  That’s far more than a start, I think it’s fair to say.

John states that the effects of clearing on the amount of risk in the system is “the very heart of the original argument behind clearing which Gensler is making.”  I’d like to see exactly what argument John is referring to.  I’ve read a lot of what Gensler has said and written in the last three years, and I haven’t even seen that issue even at the peripheries of his arguments.  Typically Gensler argues that shifting the risk to the clearinghouse eliminates interconnections and eliminates counterparty risk because the CCP stands behind trades, or because CCPs will require collateral that make sure that firms will have the resources to pay for their derivatives losses.  That’s it.  Nothing related to how clearing will affect incentives or information in a way that reduces the amount of risk in the system.

Consequently, I think the magic box metaphor is a very apt characterization of what he has been pushing since 2008.  Or, since it’s Sunday, it’s fair to say that he is promising a miracle that is sort of the inverse of the loaves and fishes: rather than taking meager fare and feeding multitudes, he is claiming that clearing will take risk from multitudes and make it meager.  There is certainly nothing as nuanced in what Gensler has said publicly as what John is attributing to him.

John closes by saying:

Let’s have a good discussion about which rules of the game produce the lowest total social risk and the greatest social payoff from the operation of the OTC derivatives market. It’s a tough problem to tackle. Oversimplification will not do.

Welcome to the party!  Seriously.  Compare that to what I wrote at the end of the piece in Regulation, “The Clearinghouse Cure,” published in 2008 (linked above):

The nature of this analysis is inherently qualitative. It is difficult for anyone, be they academics, market participants, or regulators, to determine definitively whether a clearinghouse would improve the  efficiency of the CDS market. I certainly do not claim to possess such definitive knowledge. It is troubling, however, that basic considerations relating to the economics of risk sharing and information have been almost completely absent in the public discourse over CDS clearinghouses. It is also troubling that the  potential pitfalls have not been fully aired. Nor has there been an extensive comparative analysis of alternative risk-sharing mechanisms. Therefore, at the very least, this article aims to raise the quality of the debate by identifying crucial issues that have been largely ignored until now, and to challenge a consensus that threatens to engineer a fundamental transformation of the financial markets without proper regard for fundamental economic issues. Moreover, the considerations identified herein should be kept in mind when designing a CDS clearinghouse to ensure that information problems do not make this prescription worse than the disease it is intended to cure.

I’ve been calling for a good serious discussion around these issues for arguably longer than anyone, and have written extensively about many of the “hard problems.”  There is indeed an oversimplification problem in this debate–and that’s precisely why I’ve been so hard on Gensler (and Geithner): because they’ve been the ones oversimplifying repeatedly and consistently, and as a result, we run the very serious danger of adopting arrangements that do not generate the greatest social payoff.  If I seem combative making that point (Combative? Moi? Nobody’s ever accused me of that before!) it’s primarily a response to the repeated oversimplification by the advocates of clearing mandates.

I know I can have a constructive discussion with John Parsons, even though it is highly likely that we would disagree on crucial issues.  But it would be a real discussion about real issues, and based on my extensive reading on the entire regulatory and legislative discussion leading up to Dodd-Frank and clearing mandates, that’s precisely what’s been missing in the 202 area code.

Gary has a magic box, called a “clearinghouse.”  You put counterparty risk in the box, and it disappears!:

One of the central goals of Dodd-Frank is to redirect much of the OTC derivatives market through exchanges, electronic trading platforms and central clearinghouses that stand behind dealings in derivative contracts.

“What that means to the American public is it’s less likely that the taxpayers stand behind that transaction,” [Gary Gensler] said.

“Instead the clearinghouse stands behind it, and I think that’s what Congress recognized. Moving as much of this into clearinghouses lowers interconnectedness, but also says a clearinghouse stands there, not the taxpayer.”

Uhm, but what stands behind the clearinghouse?  Where does that risk go?  Well, financial institutions—including many major banks—actually stand behind clearinghouses.   Meaning that if counterparty losses are big enough, the banks bear a big chunk of the loss (so things are still interconnected).  Or, if the banks limit the amount of loss they are willing to bear, the clearinghouse can fail.  Who wears the loss in that event?

Gensler might argue that collateralization in clearinghouses makes it highly unlikely the banks will bear any loss, and even less likely that the clearinghouse will fail.  Let’s say that collateralization is indeed extremely robust, so that the risk of clearinghouse failure is vanishingly small.  Does that mean that everything is great?

Well no, really. The risk still hasn’t disappeared.  Given the positions that firms take*, collateralization (and netting, another commonly touted benefit of clearing) affects the distribution of losses arising from the bankruptcy of a derivatives trading firm, not the total amount of the losses.  If collateralization is so robust that derivatives counterparties always get paid, that means that the entire loss arising from a bankruptcy falls on the firm’s other creditors.  So the magician may point to the magic derivatives clearinghouse box and say: “See!  No losses!  They disappeared!”  But they are somewhere, behind the curtain, borne by somebody else; collateralization changes the priority of claims, not their magnitude.**  Most likely, the loss is shifted to unsecured creditors—who may include banks backed by taxpayers, or owners of money market mutual funds who may run if it looks like their funds will break the buck, which can also lead to a Federal bailout (like what happened in September, 2008).

There’s also the issue of where the collateral comes from.  Some of it may come in the form of loans extended by banks that used to extend credit via derivatives trades; like in a real-world magic trick, the credit didn’t disappear, it was just shifted somewhere else.  Some collateral may come from firms foregoing higher yielding, but less liquid investments: this is a real cost as too many resources are tied up in liquid assets and too little invested in more productive projects.

There are other things going on behind the curtain.  Rather than enter into expensive collateral derivatives trades, firms may decide to hedge less, forcing their claimants (including lenders, employees, suppliers, and shareholders) to bear more risk.  Again, the risk doesn’t disappear–it leaves through a trapdoor and winds up someplace else.

And collateral can have perverse effects in a crisis.  The pressure of collateral calls can force firms to liquidate positions, exacerbating price moves.  Or firms may engage in fire sales of other assets to meet the calls, causing price shocks to spill over from the derivatives market to other markets.  How’s that for an interconnection?

Gary also has a magic transparency trick, a visibility cloak if you will.  Exactly the opposite of Harry Potter’s invisibility cloak, it makes the invisible visible:

“I also think transparency helps,” he said, looking back to the widespread uncertainty during the crisis of the value of assets on the books of giants such as American International Group.

“The law now says they have to be valued daily and valuations have to be shared between the counter-parties and if they run a clearinghouse, the clearinghouse has to share it with the public.”

Indeed, this cloak is so magical it can make visible things that don’t even exist.   For, in situations like AIG, the problem was that the values of the assets were uncertain because there were no trades: these things weren’t marked to market, they were marked to a guess—or to a self-serving price that was hard to challenge because there were no real prices to compare it to.   Many of the contracts that Gensler would like to see cleared trade little, if at all—and no trades, no prices.  It is a magical cloak indeed that can make prices and valuations visible when there are no trades to produce actual prices.

Magical thinking about clearing, counterparty risk, and transparency is extremely dangerous.  It creates very real risks.  Those who believe that things like clearing and transparency are magical solutions, and who do not grapple with the complex realities and difficult trade-offs are all too likely to impose rules and regulations that make things worse, not better.  Sad to say, I think that’s happening in spades, both here in the US and in Europe–and that’s not a card trick.  The consequences are pretty sobering to contemplate.

* The amount of margin will affect the sizes of positions and the structure of positions that firms take.  Netting will also affect positions, because (a) netting can actually economize on collateral, and (b) the amount of collateral savings can depend on how extensive cross-margining and portfolio margining are.  It is difficult to know what the net effect of clearing mandates will be on the trades that firms make, and the composition of the firms that make them.  I mention one possible effect below–some hedgers may exit the market, or hedge less.  Indeed, the potential effects are so extensive it is difficult even to list them.  Making it costlier to shift risks via derivatives transactions affects not just risk management decisions, but capital structure decisions (hedging really being just a capital structure choice), investment decisions (the amount and composition of investment), management compensation decisions, and on and on.  All I want to emphasize in the main discussion is that one major effect of collateralization is to affect claim priority, given the total aggregate size of claims against a bankrupt firm.  It secures some claims–which reduces the priority of other claims.

**Same caveat.

The Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues has issued its findings regarding the Flash Crash and potential regulatory remedies to such events.  Overall it is a solid effort that makes a serious attempt to grapple with the thorny issues arising out of the May 6 events, and changes in financial market structure more generally.

My primary criticism is that the report assigns far too much importance to the speed of modern, electronic markets dominated by high frequency traders that are the primary liquidity suppliers.  This over-emphasis is pronounced in section I, titled “Volatility.”

The report confirms what has been pretty evident from the start, namely, that liquidity was eroding before May 6, and then virtually disappeared for a short period of time on that date.  But it does not provide any reason to believe that this was something that was driven particularly by high speed electronic trading.  The economics of market making have been the same for a long time under a variety of trading technologies.  These economics are dominated by considerations related to information–and especially information asymmetry–and risk.  These considerations are present in every trading and technology environment.  There are, moreover, informational and risk conditions in which liquidity suppliers leave the market in droves.  This happened in old-fashioned face-to-face markets: witness the fact that on 19 October, 1987 most futures market locals left the floor–or were pulled off by their clearing firms.  The Flash Crash just demonstrates that these factors are relevant in electronic markets too.

By focusing on high speed computer trading, and suggesting that it is fundamentally different from liquidity supply in the old days, the report distracts attention from the more fundamental causes of crashes.  Yes, HFT is new, but HFT market makers are responding to the same economic factors in similar ways to their old school floor trader counterparts.  The main novelty of HFT is that high frequency traders trade across markets, rather than in one or two.  The report would have done better to focus how to best mitigate the age old plagues of market making in an electronic environment.

The report discusses the advisability of imposing obligations on market makers, but wisely demurs from recommending this.  It recognizes the difficulties, though it does not acknowledge the most important problem, namely, that obligations are costly and will affect adversely liquidity supply in non-crisis periods.

The report also correctly lauds the CME’s stop functionality, and recommends it be adopted in other markets as well.  It makes constructive and reasonable recommendations about how this functionality can be tweaked to make it more robust.  In brief, it recommends what could be described a “reload” feature that would kick in if the initial application of the stop functionality failed to stem a crash.

One particularly interesting part of the report relates to “Preferencing, Internalization, and Routing Protocols.”  It is particularly interesting because it highlights an issue that I analyzed in my 2005 article “The Thirty Years War.”  In that article, I noted that the SEC had deliberately chosen an “information and linkages” approach rather than a central limit order book  (CLOB) approach to securities market structure.  I further noted that the rules adopted by the SEC did not preserve time priority across trading venues, and did not protect all limit orders in all books against execution on another venue at an inferior price to those not at best of book.  These were problematic features of the SEC RegNMS, and I was critical of both (especially the fact that only limit orders at the top of the book are protected).

The report argues that the lack of time priority inherent in the “no trade through” rule has encouraged internalization of orders, and that the lack of integration across books at prices away from the inside market can exacerbate price movements.  It therefore recommends that the SEC study the costs and benefits of changing these aspects of RegNMS.  Specifically, it recommends study of the imposition of a “trade at” rule which would effectively restore time priority.

I agree with the recommendation, but think that these issues are somewhat of a red herring with respect to the Flash Crash.  This is especially true of the “trade through” rule.  The report authors argue that the current rules favor internalization; internalizers supply liquidity; but internalizers stopped providing liquidity during the Flash Crash, leading to an additional flow of orders to public markets that stressed an already liquidity constrained situation.  Imposing a “trade at” rule that would make it impossible for internalizers to match quotes standing in the public market would encourage additional liquidity supply in the public markets.

This is no doubt true, but the report doesn’t analyze the counterfactual, i.e., how things would have worked under the trade at rule.  Yes, there likely would have been less internalization.  Thus, in normal circumstances, more liquidity would be supplied via public quotes and less via internalization.  But we saw during the Flash Crash that public market makers fled and as a result quotes disappeared.  Internalizers provided less liquidity at the same time.  But isn’t it highly likely that the liquidity suppliers that entered the public markets during “normal” times to replace internalizers would have also fled the market in conditions like those that provoked the Crash? I think so.  The report doesn’t consider this counterfactual, so it cannot support a different conclusion.

That is, I think that it is accurate to say that a “trade at” rule would shift liquidity from internalizers to public quotes during normal times, but that this does not imply that liquidity would be higher overall (across all sources of liquidity supply) during stressed periods.  The quotes that appear in public markets because quote matching becomes harder would be highly likely to disappear in Flash Crash-like conditions because it is particularly costly to provide firm quotes under those conditions–that’s why the quotes disappear.  Thus, it is worthwhile to have a debate/study about the wisdom of the trade at rule, but that debate study should recognize that just because internalizers fled when the market went crazy doesn’t mean that the new public quoters attracted to the markets when internalizers are hobbled will stick around.

A look at the futures market bolsters this skepticism that internalization was a major contributor to the Crash itself.  The index futures markets are not fragmented, and are not subject to internalization.  The quote matching problem doesn’t exist there.  At all.  But it suffered serious liquidity withdrawals on 6 May.  Thus, in my view, internalization is a red herring with respect to Flash Crashes.  It is an important issue, but its relevance is primarily during “normal” times and that should be the focus of any study.

I was also intrigued by the report’s discussion of peak load pricing and the problems of system capacity constraints driven in part by high cancellation rates for HFTs.  This subject was, in fact, the subject of the first substantive post on SWP.*  There I puzzled as to why exchanges didn’t set traffic-sensitive price schedules for access to exchange matching computers.  I noted that the lack of pricing of capacity could lead to overconsumption of computer resources, lags in getting orders executed, and even shutdowns of the trading system.  Interesting to see that 5 years after I wrote that piece the issue is getting some attention.  I’m still puzzling, and look forward to seeing how the exchanges and regulators deal with this issue.  (The report mentions the difficulty of pricing cancellations in a fragmented market structure.  This is another manifestation of the US equity market-centric mindset of the report’s authors.  That isn’t an issue in futures markets, or foreign markets that are less fragmented.  The puzzle is not explained by market fragmentation.)

In sum, the report moves the ball forward some.  I think it gets sidetracked on some issues, but its focus on the need to encourage liquidity supply during stressed times is salutary.  A lot of work remains to be done to see just how that can be accomplished in an efficient way, however.

And speaking selfishly, that’s a good thing.  For the report confirms something I wrote in the conclusion of “The Thirty Years War”:

Therefore, the proposed rules [Reg NMS] are not the final battle in a ThirtyYears War. I fully expect that in 2075, some professor will write an article about the latest clash in an ongoing Hundred Years War over securities market structure regulation.

These market structure issues are thorny indeed, and will not be resolved any time soon.  I am sure they will not be resolved by early-2013, when my next book, Financial Market Macrostructure: The Organization of Securities and Derivatives Markets should appear.  Which should be good for sales 🙂

*The post was titled “VOLT”, a neoacronym (which might be a neologism) for “Value of Lost Trade.”  The idea was that in figuring out how much generating capacity is needed in an electricity market, it is conventional to assign a “value of lost load” (VOLL) to the consumption of power lost when system capacity is reached.  Similarly, when deciding how much trading capacity to build, it would be advisable to determine the value of a trade lost or delayed due to a shortage of system capacity.

. . . of SWP discussing clearing, here’s a video (approx. 90 minutes) of my talk on the subject at the Law and Economics Workshop at Columbia Law School from December of last year.  You need to supply your own NoDoz.

The big news in Exchangeworld is the likely merger of NYSE-Euronext and Deutsche Borse.

This reflects in some sense a return to financial normalcy in the aftermath of the crisis.  The years leading up to the crisis saw a plethora of exchange mergers and combinations, but the pace of consolidation slowed noticeably in 2008-2010.  Now it is picking up again.

Both NYSE-Euronext and DB operate cash equity and derivatives exchanges.  The former operates NYSE, of course, and also European equity markets in the Netherlands, Portugal, France, and elsewhere, and the LIFFE derivatives exchange in London.  The latter operates the German stock market, a US-based options market ISE (a purchase in the pre-crisis boom which turned out to be a rather bad deal for DB) and the Eurex derivatives exchange which trades equity options and a wide range of financial futures.  DB is highly vertically integrated; most importantly, it operates its own execution and clearing platforms in both equities and derivatives.  LIFFE historically outsourced its derivatives clearing to LCH.Clearnet, but is also vertically integrating into clearing (although it still contracts with LCH for some clearing services).

Cost savings are the major driver of this merger.  There are substantial scale and scope economies in execution systems.  In derivatives, moreover, there are substantial scale and scope economies in clearing.  In particular, margining and netting efficiencies reduce customer capital costs.

The competitive effects are likely to be relatively small, even though that has been a focus of a lot of the commentary.  Cash equities are already ruthlessly competitive, especially in the United States: RegNMS socialized order flow, eliminating any tipping effects, as demonstrated by the precipitous decline in NYSE market share from the mid-80s to the mid-20s in the years following RegNMS.

With respect to derivatives, the LIFFE and Eurex do not compete head to head in any major product.  Cross-product competition is relatively tame in futures.  And just as with the CME-CBT merger, putting LIFFE short term interest rate futures and UK government bond futures and Eurex European bond products on the same platform would facilitate spreading trades and enhance liquidity and reduce trading costs and execution risks for customers.

Nor do LIFFE and Eurex compete head-to-head with any CME product.  Thus, the direct competitive effect of the merger on CME is also likely to be relatively mild.  By reducing trading and clearing costs, a LIFFE-Eurex combination may attract some business from CME product groups to its product groups, but again, these inter-product class cross elasticities do not appear to be large.  Order flow has not been socialized by regulatory fiat in derivatives on either side of the Atlantic, meaning that the order flow network effect is still in place.  This means that LIFFE and Eurex could not credibly compete against CME on its home turf (each had conspicuous failures trying): it also means that a combined LIFFE-Eurex will face daunting obstacles in trying to do so.  Indeed, I doubt they will seriously try; twice burned, thrice shy would be a reasonable motto.

Consistent with this, CME Group’s stock price has been up close to 2 percent since the news of the potential tie up became public.

The biggest uncertainty surrounding the deal involves European antitrust approval.  As noted above, the merging exchanges are not direct competitors in any major product.  In the US, in the mergers of CME and CBT and CME and NYMEX, that fact was decisive in avoiding  Justice Department challenges.  It should be in Europe too, but I’m not as familiar with European antitrust thinking or precedents so I’m not sure they’ll see it the same way.

The most interesting question involves clearing.  European policymakers have been critical of vertical integration in clearing.  (The USDOJ is too, but only disclosed its (economically nonsensical) objections after the CME-NYMEX merger closed.)  They deem vertical integration as anticompetitive, and have failed to consider seriously the efficiencies that integration can generate (a subject I’ve written a lot about on SWP and my academic research).

Given this skepticism, the Euro antitrust folks may view this merger as an opportunity to open up access to clearing at Deutsche Borse and LIFFE.  That is, I could see them conditioning approval of the merger on the parties’ agreement to open up access to their clearing services.  It will be interesting to see whether they attempt to do so: I estimate that there is a non-trivial probability of this happening.  If they try, it would likely be a deal killer.  DB in particular has been adamant that integration is an essential part of its model and strategy, and LIFFE has adopted that view as well.  A deal becomes much less attractive–and, in my opinion, unattractive–if it requires a fundamental transformation of the exchanges’ business models.

The news of the potential deal has sparked considerable speculation about other tie-ups.  One commonly heard belief is that CBOE is the odd-man out, and that it should tie up with CME.  Other than the fact that both have “Chicago” in their names, these entities don’t have a lot in common, or a lot to gain by combining. In particular, there are no benefits on the clearing side. There are no economies on the regulatory/compliance side.  There are not really big advantages on the system side either.  So, other than savings on letterhead and some management salaries, there is nothing to be gained by merging.

It is likely that many more possible combinations will be mooted and discussed in the coming days.  I’ll be among those discussing them, but that will have to wait.  For teaching calls.  It’s rough work, but somebody has to do it.

The SEC is continuing to flog the idea of imposing obligations on high frequency traders:

Regarding market structure, Schapiro said more work needs to be done to shore up investor confidence and transparency amid advances in high-speed trading.

“We are examining trading or other obligations that might be required of today’s de facto market makers: the high-frequency traders,” said Schapiro during remarks at SEC Speaks, a conference hosted by the Practising Law Institute.

“We are asking if these firms should be subject to an appropriate regulatory structure, including with respect to their quoting and trading activities.”

As I’ve said numerous times before: ain’t nothing for free.  Obligations impose costs, and the costs may be large as what Schapiro describes would constrain HFTs to offer more liquidity during times of high risk/uncertainty; if the obligations are binding, it means that HFTs must incur very high costs to supply liquidity during these periods as some prefer to make no market at all, or only very wide markets then.  They only act in that way if it is extremely risky–costly–to make markets then.

These costs must be covered.  Since entry into the market is relatively free, market makers earn a competitive rate of return on their capital.  Higher costs in some states of the world depresses that rate of return, leading to an exit of capital and higher trading costs for liquidity consumers at other times.  Thus, imposing obligations will reduce liquidity on average, and redistribute liquidity over time.

It’s also important to remember that the withdrawal of capital will offset even in volatile times the liquidity-enhancing effects of the obligations.  Yes, those market makers who remain will put a bigger fraction of their capital at risk during those periods, but there will be less of it overall to risk.  The net effect is likely to be positive during these volatile times, but probably not as much as Schapiro and others believe.  It seems that they assume that the obligations are costless and will not affect the supply of market making capital.

It is also costly to enforce these obligations.  It is costly to specify them.  This is especially true with HFT.  Liquidity has many dimensions.  How do you specify obligations on all dimensions?  What happens if crucial dimensions are left out of the rules?  How can programmers game the rules?  I have seen no serious discussion of these issues from Schapiro et al.  Economists are often–rightly–ridiculed for assuming the existence of 100 story ladders to rescue them from burning high rises, but regulators and legislators are far, far worse in this regard.

Historically, the NYSE imposed obligations on specialists.  But it compensated the specialists by giving them privileges: these privileges inflated trading costs during periods when the constraints weren’t binding.  Enforcing the constraints wasn’t easy, and in periods of extreme stress–such as 19 October, 1987–it is hard to judge whether they really performed the way their advocates would like.

Other markets–the futures exchanges, most notably, and the OTC stock and derivatives markets–have never imposed obligations.  It’s by no means clear that they’ve suffered as a result.   If these constraints are beneficial, why wouldn’t exchanges implement them unilaterally?

For once, I would like to see a serious analysis of the costs and benefits of obligations.  Schapiro keeps touting them, hyping their benefits but never even acknowledging the costs.

A serious argument would require identification of some sort of externality.  There have been papers (Greenwald-Stein in the aftermath of the ’87 Crash comes to mind) that have done so.  But even in the context of those models, it’s not obvious that market making obligations are the best way to respond to uncertainty shocks.  Greenwald-Stein argue that trading halts–circuit breakers–can handle the problem.  In the old NYSE, specialists could call trading halts when order imbalances became extreme.  This has some advantages over price-based circuit breakers, but in the current decentralized market structure, it’s hard to observe aggregate order imbalances–ironically, this is a consequence of an earlier SEC initiative, RegNMS.

Schapiro talks a lot about market maker obligations.  Well, what about regulator obligations?  Like the obligation to make a serious case based on a well-thought out diagnosis of the problem, and a careful identification of the sources of costs and benefits, and quantification thereof.  Liquidity was in short supply during the Flash Crash, but regulators acting in such a responsible way are in chronic short supply, especially in the world of Frank-n-Dodd.

Inflation is picking up in Russia–and elsewhere.  This presents a policy quandary for Russia.  Sadly, some Russian policymakers are considering the worst response: price controls.

Deputy Economics Minister Andrei Klepach said on Monday that the Economics Ministry may consider resorting to the tried-and-tested price control system to contain prices, but added that there were no plans to implement this in the near future. “This is a tool which can be used, and I do not rule out that such restrictions will have to be used this year,” Klepach told Interfax in an interview. Price caps, if and when introduced, are expected to affect staple foodstuffs like buckwheat, potatoes and other fruits and vegetables, he said. According to this seldom-used regulation, the government can impose price controls on certain food items for a period not exceeding 90 days if there is an increase in retail price of 30 percent or more in one or more regions.

Fortunately, however, some policymakers and market observers recognize the folly of these controls:

However, many economists, including the Russian Economics Minister Elvira Nabiullina, have rejected direct price control as a method to stabilize rocketing food prices. Nabiullina suggested during a one-to-one meeting with Prime Minister Vladimir Putin in September that the government could use other non-distortive means, such as market intervention from reserves, to keep prices down. Alfa Bank economist Natalia Orlova supports such views, adding that price control has never been an efficient way to keep down inflationary pressure. “Price control is a stop-gap measure meant to postpone the worst till later years,” Orlova said. “As Russia enters the election season, government officials believe such measures could provide temporary relief by keeping inflation below ten percent. But would it last?” The best that can be expected, she said, is a worsening of Russia’s trade relations with other countries. “For many companies, it will be no longer attractive to buy certain items from abroad – and even in the domestic market,” Orlova said. Ideally, Russia simply needs to increase the level of local competition in order to combat high prices, Orlova said. “One of the explanations for a high level of inflation in the country in recent years is that there is still a lack of competition in a number of markets,” Orlova said. “In both the construction and consumer markets, for instance, there are only a handful of big players and these players are able to dictate prices.”

Nadorshin, who heads market research at Jones Lang LaSalle, said placing price caps is hardly the most productive measures to contain rising inflationary pressure. “We have applied this method before in 2007 and again in 2008, and the effects on prices were quite negligible,” Nadorshin said. “Price control in the past has also led to hoarding by farmers and there is no guarantee that farmers would not do so this time around.”

Another hurdle before policymakers is that rising prices on staple foods is not peculiar to Russia, he said. Many developing countries including India, China, Malaysia and Indonesia are all facing similar problems. “If the problem is global, homebrew solutions can only exacerbate the situation,” Nadorshin said.

Overall, Russian macro policies have been reasonably sane in recent years.  The reluctance to employ price controls is a sign of good sense.

Russia, of course, is not the only nation struggling with food price inflation.  Emerging markets in particular are facing acute problems.  Food price inflation is arguably the issue that caused the widespread dissatisfaction with the governments in Tunisia, Yemen, and Egypt to coalesce into mass protest and revolt.  China is very uneasy about the political implications of rising food prices.

Some of this is driven by bad harvests in Russia, Argentina, and Australia.  But especially in emerging markets QE2 is a major factor.

On Friday I gave a talk at the Argus Americas Crude Oil Conference.  The title was “A Year of Living Dangerously.”  The basic theme is that there are many sources of uncertainty that will buffet economies and policymakers in the coming year.  A major one is QE2.  Although it appears to be having only limited success–if any–at achieving its stated purpose of spurring employment growth in the US, it is having huge collateral effects around the globe.  Again, in emerging markets in particular, hot money is putting pressure on governments and central banks; they don’t want to let their currencies appreciate relative to the dollar, which means importing inflation.  The policy responses are unpredictable.  There is gaming between countries.  Policy errors are more likely in such an environment.

And perhaps most importantly, as Sherwin Rosen said to my rather startled Econ 300 class at Chicago in the early-80s, “inflation F*CKS UP relative prices.”  Of currencies.  Of goods and services (most notably, of commodity prices relative to other stickier prices.)  This leads to distortions, resource misallocations, waste.

Some of the consequences are economic.  Others–pace Egypt–can be social or political.  And who can foretell what the consequences of monetary and policy gamesmanship between China and the US?

On its own terms, I think QE2 is dubious policy.  As I wrote soon after it was launched, it is designed to fight deflation, and prevent a Fisherian deflationary spiral–but who ever saw a deflation with spurting commodity prices across the board?  But its unintended consequences are ominous.  Bernanke is the Sorcerer’s Apprentice to top all Sorcerer’s Apprentices.  Just what will get inundated?

Writing in Commodities Now, Reuters reporter John Kemp takes issue with my criticism of the CFTC proposal on position limits. I appreciate the attention, but I’m underwhelmed by his arguments.

There are a lot of details, but the gravamen of his complaint is that my view on the purpose of position limits is far too narrow:

Pirrong defines the rationale for intervention too narrowly. Large leveraged positions run by the Hunt Brothers did indeed threaten to bring down their own brokers and several other financial institutions. But systemic risk is not the only reason for regulators to intervene to prevent market manipulation.

Kemp directs his beef at the wrong guy.  His real problem is with the CFTC because these were the only–I repeat only–reasons the CFTC set out it its NOPR.  My critique of the proposal is that it was a vastly overinclusive way to achieve the objectives the CFTC set out.  Again, the objectives the CFTC set out.  I was responding to what was in the proposal, but I did mention quite pointedly that the CFTC was utterly silent on whether speculation was culpable in the mid-2000s price spikes, or those going on now.  How is it possible to respond to arguments and assertions that are not made?

Since it was the CFTC that was setting out the rationale for its proposed intervention, if that rationale is too narrow, Kemp should direct his ire where it belongs–the CFTC–not where it doesn’t–yours truly.

Kemp also critiques my views on manipulation and the proper way to deter it.  Oh no!  Please don’t throw me in the manipulation briar patch, Brer Fox!

Actually, born and bred in the briar patch, John.  We are agreed that past efforts to deter manipulation through ex post enforcement have been troubled, at best.  In this, Kemp is no doubt late to the game, because I’ve been making that argument since the mid-1990s.

That said, I’ve noted that manipulation is not inherently “unprosecutable” (a word Kemp lifts from Jerry Markham).   The problems with detecting, deterring, and punishing manipulation can be corrected by a proper understanding of the economics, and a judicious use of, yes, econometrics–something that apparently sends Kemp into apoplexy.

Moreover, I have made very concrete recommendations as to how manipulation law can be reformed to address the problems it has experienced.  (Not that you would know that from reading Kemp’s description of my views and arguments.)  The problem is that instead of taking a new, economics-based approach to the problem, Congress keeps returning to the vapory SEC 10(b)-5 “manipulative contrivance or device” standard, like a dog returning to its own vomit.  Doing the same thing over and over again and expecting different results is insane.  I’ve recommended specific and practical ways to stop the insanity.

As an aside, Kemp laments that manipulators have only been subject to civil, rather than criminal, sanctions.  There are a couple of issues here.  The first is that criminal sanction–imprisonment–is socially inefficient when defendants are not judgment proof.  The second is that Kemp’s lament actually supports the point I made in the previous paragraph.  Judge Miller in Houston found the existing anti-manipulation statutes unconstitutionally vague, and threw out criminal indictments against BP propane traders.  The suggestions as to how to correct the law would go a long way to addressing that vagueness problem that impedes criminal prosecution.

Speaking of econometrics, here Kemp is extremely misleading, and puts words into my mouth that I did not utter, and which do I endorse.  He says that I propose that the CFTC not “set limits or commence enforcement proceedings unless econometric tests showed an unequivocal effect” [emphasis added].

If there is anything unequivocal, it is that his statement is unequivocally false, for I never said any such thing.  Indeed, insofar as manipulation is concerned, he turns reality on its head.  For what I have shown in numerous articles, a book, and in testimony, is that econometric evidence and economic analysis generally is the best way of proving manipulation, rather than being an obstacle that makes prosecution of manipulators virtually impossible.  It is a sword that can be wielded against manipulators, not  a shied that defends them: although it is effective as a shield protecting the innocent.  Rigorous analysis of data is the best way to cut through trader BS, and prosecutor ignorance.

And that’s the point: we want methods that avoid false positives and false negatives.  My work shows that econometrics, when combined with rigorous economic reasoning and other economic tests that are not econometric per se, can do just that.

Before characterizing my views, John, you might want to be more familiar with what they actually are.

Even with respect to the issue of whether speculation has distorted prices in ways other than the Hunt-type scenario, I have been quite open about the basic limits of econometric analysis.  Here’s what I wrote in a piece in Regulation last summer:

One of the most important functions of markets is to discover prices; to provide a mechanism whereby information about supply and demand dispersed among millions can be aggregated.  Thus, no one has the information to know what the price “should” be; if someone did, we wouldn’t need markets.  But this always makes it very difficult to rebut assertions that a particular market price is distorted by speculation, or to prove that they were.

Moreover, in that article, I use some econometrics, but only very little.  I instead utilize some non-econometric approaches to test the implications of the speculative distortion story.  Thus, to attribute to me a slavish and myopic devotion to econometrics is just wrong.  I have a very catholic view of what kind of evidence is persuasive.

But I am a firm believer that data and evidence should be decisive.  Kemp argues that “policymakers must act on the balance of probabilities.”  Fine.  But just where, pray tell, are those probabilities to come from?  Kemp bashes econometrics, but advances no alternative.  Zero.  Zip.  Nada .

Sorry, but that just doesn’t cut it.  Econometrics is one tool that can be used to inform judgments about probabilities.  There are other tools–qualitative comparisons, and rigorous analysis of the economic logic of purported causal connections between speculation and price distortions, for instance–that can also inform those judgments.  The best approach integrates statistics, econometrics, qualitative comparisons and rigorous economic reasoning.  That’s the kind of approach I favor, and the kind of approach I’ve used–though you would never guess that in a million years if your only impression of my work is Kemp’s description thereof.

In the end, Kemp takes refuge in the position that as a matter of law, Congress has required the imposition of position limits, and that’s the end of that.  He worries that the CFTC could be sued if it failed to adopt such limits.

But even that legalistic defense is incomplete.  Congress has mandated the imposition of limits to achieve a specific purpose: the prevention and diminution of “unwarranted fluctuations” in prices.  Limits that are unnecessary to achieve that goal–because such unwarranted fluctuations are extremely unlikely to occur–or limits that are so overinclusive that they impede the achievement of other Congressionally mandated objectives, shouldn’t hide behind the fact that courts may find the exercise of such powers Constitutional.  “We do it because we can” is a recipe for regulatory mischief that undermines the very goals that Kemp claims to endorse.

My criticism of the CFTC NOPR is that it (a) identified a way in which large positions could cause unwarranted fluctuations, and (b) imposed limits that were completely unnecessary to address the very problem the CFTC identified.  Maybe Kemp has different theories regarding (a).  If so, he should spell them out, and specify his proposed remedies so that they can be evaluated and critiqued in order to ensure that they are indeed problems and the remedies are an efficient and effective way to address them.

In the end, I guess I do agree with Kemp on one thing: it comes down to an issue of the burden of proof.  I believe in markets more than regulators.  He apparently takes the opposite view.  I am more than willing to debate this anytime, anywhere.

But contrary to what Kemp insinuates, I do not believe that markets are unerring, that market power is not a problem, and that certain laws and regulations can improve the performance of markets.  I am not some sort of Dr. No, insisting upon unreasonable level of empirical support to reject the hypothesis that the Market Is Always Right.  (Indeed, a former colleague, upon reading my work on manipulation, referred to me as a “Chicago apostate.”)  I have a presumption in favor of markets, but it is a rebuttable presumption.  And with respect to manipulation in particular, I have both rebutted the widespread view that manipulation is not a problem, and recommended specific, targeted legal responses to mitigate that problem.

When it comes to speculation and position limits, however, those who have questioned markets have come no where near to rebutting the presumption in favor of markets.  I note–indeed emphasize–again that the CFTC does not even try beyond the specific areas identified in the NOPR: areas which Kemp believes are too narrow.  But Kemp hasn’t provided a credible alternative either.

Given the havoc that bad regulations routinely inflict on markets, a credible story and at least some evidence should be required to support a particular policy proposal.  A fair acknowledgement of the potential for unintended consequences is also appropriate.   I note too that Kemp does not even attempt to critique the unintended consequences of the CFTC proposal that I lay out in my comments.

When it comes to the specifics, Kemp ironically endorses my view–although he does not acknowledge this.  He says:

Reversing the burden of proof, it is worth asking opponents why anyone would want to run positions above the very high levels set out in the CFTC’s proposals. Are there legitimate reasons to want to run very large net positions, including in the spot month? Or is the only reason to exercise market power?

Uhm, that’s very close to what I recommend.  Give the CFTC the authority to question the legitimacy of very large positions, and intervene accordingly if there is no legitimate reason.  But that’s a far, far, different thing from a blanket prohibition of positions in excess of a particular size.

In sum, I stand by my specific criticisms of the CFTC position limit proposal.  Moreover, I emphasize that Kemp has presented a distorted view of my arguments, beliefs, and work.  His arms must be tired from giving a straw man such a thrashing.

But I’m still standing.