Streetwise Professor

July 22, 2010

Chocolate Kisses, or the FT in the Tank

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 10:34 am

I have been a close observer of manipulation since the mid-1980s, when the Japanese were squeezing the 30 year while I was devising interest rate hedging strategies for the clients of the FCM I worked for.  Since then, I have examined, intensively and forensically, manipulations in soybeans, Brent, Bunds, Treasuries, canola, copper, aluminum, propane, natural gas, WTI, and other things.  I have researched every major manipulation that I could identify, dating back to the 1860s.

I have heard all of the lame alibis, sometimes directly from the manipulators’ mouths, sometimes from the mouths of their mouthpieces.  Excuses from the likes of them are to be expected.  It is disappointing, however, to see the Financial Times regurgitate their tripe.

Yesterday the FT ran an editorial that recycled many of the tired tales that manipulators tell in defense of Anthony Ward’s actions in the cocoa market.  None of it is exculpatory, in the least.

To start with, the FT opines:

Armajaro breached no rules when, in pursuit of its view that cocoa prices would rise after a poor harvest, it snapped up contracts to purchase cocoa beans on the Liffe futures exchange. These gave it the right to take physical delivery of the beans if it chose. What stirred the controversy was that Mr Ward exercised that prerogative over 24,100 contracts. These amounted to about 7 per cent of annual world production.

Yes, the old “I had the contractual right to do what I did” defense.  But a market power manipulation involves the opportunistic use of this contractual right to distort prices and the flows of a commodity in commerce.  This action degrades the effectiveness of futures contracts as a risk shifting and price discovery mechanism, and leads to wasteful use of the commodity.  If “contractual right” trumps everything, then rules against corners are a nullity.  If that’s the way the game is played, maybe I should start The Corner Fund and go to town.  I’ll hire the FT to flack for me.  But I probably won’t even have to hire it: it seems it’s willing to do it for free!

The FT continues with another old standby: the “They had it coming to them for walking in this neighborhood alone dressed in shorts like that” story:

There is no doubt that his decision caused agony for some on the other side of the contracts. A number of cocoa traders use Liffe to hedge against falls in the prices of the stocks they hold. They suffered because they not only hedged their beans – but their holdings of cocoa powder and butter also. These were ineligible for delivery against the contracts, thus forcing the hedgers to settle contracts for cash at penal premiums or to buy sufficient beans to close the trade.

It is hard to see how Mr Ward can be blamed for this. The hedgers did not need to run a mismatch risk. They could have found other ways to insure their exposures – such as entering into a derivative with a bank. That would have been more expensive, but would also have been safer.

But the whole point of centralized markets is to concentrate liquidity, thereby permitting out-of-position hedgers to reduce risk with maximum flexibility while incurring low transactions costs.  They willingly trade basis risk for transactions costs.  That is no reason to excuse opportunistic actions that exacerbate basis risk.  The risks of being cornered induce hedgers to take costly preventative measures, such as investing collecting information about the activities of other traders that is socially wasteful because it is merely intended to reduce the risk of being the source of a wealth transfer, or using markets where transactions costs are higher.

Beating me to the punch, Tullet Prebon’s CEO T.C. Smith skewers the FT’s fatuousness–and hypocrisy:

Many commentators maintain that one lesson of the financial crisis is that all over the counter derivatives should be traded on exchanges.

I wonder how the revelation in your editorial, that the cocoa consumers who attempted to hedge their powder and butter through the imperfect mechanism of the Liffe futures in cocoa beans would have suffered much less if they had taken out OTC contracts with banks which precisely hedged their risk, fits their theory.

They can file your editorial with the reports on the as yet unexplained “Flash Crash” of May 6, in which Apple’s shares traded at one cent per share and $100,000 a share within 20 minutes.

But then, why let the facts get in the way of their theory? It will all be safer and more transparent when everything is on exchange.

Couldn’t have said it better myself.

The FT then plays three card monte and attempts to distract attention from the real issue:

It has been suggested that Mr Ward’s conduct was akin to cornering, and thus led to a disorderly market. But this is a hard case to sustain. Disorderly markets occur when two-way prices cease to be made – thus making cash settlements impossible. But the open interest on the cocoa contract fell in the weeks prior to expiry.

That is, shall we say, an idiosyncratic definition of “disorderly market.”  In fact, in many corners trading activity can reach a frenzy.  There are two-way prices, but the prices are far above where they would be in a competitive market, and the “cash settlements” are at essentially extortionary prices.  Apparently that’s hunky dory with the FT.  And even in cornered contracts open interest typically falls.  In fact, that’s almost always true.  Indeed, it often falls the most when the cornerer makes money by liquidating futures at supercompetitive prices.

The FT then suggests that the quiet word among gentlemen approach is preferable in such matters:

However, squeezes can be managed. Liffe tries to do this by directly stepping in where necessary to guide the activities of traders. This approach, which has been compared to being summoned to the “headmaster’s study for a quiet word”, effectively substitutes for a detailed rule book. The flexibility it provides can be valuable so long as the market is actively policed.

Yeah.  That works, except when it doesn’t.  And the London markets provide numerous examples of it not working.  Remember Sumitomo, and the LME’s rather, shall we say, prone, not to say accommodating, posture in dealing with Hamanaka right to the end?  Or all of the Brent shenanigans that occurred over the years?

And in that vein, a shout out to LIFFE, for validating my 1995 JLE article arguing that exchanges were unlikely to act against manipulation.  It would be hard to write a letter that does a better job at missing the elephant in the room.

Perhaps due to space limitations, the FT does manage to overlook some of the standard lines from the manipulator’s manual.  But a couple of commentors over at SeekingAlpha fill the void.

In this case, it appears that Armajaro already had customers for the cocoa delivered to it.  See!, the commentor says, there is real demand, real customers.  Well, if you know anything about manipulation, you know that the biggest danger is related to burying the corpse of the manipulation: that is, selling the massive deliveries that you take to squeeze the market.  A clever fellow bent on manipulating the market pre-arranges the funeral.  If the reports about forward sales of old crop cocoa to processors are correct, that was done in this case.  So, rather than being exculpatory, such sales are actually evidence of manipulative intent.

(I’d be interested to know who is making the deliveries.  It would be telling if any of the deliveries were made by those who had contracted to buy from Armajaro.  It would also be interesting to know more of the details of those contracts, not just the pricing terms but any other features in the contracts relating to use or marketing of the cocoa, and the delivery locations for the contracts.)

The other common excuse, again seen in my SA comments, is that the stuff that is delivered will be consumed.  Well, duh.  It’s not like the guy is going to eat it all himself, or burn it, or build houses out of cocoa beans.  It is going to be consumed.  But manipulation distorts consumption pattens–the timing and location of consumption.  The stuff is consumed, but in the wrong place at the wrong time, and too much of it is shipped around to the wrong places.  The fact that the delivered cocoa will eventually be consumed does not imply that the deliveries are efficient.

All in all, none of the arguments raised in Armajaro’s defense are even remotely exculpatory, and some are actually adverse.  A final judgment would require a full forensic and econometric evaluation of prices, pricing relationships, price-quantity relationships, and movements of cocoa.  Time permitting I hope to do some of that.  But at this juncture, there is sufficient evidence to conclude that there is a colorable case against Armajaro, and that the arguments raised in its defense are risible.

Taking huge deliveries in a large backwardation is consistent with manipulation.  This is especially true when one party takes all the deliveries.  Delivery economics are pretty straightforward, and if they work for one party they tend to work for several.  One firm taking all of the deliveries is suspect.

Moreover, the purported rationale for the trade–an expectation of a small new crop in the autumn–does not explain why the old crop price richened relative to the new crop price.  If the real motivation was a view that the market did not appreciate sufficiently the likelihood of a small crop, then the trade should have been to go long the new crop and cash in if and when that view was validated.  Taking delivery into a big backwardation, and seeing the backwardation actually increase as result of the deliveries, is not a sensible way to play an anticipated shortage in the new crop.  The backwardation across crop years screams: “don’t carry over inventory into the new crop year.”  So current inventories do nothing to alleviate future shortages (because the spreads signal that all of the cocoa should be consumed before those shortages arise).  (As an example of how the market should work in response to anticipation of a crop shortfall, during the big US drought of 1988, the old crop-new crop spreads for corn and soybeans snapped into a huge carry; indeed, the spreads exceeded full carry charges measured using official storage rates.  The warehouses in Chicago were filled to the top with grain and beans. That’s because the market realized that it was desirable to carry over old crop supplies in larger quantities than usual to alleviate the anticipated shortfall in the 1988-1989 crop.)  (Ferruzzi told the same lame betting on a new crop shortfall story during its bean manipulation in 1989.)

The rise in the London price relative to the NY price is also what you’d expect to observe in a corner.

I’m not rushing to judgment.  But neither should the FT .  Its unseemly haste to play Ward’s mouthpiece, its heaving up of tired excuses made for manipulators from time immemorial, and its complete lack of any skepticism, are not befitting a premier financial publication.

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  1. “If “contractual right” trumps everything, then rules against corners are a nullity.”

    But contractual rights do not trump everything. What trumps everything is each trader’s and each exchange’s legal obligation to act only in a manner that maintains a “fair, efficient and orderly marketplace.” If Armajaro and Anthony Ward acted in a manipulative manner, how would fault be apportioned? Armajaro and Ward would arguably bear responsibility for acting in a manner that failed to maintain a fair, efficient and orderly marketplace, but the LIFFE would arguably also bear responsibility for allowing the trades to stand.

    Comment by Charles — July 22, 2010 @ 12:44 pm

  2. Yes, Charles, but the FT’s argument–and I’ve heard it before, many times–is that contractual rights do trump. What is “fair, orderly, and efficient” tends to vary, depending on the eye of the beholder. Often fine words, with no practical effect. So what happens is that contractual rights wins out, and nobody is held accountable.

    A crucial question is: who should hold manipulators responsible? My ’95 JLE piece shows, in gruesome detail, that it is often futile to rely on the exchanges to do that. EG, Sumitomo rode roughshod over LME for years. Years. And that’s not the only example. Gov’t regulators are usually clueless as well. They have an unerring instinct to miss the real manipulations and focus on the ones in their imaginations.

    The only thing that has imposed any costs on manipulators is private litigation, and that has been hamstrung by some boneheaded court decisions.

    You are right in saying that the contractual right is not an unlimited one. It is limited by one’s obligation not to manipulate. But the problem is that in practice, people default to the contractual right argument–as the FT did here.

    The ProfessorComment by The Professor — July 22, 2010 @ 1:09 pm

  3. But if contractual rights win out and no one is held accountable, whose fault is that? Clearly, allowing contractual rights to prevail over the obligations to maintain a fair, efficient and orderly marketplace is a misapplication of law. Are the courts failing to properly apply the law or are regulators (yet again) proving to be utterly clueless and inept?

    The fact that the FT doesn’t understand much about the subject of manipulation doesn’t bother me much. I pretty much expect journalists to continuously prove they are idiots. Rarely am I disappointed.

    And, for the record, I still maintain that there will never be meaningful reform of the financial and commodities marketplaces until we first reform the regulators. Until we get regulators who can apply regulations fairly and effectively it doesn’t matter what regulations are on the books. After all, the reason people seek to manipulate markets and act unlawfully to deceive investors is that they have carefully calculated the risks and find them acceptable.

    Comment by Charles — July 22, 2010 @ 2:16 pm

  4. The point of a lot of what I’ve written over the last 20 years is that “misapplication of the law” is the rule, rather than the exception. Or at least, such misapplication occurs far more frequently that it should, or need to.

    Regulators: almost uniformly inept. Which is why it is such a joke to expect that heaping more responsibilities on them will improve matters. Courts: better, but still problematic. Indeed, many of the problems that courts face is that the CFTC made several terrible decisions in the 1980s that completely muddies the waters.

    The big problem is Congress: it has stubbornly refused to recognize the problems with the existing law (which dates pretty much unchanged back to 1922), and so hasn’t rewritten the laws to deal with the clearly evident problems. Judge Miller in Houston made this plain when he said in a decision relating to the BP propane criminal charges that the CEA was unconstitutionally vague. This only has a direct impact on criminal cases, but a vague statute can hardly be a reliable guide for civil or regulatory action either.

    You’d think Miller’s decision would be a wake-up call. They had a chance to improve the manipulation sections of the CEA when doing Frank-n-Dodd, and instead all they did was add an additional, and maddeningly vague, recklessness standard in lieu of specific intent. Morons.

    I think the regulators are essentially unfixable: again, I recommend working on time travel instead, due to its higher likelihood of success. My recommendation is a rewrite of the law, combined with right of private action. Re how the law should be rewritten, I have some suggestions in a recent issue of the Energy Law Journal. I can send you a copy if you’re interested. Hey. . . I can even send you an autographed copy on dead tree. Might be valuable some day, in case of a big paper shortage.

    The ProfessorComment by The Professor — July 22, 2010 @ 4:22 pm

  5. I would be interested in reading your suggestions. Can you send it by pdf?

    Comment by michael webster — July 23, 2010 @ 8:02 am

  6. @Andrew–wilco. Shoot me an email and I’ll attach the doc and reply. [email protected]

    The ProfessorComment by The Professor — July 23, 2010 @ 9:35 am

  7. SWP,

    I’d love to read your suggestions as well.

    [email protected]

    Comment by John McCormack — July 23, 2010 @ 10:38 am

  8. Thanks, John. Think I’ll post it too.

    The ProfessorComment by The Professor — July 23, 2010 @ 10:59 am

  9. Just put up a post with a link to the ELJ paper, plus a bonus link to my new Cato piece on clearing mandates.

    The ProfessorComment by The Professor — July 23, 2010 @ 12:05 pm

  10. I had occasion to meet with these guys a few years back about investing in their funds. I left with the distinct impression that squeezing cocoa when they could was their full time occupation.

    Comment by Al — July 23, 2010 @ 10:23 pm

  11. Thanks, Al, for that intriguing information. I’m doing a little data work now, and it is consistent with your impression.

    The ProfessorComment by The Professor — July 23, 2010 @ 10:26 pm

  12. They offered a regular CTA fund which was really fairly impressive. It didn’t trade cocoa. They said they had another fund which only traded coca futures which was closed and they wouldn’t share any info on it like AUM or returns. I’m not sure why they disclosed it. Probably they felt duty bound when we asked about their firmwide AUM. As well they said they had factories in Asia which supplied the major candy guys. They said they had computerized sensors embedded in the trees in W. Africa. They also said they had big interests in the nuts. Perfect set up right?

    Comment by Al — July 26, 2010 @ 3:38 pm

  13. @Al–Coca futures: that would be interesting 🙂

    Kidding aside, yes, it does seem like the perfect setup. And the perfect cover for some shenanigans from time to time.

    Thanks again.

    The ProfessorComment by The Professor — July 26, 2010 @ 4:36 pm

  14. Another thing i thought of: They were going on about their coca operation and how they offered sourcing of cocoa, milk products and nuts to candy makers and I thought he left out sugar so I asked if they didn’t trade sugar as well and the guy said we don’t know anyone in the Brazilian government so we don’t have an edge in that. They wouldn’t say who the investors were in the cocoa only hedge fund. I asked specifically because I wanted to know if we were possibly invested with someone who was already involved and they wouldn’t say. I thought it weird that they would have this fund though. If it’s a physical trade house, even if they are trying to manipulate, wouldn’t the futures positions just go in the house account? A dark thought: maybe they have government officials from where? Ghana or Ivory Coast as investors in that cocoa only hedge fund.

    Comment by Al — July 26, 2010 @ 6:09 pm

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