Streetwise Professor

And now for something completely different . . . finance.  (More Russia/Ukraine later.)

The Bank of England wants to put a stay on derivatives contracts entered into by an insolvent bank, thereby negating some of the priorities in bankruptcy accorded to derivatives counterparties:

he U.K. central bank wants lenders and the International Swaps and Derivatives Association Inc., an industry group, to agree to temporarily halt claims on banks that become insolvent and need intervention, Andrew Gracie, executive director of the BOE’s special resolution unit, said in an interview.

“The entry of a bank into resolution should not in itself be an event of default which allows counterparties to start accelerating contracts and triggering cross-defaults,” Gracie said. “You would get what you saw in Lehmans — huge amounts of uncertainty and an uncontrolled cascade of closeouts and cross defaults in the market.”

The priority status of derivatives trades is problematic at best: although it increases the fraction of the claims that derivatives counterparties receive from a bankrupt bank, this effect is primarily redistributive.  Other creditors receive less.  On the plus side, in the absence of priorities, counterparties could be locked into contracts entered into as hedges that are of uncertain value and which may not pay off for some time.  This complicates the task of replacing the hedge entered into with the bankrupt bank.   On balance, given the redistributive nature of priorities, and the fact that some of those who lose due to the fact that derivatives are privileged may be systemically important or may run, there is something to be said for this change.

But the redistributive nature of priorities makes me skeptical that this will really have that much effect on whether a bank gets into trouble in the first place.  In particular, since runs and liquidity crises are what really threatens the stability of banks, the change of priorities likely will mainly just affect who has the incentive to run on a troubled institution, without affecting all that much the overall probability of a run.

Under the current set of priorities, derivatives counterparties have an incentive to stick longer with a troubled bank, because in the event it becomes insolvent they have a priority claim.  But this makes other claimants on a failing bank more anxious to run, because they know that if the bank does fail derivatives counterparties will get a lion’s share of the remaining assets.  By reducing the advantages that the derivatives couunterparties have, they are more likely to run and pull value from the failing firm, whereas other claimants are less likely to run than under the current regime.  (Duffie’s book on the failure of an OTC derivatives dealer shows how derivatives counterparties can effectively run.)

In other words, in terms of affecting the vulnerability of a bank to a destabilizing run, the choice of priorities is something of a Hobson’s choice.  It affects mainly who has an incentive to run, rather than the likelihood of a run over all.

The BoE’s initiative seems to be symptomatic of something I’ve criticized quite a bit over the past several years: the tendency to view derivatives in isolation.  Triggering of cross-defaults and accelerating contracts is a problem because they can hasten the collapse of a shaky bank.  So fix that, and banks become more stable, right? But maybe not because it changes the behavior and decisions of others who can also bring down a financial institution. This is why I am skeptical that these sorts of changes will affect the stability of banks much one way or the other.  They might affect where a fire breaks out, but not the likelihood of a fire overall.

The world petroleum market is undergoing substantial organizational changes, with private oil companies become progressively less vertically integrated and increasingly focused on the upstream.  The latest indicator of this trend is that Chevron is investigating the possibility of divesting its midstream operation.  This follows hard on the heels of the sale of Shell’s midstream and downstream operations in Australia to Vitol (bonus SWP quotes in the linked Reuters article).

This represents an interesting case study in transactions cost/Coasian economics.  In particular, the development of vibrant spot and forward markets for crude oil and petroleum products, and the growth and development of specialized trading firms (like Vitol, Trafigura, and Glencore) have reduced the costs of transacting on the market via the price system relative to the costs of conducting transactions within integrated firms.  Given the existence of thick, liquid, and active spot markets, and the development of logistical expertise by trading firms, assets at a particular stage of the value chain are less subject to holdup by owners of assets at adjacent links of the chain.  For instance, the existence of highly competitive spot markets for crude means that a refinery is  not locked into a small number of upstream suppliers, and thus need not be integrated with a source of crude supply to avoid contractual hazards.  The existence of active product markets has a similar effect.

It is interesting to note that much of the recent disintegration is occurring in smaller markets, and emerging markets, where contracting hazards have historically been particularly acute.  But this is precisely where the trading firms (notably Trafigura and Vitol) have stepped in and acquired assets from oil majors.

This evolution allows the majors to free up capital that they can employ in higher returning-and massively expensive-upstream exploration, development, and production activities.

I said that this was an illustration of transactions cost/Coasian economics in action.  As in most things economic, Adam Smith should really get the credit.  He noted that the division of labor (i.e., specialization) is limited by the extent of the market: Stigler used this insight to explain vertical integration.  The past thirty years have seen the development of a very extensive and vibrant market for oil and refined products (with Marc Rich deserving much of the credit for starting the process).  This spot market facilitates specialization, with the petroleum markets being increasingly characterized by firms that specialize in upstream, midstream, or downstream activities.

Interestingly, this development creates political and regulatory battles, as specialized firms at different segments of the value chain use political and regulatory means to capture a bigger share of the value of a barrel (pace the new battle over US crude oil exports).

Markets in action are a beautiful thing to behold.  Politics not so much.

I haven’t written much at all about Elon Musk and Tesla since the middle of last year.  I have no reason to change my opinion that the prices of Tesla and Solar City stock were manipulated in April-May, but by the same token don’t believe that their subsequent increases are primarily the result of manipulation.  Those stock prices are partying like a 1999-era dot com company.  I think the party will end soon, but I don’t know when and I could be wrong.

But my main issue with Musk was not about the stock price.  It was about the fact that all of his companies were heavily dependent on government subsidies and support.  This support socialized the potential losses, and allowed Musk (and other major investors, notably Goldman) to capture the upside.  My point was if his products and business models were so great, he could succeed on his own, by attracting private capital.

One company that I mentioned in passing was SpaceX, his  space launch venture.  Inevitably, this company is dependent on government contracts, given that a very large fraction of space launches carry government payloads.  This is something different from Solar City and Tesla, where the government is providing subsidies but not receiving any product or service in return.  But still, it means that Musk depends crucially on cultivating government support.  Government contracting-especially big ticket contracting-is hardly a pristine activity.  A firm does not succeed or fail at it primarily on the basis of the superiority of its product, but instead on the basis of its ability to influence politicians and bureaucrats.  And a lack of scruple is often a feature not a bug in that regard.

SpaceX was  looking for a commercial launch site, and  seeking state subsidies in order to build it.  The company has been playing states off against one another, looking for tax benefits. My current home state, Texas, has been one of his targets.

Cynically, Musk focused on one of the poorest parts of the state-Brownsville-and dangled the prospect of a mere 600 jobs, in exchange for  $20 million dollars or so in tax benefits.  Some of which will come from the taxpayers of that very poor community.  And sadly, the state legislature has succumbed.

I’ve been to downtown Brownsville.  I testified at a trial there in 2008.  (The reason that what was the biggest bankruptcy case in US history was being heard in Brownsville is a story in itself.)  The law office for the local counsel in the case was at the edge of downtown, and during breaks I wandered around.  It was an educational experience.  I had just flown in from Milan (another story), and to be honest, I felt more foreign in downtown Brownsville than I did in Italy: and I certainly got far more puzzling and suspicious looks in Brownsville than around Lake Como.  Let’s just say it ain’t the Bay area.  And that Elon Musk wouldn’t be caught dead there.  Well, maybe if he did go there . . .

The poorest people in Brownsville will not benefit the slightest from the SpaceX venture.  But he and his lobbyist successfully importuned the state and county to take taxpayer money and give it to SpaceX by invoking their poverty.  It was utterly cynical for a billionaire to extract tens of millions from Texas taxpayers in the name of the poor Mexican Americans of Brownsville.

I know this is the way the game is played.  And that’s the problem: the game is cynical and wrong.  It is mere rent seeking.  Musk is particularly appalling because he is a rent seeker posing as a technological visionary.  His businesses all depend on extracting rents from the government, which he pockets.

But he has a cult of personality that portrays him as some towering visionary genius.

Maybe he is.  If he is, he should be able to make it all on his own, like some 19th century titan (Rockefellar, Carnegie), without collecting hundreds of millions from taxpayers.

I say let him try.  And I am dismayed that the Texas legislature didn’t.

To return to the CBO Obamacare report.  It is really amazing that the admin spin (but I repeat myself) is that this is no big deal because hey, the job losses are a supply side effect, not a demand side effect.  Amazing, and embarrassing to my profession, because some who have made this claim are economists who should-and I am sure do-know better.

The effect that the CBO points out is related to the fact that the phase-out of subsidies as income increases under Obamacare is effectively a tax on labor income. There is a very basic tenet in economics called Tax Incidence Analysis, which says that the effect of a tax out output (or in this case, input usage) doesn’t depend on whether the tax is imposed on the buyer or the seller.  Impose it on the buyer (in this instance, employers), the demand curve shifts down: In Obamacare Spinworld, that’s BAD!.  Impose it on the seller (in this instance, workers), the supply curve shifts up, crucially by the same amount as the demand curve would shift down if the tax is imposed on the buyer.  End result: both routes lead to the same destination in terms of the amount of employment and the take-home pay of workers.

The tax-and remember, the subsidy phase out is equivalent to a tax-drives a wedge between the price that buyers (employers) pay and sellers (workers) receive.  It is this wedge that distorts decisions.  It is the size of the wedge that determines the size of the distortion, and the size of the wedge is the same whether a given tax is imposed on the buyer, the seller, or split between them in any arbitrary way.

Again, this is the most basic economics.  So how come some economists are saying the CBO report is nothing to worry about because the effect it identifies is due to a shift in the supply curve, rather than the demand curve?

Put differently, the workers who are (according to Admin Spin) going to enjoy freedom from the drudgery of labor as a result of the subsidy phase-out would be the very same workers who would be out of work if an equivalent tax had been imposed on employers.  But I guess those people in the latter scenario (again: the very same people) wouldn’t be enjoying freedom from the drudgery of labor, or something, so that would be bad.  (This brings to mind the scorn  that Keynesian economists heaped on New Classical and RBC economists who suggested that unemployment is voluntary.  What’s good for the goose . . . )  I guess you’re free to enjoy leisure when you decide it isn’t worth working, but you are not free to enjoy leisure if someone decides not to hire you.

Like I say.  Truly embarrassing to the profession that any economist would do anything but call bullshit on the spin.  Instead we see economists picking up their shovels and adding more manure to the pile.

I am not alone in this opinion.  Indeed, I should defer to Casey Mulligan, because he has been the one who has been assiduously documenting the perverse supply side effects of myriad Obama policies.  His painstaking work nudged the CBO to revising its earlier conclusions about employment declines, though he still thinks they underestimate the effect.  And he is also embarrassed and disgusted by the performance of many of our peers:

Mr. Mulligan reserves particular scorn for the economists making this “eliminated from the drudgery of labor market” argument, which he views as a form of trahison des clercs. “I don’t know what their intentions are,” he says, choosing his words carefully, “but it looks like they’re trying to leverage the lack of economic education in their audience by making these sorts of points.”

A job, Mr. Mulligan explains, “is a transaction between buyers and sellers. When a transaction doesn’t happen, it doesn’t happen. We know that it doesn’t matter on which side of the market you put the disincentives, the results are the same. . . . In this case you’re putting an implicit tax on work for households, and employers aren’t willing to compensate the households enough so they’ll still work.” Jobs can be destroyed by sellers (workers) as much as buyers (businesses).

When Mulligan says “we know it doesn’t matter on which side of the market you put the disincentives, the results are the same” he is summarizing the implications of tax incidence analysis.  When he says “when a transaction doesn’t happen, it doesn’t happen” he means that the wedge between what employers pay and what workers receive causes some people not to be employed, and it doesn’t matter whether this is because an employer finds them too expensive to hire, or they find their take home too little to justify giving up leisure (or, enjoying “freedom” if you will).

Basic economics tells you that the Administration spin is wrong.  Is it to much to ask that economists not only not spin along, but actually criticize it?

One interesting part of the Cœuré speech was his warning that the clearing business was coming to be dominated by a few large banks, that are members of multiple CCPs:

Moreover, it appears that for many banks, indirect access is their preferred way to get access to clearing services so as to comply with the clearing obligation. Client clearing seems thus to be dominated by a few large global intermediaries. A factor contributing to this concentration may be higher compliance burdens, where only the very largest of firms are capable of taking on cross-border activity. This concentration creates a higher degree of dependency on this small group of firms.

There are also concerns about client access to this limited number of firms offering client clearing services. For example, there is some evidence of clearing firms “cherry picking” clients, while other end-users are commercially unattractive customers and hence unable to access centrally cleared markets.

These are all developments that I believe the international regulatory community may wish to carefully monitor and act on as and when needed.

And wouldn’t you know.  He supports a longstanding SWP theme: That Frankendodd and EMIR and Basel create a huge regulatory burden that is essentially a fixed cost.  This increase in fixed costs raises scale economies, and this inevitably leads to an increase in concentration-and arguably a reduction in competition, in the provision of clearing services.

It now seems rather quaint that there was a debate over whether CCPs should be required to lower the minimum capital threshold for membership to $50 million.  That’s not the barrier to entry/participation.  It’s the regulatory overhead.

It’s actually an old story.  I remember a Maloney and McCormick paper from the 80s-hell, maybe even the late 70s-about the effects of the regulation of particulates in textile factories (if I recall).  The cost of complying with the regulation was essentially fixed, and the law essentially favored big firms and they profited from it.  It raised the costs of their smaller rivals, led to their exit, and resulted in higher prices and the big firms profited.  Similarly, I recall that  several papers by the late Peter Pashigian (a member of my PhD committee) found that environmental regulations favored large firms.

The Cœuré speech suggests this may be happening here: note the part about client access to a “limited number of clearing firms.”

And it’s not just pipsqueaks that are exiting the clearing business.  The largest custodian bank-BNY Mellon-is closing up shop:

More banks are expected to follow BNY Mellon’s lead and pull out of client clearing, as flows have concentrated among half a dozen major players following the roll-out of mandatory clearing in the US last year.

The decision of the world’s largest custodian bank to shutter its US clearing unit was the first real indication of how much institutions are struggling with spiralling costs and complexity associated with clearing clients’ swaps trades – a business once viewed as the cash cow of the new regulatory regime.

You might recall that BNY Mellon was one of the firms that complained loudest about the high capital requirements of becoming a member of ICE Trust and LCH.  Again: it’s not the CCP capital requirements that are the issue.  It’s the other substantial cost of providing client clearing services, and regulatory/compliance costs are a big part of that.

Ah yes, another Gensler argument down in flames.  Remember how he constantly told us-lectured us, actually-that Frankendodd would dramatically increase competition in derivatives?  That it would break the dealer hammerlock on the OTC market?

Remember how I called bull?

Whose call looks better now?  Sometimes I wonder if JP Morgan, Goldman, Barclays, etc., weren’t playing the role of Brer Rabbit, and Gensler was playing Brer Fox. For he done trown dem into dat brer patch, sure ’nuff.

Though it must be said that this was not Gensler’s biggest contribution to reducing competition in derivatives markets in the name of increasing competition.  His insane extraterritoriality decisions have fragmented the OTC derivatives markets, with Europeans reluctant to trade with Americans.  The fragmentation of the markets reduces counterparty choice in both Europe and the US, thereby limiting competition.

This is not just a matter of competition.  There are systemic issues involved as well, and these also make a mockery of the Frankendodd evangelists.  They assured the world that Frankendodd and clearing mandates would reduce reliance on a few large, highly interconnected intermediaries in the derivatives markets. That is proving to be another lie, on the order of “if you like your health plan, you can keep your health plan.”  The old system relied on a baker’s dozen or so large, highly interconnected dealers.  The new system will rely on probably a handful or two large, highly interconnected clearing firms.

The most important elements in the clearing system are a small number of major banks that are clearing members at several global CCPs.  The failure or financial distress of any one of these would wreak havoc in the derivatives markets and the clearing mechanism, just as the failure of a major dealer firm would shake the bilateral OTC markets to the core.

Just think about one issue: portability.  If there are only a small number of huge clearing firms, is it really feasible to port the clients of one of them to the few remaining CMs, especially during times of market stress when these might not have the capital to take on a large number of new clients?

What happens then?

I don’t want to think about it: there’s only so much I can handle.

But Cœuré assures us the regulators are on top of it.  Or at least they are thinking about getting on top of it: “the international regulatory community may wish to carefully monitor and act on as and when needed.”  “May wish to act as needed.”  Sure. Take your time! What’s the hurry? What’s the worry?

I won’t dwell on the  irony of those who advocated the measures that got us into this situation pulling their chins and telling us this might be a matter of concern, especially since they were deaf to warnings made back when they could have avoided leading us down the path that led us to this oh-so-predictable destination.

A board member of the ECB, Benoît Cœuré, gave a speech that discussed “the new risks associated with central clearing.” It is evident that Cœuré is a proponent of central clearing, though it is annoying to see him identify multilateral netting as the main benefit (<holds head in hands>).  But it is good to see yet again that central bankers are aware that central clearing does create new risks, and that regulators must be proactive in addressing them.

The problem is that he overlooks the most important risks.  Reading between the lines, like most regulators, Cœuré focuses on the solvency risks of CCPs, and about policy tools that can limit the probability of CCP insolvency and mitigate the adverse impacts of such an insolvency.

But as I’ve written repeatedly in the past, it’s not the insolvency risk per se that should keep people up at night.  Indeed, the measures taken to address the solvency risk can actually exacerbate the real risk a dramatic expansion of central clearing creates for the financial system: liquidity risk.

Liquidity crises are what threaten to bring down financial systems.  For most financial institutions, there is a connection between liquidity risk and solvency: banks become illiquid because (in a world of imperfect information) people believe they might become insolvent.  Maturity mismatches plus imperfect information plus possibility of insolvency combine to create liquidity crises.

CCPs don’t have the maturity mismatches, and they aren’t leveraged.  They cannot experience liquidity crises in the same way banks can.  The direct liquidity risk of CCPs is related to their ability to turn collateral into cash in the event of a member default.

But as I’ve said over and over, clearing affects the needs for liquidity by market participants.  Central clearing can be a source of, or accelerant of, liquidity crises.  Big price moves lead to big margin calls lead to spikes in liquidity demand. These are most likely to occur during periods of financial stress, and can greatly exacerbate that stress.  Moreover, failure of a CCP is most likely to occur due to the inability of traders to fund margin calls due to the shortage of liquidity.   This old article by Andrew Brimmer discusses two episodes I’ve analyzed on several occasions-the Hunts in silver and Black Monday-and shows how it is liquidity/credit/funding of margin calls for CCPs that can create stresses in the financial system.

This is where the systemic risk of clearing arises.  But the subject is totally absent from Cœuré’s speech.  Which is worrisome.

There is also the fallacy of composition problem.  The measures that Cœuré advocates to make CCPs stronger do NOT necessarily make the system stronger.  Strengthening CCPs can actually exacerbate the liquidity problems that clearing causes during a crisis.  The CCP may survive, due to these measures, but the stresses communicated to the rest of the system (and the stress has to go somewhere) can cause other institutions to fail.

This is what scares the bejeezus out of me.  Regulators don’t seem to get the fallacy of composition, and aren’t focused on the liquidity implications of greatly expanded central clearing.

These fears are heightened by reading this DTCC report about collateral and collateral management.

It contains this heading that should make every central banker and financial regulator soil his armor:

Margin Call activity to increase By up to 1000%

Then there’s this:

Operational Capabilities and Settlement Exceptions Management: The potential ten-fold increase in margin call volumes, and the resulting complexity due to market changes, could overwhelm the current operational processes and system infra-structures within banks, buy-side firms and their administrators. As a result, firms will need to invest in technology and also reengineer the settlement, exceptions management and dispute resolution processes in place today. According to a 2011 De- loitte paper, investments in operations required to build and sustain advanced collateral capabilities is estimated at upwards of $50 million annually for top-tier banks.

Be afraid.  Be very, very, very afraid.

The dramatic increase in the scope of clearing substantially increases the operational complexity of the system.  More importantly, it increases the system’s operational rigidity, because cash has to flow quickly, and according to a very precise schedule.  From client to FCM to CCP to FCM to client.  Any failures in that chain can bring down the entire system.

I say again.  Systemic risk in financial systems is largely due to the fact that these systems are tightly coupled.  Clearing increases tight coupling.  This almost certainly increases systemic risk.

More players have to move more money in more jurisdictions as a result of clearing mandates.  As the DTCC report makes plain, this is a new responsibility for many of these players, and they do not have the capability or experience or systems.  Greater operational complexity involving more parties, many of whom are relatively inexperienced, creates grave risks in a tightly coupled financial system.

The irony of all this is that the evangelists of clearing, including notably Timmy! and GiGi in the US, argued that central clearing would reduce the interconnectedness of the financial markets.  Wrong. Wrong. Wrong. Wrong.

It reconfigures the interconnections.  The entire collateral management system the DTCC document describes is a dense web of interconnections.  And to reiterate: under central clearing (and the mandate to margin and mark-to-market uncleared derivatives) these connections (couplings) are tighter than in the old system.  Both old and new systems are highly interconnected.  The connections in the new system are tighter, and are more vulnerable to failure as a result.

I’ll tell you what makes me have to go change my armor: the regulators seem oblivious to this.  To the extent they are focused on collateral, they are focused on initial margin. No! It is variation margin calls during periods of large market movements that will threaten the stability of the system. Now there will be more such calls–1000 pct more, according to DTCC–and more participants are involved, meaning that there are more links and nodes.  The tightly coupled nature of the system means that the breakdown of a few links can bring down the entire thing.

In other words, there seems to be a disconnect on interconnections, most specifically on how clearing has not reduced interconnections but reshaped them, and how the new system’s interconnections are much more rigid, tightly coupled, and time-sensitive.

Not to pick on Cœuré: his speech is just one example of that disconnect.  The thing is that most speeches by regulators and central bankers exhibit the same disconnect.  Target fixation on making CCPs invulnerable does not address the main systemic risk that an expansion of clearing creates.  That systemic risk involves the financial/funding and operational risks of meeting large margin calls in a stressed environment on a precise time schedule.

It’s about liquidity, liquidity, liquidity.  Clearing transforms credit/solvency risk into liquidity risk.  The operational aspects of clearing-the need to move cash and collateral around in large amounts on a tight time schedule-affects the demand for liquidity, and also create points of failure that can cause the liquidity mechanism to seize up, threatening the entire system.

This is what should be the focus, but I’m seeing precious little evidence that it is.  Someday we’ll pay the price.

One of the annoying things about the debate over HFT, particularly related to the quality of liquidity supplied by HFT traders, is the lack of any historical context.  HFT firms are criticized for pulling liquidity suddenly, particularly when volatility ticks up, thereby exacerbating price moves and the impact of order flow on prices.

The thing is, that market makers/liquidity suppliers have been doing this since time immemorial. Liquidity suppliers have always chosen flight over fight.

I’ve written about that in the past (focusing, for instance, on Black Monday).  This recent blog post provides some excellent historical color that illustrates the point quite well.

Having traded the markets since 1985, I would like to explain what market liquidity actually meant in the pre-electronic days and what it means in the world of electronic trading.

During the 1987 October crash, Black Monday, I was a junior trader in government bonds and futures. Black Monday was not a crash which was over in seconds or minutes; no, the world stopped turning actually for days. The mini crash of 1989 had a similar pattern. Chernobyl 1986, Gorbachev crisis in 1991 and UK election day in 1992, were all similar liquidity gap events seen by market traders.

The beauty of those days (the late 80s) for a trader, was that markets were very often in a ‘fast market’ condition. This meant that one was able to trade at any price and all rules were thrown overboard until the board officials were able to control the pit again. Without computers, we simply could not deal with the enormous amount of activity in the markets at those times and simply stopped (or delayed) sending price information out, not just for seconds, but minutes and even (during the week of Black Monday) days. Clearers had backlogs to clients for days.

What investors, customers, institutions looked at in those days were screen prices on systems like Reuters or Bloomberg: feeds fed by the voice of the official. If the official did not yell a price in the mic, the data group would not enter a price, and the world would never see this price. Under fast markets no prices were entered and the screen would just read ‘fast’ (if you were lucky). Future and option prices on screen were seen as tradeable prices and in slow markets they may have been pretty close to the truth. In fast markets they were inaccurate and it was not possible to trade the price indicated on the Reuters screen. Yet the world still thought this was the correct price.

Being in the pit, one cannot keep buying or selling an instrument, so traders would hedge their positions. Hundreds of times I have been in situations where there was simply no bid or offer in the instrument to hedge in. The signal from a broker out of the futures pit simply stated, ‘no bid, no bid’, yet all the screens where showing a bid or an offer. Was this liquidity? The world clearly thought it was, but we all knew there was panic on the floor and you were lucky to trade one lot.

Yes, I know Mr. Spanbroek is talking his book.  (The EPTA represents HFT firms.)  But what he writes about the good old days on the floor are accurate.  They were good days mainly for the guys on the floor, who would supply liquidity when it was profitable, but would head for the exits when the order flow was toxic.  Ditto traders upstairs in the OTC markets.  This is a characteristic of liquidity supply and liquidity suppliers pretty much everywhere and always.

This subject always brings to mind a legendary-and I mean legendary-trader, who told me in the early-00s he was all in favor of the markets going electronic because he was “sick of getting raped by the floor.”  About 2 years ago he told me that he couldn’t compete with HFT.  I guess there was a Goldilocks “just right” era in between, say 2002-2007 or so, but the criticisms of liquidity suppliers is a hardy perennial.  And there is some justice to the charges.  The point is that it is not new, and it is not unique to HFT.  It is inherent in the economics of liquidity supply.

And there is no easy policy solution.  A policy intended to fix one problem will just create others.  Again, the problems inhere in the economics of liquidity supply.

Emails from two readers raise some interesting points about the alleged front-running of Fannie and Freddie by swap dealers.

And that’s one of the points.  Swap dealers. These were principal-to-principal transactions: the dealers were the principals to the trades.  Front running  traditionally involves violation of an agency relationship.  A broker that has a fiduciary relationship with a customer who trades ahead of that customer’s order is front running.  The dealers have no fiduciary duty to their counterparties, as far as I know.

Also, F&F were repeat players, and could refuse to trade with dealers they thought were taking advantage of information about their order flows.  Back in the block trading days, firms that “bagged the street” by selling blocks when they were in possession of private information had a difficult time of finding counterparties.  As a face-to-face market, something similar should have worked in the swap market.

This correspondent also suggests that F&F might have benefitted from this, and may have let dealers know what was coming so the dealers could hedge, meaning if anybody was hurt here, it was the futures traders who were picked off by the dealers placing their hedges. (But then again, given that this would have happened over a long period of time, the futures quotes should have compensated the traders for the risk of being picked off in this way.)

So, there is some doubt that this is even front running, let alone manipulation.

The other correspondent wonders whether the new Dodd-Frank language banning “any act, practice, or course of business that is fraudulent, deceptive or manipulative.”  That could be.  The same language is in SEC Rule 10b-5, and this has been used to prosecute front running.  So it wouldn’t be surprising to see this used to in the Fannie and Freddie case.

I have studied manipulation for going on 25 years now, and one of my pet peeves is the promiscuous and imprecise use of the term.  I often quote a cotton broker, William Clayton, who in Congressional testimony said “The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

Case in point: a story from a couple days ago about the FBI investigating the trading of interest rate swaps:

Wall Street traders may be manipulating a key derivatives market and front running Fannie Mae and Freddie Mac, hurting the US-owned mortgage giants in the process, according to an FBI intelligence bulletin reviewed by Reuters.

. . . .

Disclosure of the suspected manipulation and front running came in an FBI intelligence bulletin that was distributed last week by the bureau’s field office in Charlotte, North Carolina, to security officers at financial services firms.

Front running  is not manipulation.  Manipulation distorts prices, and causes them to move away from where they should be (at least temporarily, although the effects can be highly persistent).  If anything, front running causes prices to move where they were going to go anyways, but faster.   Front-running is a source of information leakage.

Front running raises the trading costs of the entity that is front run–allegedly Fannie and Freddie in this case.  It results in a redistribution of wealth away from those who are front run to the front runner.  But these effects are notably different from real manipulations, like corners and squeezes, or banging the close/settle, or the release of false information.

In the stock and futures markets, front running by a broker or specialist is a violation of the agency relationship with the client.  In securities markets in the US it is a violation of Section 10(b) of the 1934 Securities Exchange Act.  I don’t know, and don’t have time to research at the moment, whether front running of interest rate swaps falls afoul of any law or regulation.

But it ain’t manipulation, as the term should be construed as conduct that distorts prices.  Although everything that is manipulative is bad, not everything that is bad is manipulative.  But as William Clayton noted 80 odd years ago, that distinction is almost universally overlooked.  Especially now, in media coverage of financial markets.

Scott Irwin has provided his responses to David Kocieniewski.  Read the whole thing.

It’s My Turn

The responses to the recent NYT article by David Kocieniewksi certainly make interesting reading.   I don’t want to belabor points already made so well by others in response to the numerous problems with the article (especially Craig).  Instead, I want to offer some additional points that I think merit further consideration or elaboration:

1. To start, it is important to clarify that the heart of the controversy is the trading activities of a new type of participant in commodity futures markets—financial index investors—during the 2007-2008 commodity price spikes.  The concern was that unprecedented buying pressure from index investors created massive bubbles in commodity futures prices, and these bubbles were transmitted to spot prices through arbitrage linkages between futures and spot prices.  The end result was that commodity prices far exceeded fundamental values during the spikes.  Dwight Sanders and I labeled this the “Masters Hypothesis” in honor (dishonor?) of the central role that hedge fund manager Michael W. Masters played in pushing this line of thinking.   It is crucial to understand the key features of the Masters Hypothesis.  First, it implies that index buying in commodity futures markets created massive price bubbles—20, 30, 50% overvaluations (take your pick).  Second, it implies the price bubbles were long-lived, measured in months if not years.  These features have driven the acrimonious debate about “speculation” in commodity markets that first erupted in 2008.  Without the charge of massive and long-lasting bubbles the intense public policy debate about speculation limits would not have taken place.
2. My position on the validity of the Masters Hypothesis has been consistent from the earliest days of the controversy.   In fact, in an ironic twist, one of my earliest publications on the controversy was an op-ed that Dwight Sanders and I jointly authored—drum roll please—yes, in the NYT in July 2008.   A few quotes:  “Over all, there is limited evidence that anything other than economic fundamentals is driving the recent run-up in commodity prices…The complex interplay of these factors and how they affect commodity prices is often difficult to grasp immediately, and speculators are a convenient scapegoat for the public’s frustration with rising prices. That’s unfortunate because curbing speculation — and hobbling the ability of businesses that rely on futures markets to reduce their risk — is counterproductive.{
3. If my work was somehow tainted by associations with “Wall Street,” then why the editorial endorsement by the Paper of Record in 2008?   It also seems convenient that this little fact was omitted in Mr. Kocieniewksi’s recent article.   I made sure he was aware of my previous NYT op-ed article when he interviewed me. I suspect he was already aware of it given his exhaustive background research on the two of us.
4. The academic research pertaining to the Masters Hypothesis since 2008 has been overwhelmingly negative.  I submit that there is very little credible academic research that is consistent with the basic tenets of the Masters Hypothesis.  That is, index buying is not associated with massive and long-lasting price bubbles in commodity futures markets.  There are no “accidental Hunt Brothers.”   Some unnamed persons (one has the initials GG) like to characterize academic research on the subject as being roughly equally divided between studies that find a positive impact of index positions on prices and studies that fail to find an impact.  This characterization is misleading.  Yes, some studies find evidence of a positive impact but the impacts are invariably small and fleeting or do not line up with the spikes of 2007-2008.  This type of evidence does not support the Masters Hypothesis.  So, when properly interpreted the evidence to date is not divided equally, but instead overwhelmingly rejects the Masters Hypothesis.  And this is what is important from a public policy perspective—small impacts do not provide much justification for costly new regulation of commodity futures markets.
5. My approach to research on the market impact of index investment has always been to go where the data lead.  My co-authors and I have sliced and diced the available data many different ways and we cannot find a smoking gun (a full list can be found here).  As I like to put it, if the Masters Hypothesis is true then the relationship between index positions and commodity futures prices should literally jump off the page.  It does not.  Importantly, there is also limited evidence of bubbles in commodity futures markets independent of whether or not they are associated with index investment.   My co-authors and I could not find evidence that bubbles have become larger or longer-lasting since index investment came on the scene.  If anything they have become smaller and less frequent.
6. If my research on speculation is slanted/biased/tainted then it sure has fooled a whole bunch of academics who serve as journal editors and reviewers.  I have published 13 papers since 2009 dealing directly with the speculation controversy in 9 different academic journals.  And several more are currently under review.  Yes, under review.  This means the articles don’t get published unless they first pass muster with reviewers and then a journal editor.  I don’t know exactly how many editors and reviewers I have dealt with on these papers (several were invited submissions but still subject to peer-review), but it is safe to say that it must be at least 20-30 people.  So, we are to believe that my biased research ran this gauntlet of editors and reviewers and the bias managed to go undetected the entire time?  Give me a break.
7. Just for the record, I want to state in public that I did not even know about the Chicago Mercantile Exchange (CME) donations to the business school here at the University of Illinois when the donations were made.  I only became aware of them in the last year or so through conversations with our development staff.   (OK, I should actually be a little embarrassed by that last statement given my work on commodity futures markets.)   In any event, to draw an inference between the gifts to the business school from the CME and my research really is ridiculous.  I made this clear in my interviews with Mr. Kocieniewksi.
8. I do have a long working relationship with the CME, and before that, with the Chicago Board of Trade (CBOT).  This after all is my research area.   The CME has not funded any of my research since 2007.  However, I did work on a commissioned white paper for the CME in 2005 when the grain contract convergence problems first erupted.  My co-authors (Phil Garcia and Darrel Good) and I were paid a total of $15,000 for the work, which we split equally.   I did accept a position on a new Agricultural Advisory Council that the CME started in late 2013.  The council will meet three times a year at various locations around the country and serve as a sounding board for various issues that come up with regard to agricultural futures markets.  I will receive the same $10,000 annual stipend for this position as the other members of the council.   That is the sum total of my financial ties to the CME.
9. I have had numerous interactions with CME staff in recent years on a host of issues related to commodity futures markets, including, of course speculation.  Sometimes I have reached out to them and sometimes they reach out to me.  Most of the time it is the former and involves pretty obscure questions about things like how the grain delivery process works or help in getting some data.  My research would be far less interesting and useful without this help.  I have the utmost respect for the professionalism of the CME staff and I have never been asked for any type of quid pro quo.  Never.  When I have agreed to participate in presentations, write blogs, etc. I have done so because I believed my research and analysis contributed to better understanding of the issues.
10. My other research on commodity market speculation has been funded from three main sources.  First, the Laurence J. Norton Chair that I hold here at the University of Illinois provides earnings each year that go to support my research program (thank you U of I!).  Second, I have had two grants from the Economic Research Service of the USDA on commodity speculation related topics since 2008.  The first one included work directly on speculation while the second focused on convergence in grain futures contracts. Both have been completed.  Third, Dwight Sanders and I did a commissioned study for the OECD in 2010.  I lost track of the emails with the exact amount we were paid but I know it was only a few thousand dollars.
11. Yieldcast is a product of T-Storm Weather that I helped develop with a former graduate student, Mike Tannura, and Darrel Good.  Yieldcast provides “real-time” U.S. corn and soybean yield forecasts for subscribers.  My main role is to build the statistical models that form the basis of the forecasts and to prepare the weekly forecasts during the growing season.  As indicated in the NYT article I do not have direct contact with Yieldcast subscribers.  I am fortunate that side of the business is ably handled by Mike Tannura through T-Storm.  It is really laughable to think that I have somehow been rewarded through this channel by Wall Street as a payoff for my speculation research.  I know how hard Mike has worked to build the base of subscribers for this product, and if it only were that easy!  I have never seen one email, one voice mail, or absolutely anything that connects my research on speculation to taking out a subscription for Yieldcast.
12. As the NYT article indicated, Dwight Sanders and I did conduct a study in 2012 for Gresham Investment LLC on the market impact of index investment.   Given the political sensitivities surrounding the speculation issue, I gave considerable thought as to whether I ought to pursue the consulting project.  I knew some would see taking any funding from a commodity firm as being a conflict of interest.  But, the project provided access to detailed firm level position data that has previously been unavailable to researchers and this made it worthwhile in my mind.  Sure, I didn’t mind getting paid as well.  The NYT article got it wrong when it said I was paid the full $50,000.  Dwight and I split that equally so I was actually only paid $25,000.  We are working on several interesting papers based on this new dataset.
13. If the charges (really, innuendoes) in the NYT article are baseless, then readers might reasonably ask what does motivate my “defense of Wall Street”?  Good question.   I am indeed a “freshwater” economist that became convinced early in my career that commodity futures markets were an invaluable market institution that improved the discovery of prices and the ability of market participants to shift risks.  While these markets are by no means perfect (as Craig’s work on manipulation highlights), on balance, the good vastly outweighs the bad.  So, when the current speculation controversy erupted in 2008 I was struck by the similarity of the present controversy and those that have buffeted the industry in the past.  Change only the names and dates and not all that much is different.  This has been a reoccurring theme in my own writings since 2008 (including the July 2008 NYT article…could not resist).  And I admit that I made an intentional decision early on to play a more public role in the present controversy.  Three of my professional heroes are Holbrook Working, Tom Hieronymus, and Roger Gray, who spent much of their illustrious academic careers defending futures markets.  All the motivation I needed.

Scott Irwin

University of Illinois