Streetwise Professor

It looks like the energy markets have dodged a bullet; the Stop Excessive Energy Speculation Act (S. 3268) has failed a cloture vote, and is in limbo despite an earlier 94-0 vote in favor of cloture on the motion to proceed. This sparked a Harry Reid hissy fit (always music to my ears.)

And a good thing too. Although not including some of the most damaging proposals that have been mooted, such as draconian increases in margin or the outright banning of large financial institutions from the energy derivatives markets, it was plenty bad enough.

Some of the bill’s greatest misses include:

• Designating some market participants as “nonlegitimate hedge traders” and limiting the designation of “legitimate hedge traders” to those entities that actually produce or consume physical petroleum or natural gas.
• Establishing an advisory committee consisting of legitimate hedge traders only to make recommendations to the CFTC on position limits applicable to nonlegitimate hedgers and speculators.
• Extending position limits to OTC markets.
• Giving the CFTC the authority to intervene in the OTC market in the event of “a major market disturbance.”

All of these measures are pernicious. The would do nothing to reduce manipulation or improve the efficiency of the energy markets or reduce prices, but would reduce the effectiveness of these markets as risk transfer and price discovery mechanisms and raise compliance costs.

The creation of a separate caste of hedgers–“nonlegitimate”–makes no sense economically. Financial institutions that use the energy markets as part of a portfolio management strategy are as legitimate hedgers as an oil company or an airline. Even the very language “nonlegitimate” is tendentious and offensive.

Moreover, it is a dangerous precedent to give one group of market users a say over what other market users can do. The favored group is likely to use its power to benefit its own members to the detriment of the unfavored ones. Note that many firms that could fit in the “legitimate hedger” category speculate too, and could exploit the powers vested in the advisory committee to favor themselves at the expense of other competitors in the supply of risk bearing services. Similarly, long hedgers (airlines, as an example) would benefit if long speculation, or long portfolio hedging, is constrained. (Long speculators offset the effect of short hedging pressure, and thereby cause the futures price to rise relative to the expected spot price. Long hedgers benefit from a fall in the futures price relative to the expected spot price, and hence would benefit from constrianing other longs in the market.) These entities could also use their position on the advisory committee to advance their interests at the expense of short hedgers and long speculators.

Since speculative limits designed to make speculation more costly are detrimental to the efficient operation of the market (by constraining the ability of the markets to shift risk), extension of these limits to the OTC market will impair the effectiveness of the markets as risk management tools. Moreover, the CFTC (and its fox-in-the-henhouse “legitimate hedger” advisory board) are charged with the responsibility of setting position limits to eliminate “excessive” speculation. Good luck with that. These limits will just become another political and regulatory football over which competing interests will squabble.

The extension of emergency authority to the OTC market is a particularly scary expansion of regulatory authority. Here’s the language in full:

GENERAL.—In the case of a major market disturbance, as determined by the Commission, the Commission may require any trader subject to the reporting requirements described in paragraph (3) to take such action as the Commission considers to be necessary to maintain or restore orderly trading in any contract listed for trading on a registered entity, including—
”(i) the liquidation of any over-the counter transaction; and
”(ii) the fixing of any limit that may apply to a market position involving any over-the-counter transaction acquired in good faith before the date of the determination of the Commission.

The definition of “major market disturbance” is extremely broad and vague:

• `(C) MAJOR MARKET DISTURBANCE- The term `major market disturbance’ means any disturbance in a commodity market that disrupts the liquidity and price discovery function of that market from accurately reflecting the forces of supply and demand for a commodity, including–
• `(i) a threatened or actual market manipulation or corner;
• `(ii) excessive speculation;
• `(iii) nonlegitimate hedge trading; and
• `(iv) any action of the United States or a foreign government that affects a commodity.

In other words, not only does this provision permit the CFTC to intervene in the event of a corner–a real manipulation–it gives the Commission the authority to interfere directly in the market whenever in its infinite wisdom it deems that “excessive speculation” (where excessive is evidently in the eye of the beholder, and is not defined and is not capable of being defined) or “nonlegitimate hedging” is distorting prices. This in effect gives the Commission the authority to second guess the market. Moreover, since regulators are subject to pressure from organized interests who may benefit from an intervention, this opens the door to all sorts of influence activities and will undermine the certainty of contract in the energy markets. Think of it; somebody makes a bad trade, begins to howl about excessive speculation distorting the markets, and just might succeed in buffaloing the CFTC into forcing liquidation of the offending contracts. Great. Read my 1995 JLE piece on self-regulation of commodity markets for a few examples of how these powers can be used to make mischief.

In all honesty I doubt that the CFTC would use these powers. But they are there, and an activist Commission or one subject to intense lobbying or Congressional pressure could well use them, and wreak tremendous havoc in the markets. This is a really bad idea.

I would oppose this provision even if its application was limited to “(i) a threatened or actual market manipulation or corner.” As I have argued for well over a decade in my academic research, it is best to address corners and real manipulations ex post. The likelihood of a wrongful intervention is much greater (due to the lack of good information and the difficult of making decisions under time pressure) when a regulator attempts to intervene while a corner is in progress. Moreover, the regulator is likely to intervene only when the price distortions resulting from the exercise of market power are large, so early intervention is unlikely to mitigate price distortions all that much. Manipulation is perfectly suited for deterrence through harm-based sanctions, like those imposed on BP in the aftermath of its propane adventure. It is inefficient to rely on emergency authority, and its extension to the OTC markets is a bad idea.

Advocates of this type of regulation make ominous allusions to the dangers of “dark markets” not subject to constant government observation and meddling. Like small children, paranoics, and control freaks, they appear to be phobic about things that consenting adults might do out of their sight.

I, for one, am not scared of the dark, or most of the things that go on in the “dark” OTC markets. One thing is for sure; if a real manipulation takes place, it will come to the light in short order. As Frank Easterbrook has written, an undetected manipulation is an unsuccessful manipulation. If somebody corners the market, it will not remain a secret, its perpetrators will be known to other market participants–and to the authorities shortly thereafter. That is the time to bring the legal guns to bear. Until that time, let adults do in the dark what they will.

The BP propane episode is a perfect example of this. It is hard to conceive of a darker, more obscure corner of the energy market than propane. It is traded almost exclusively OTC, and trading activity in that commodity is dwarfed by that for other energy commodities. BP’s actions soon sparked the outcry from affected market participants, and soon parallel civil and criminal investigations were commenced. One trader plead guilty to a felony, and sometime thereafter the company entered into a deferred prosecution agreement with the government and agreed to pay a large civil fine and criminal penalty. We’re talking 9 figures.

It is far better to devote scarce enforcement resources to investigate instances of real potential harm that occur relatively infrequently, rather than spend resources to monitor all market activity on an ongoing basis, since most of that activity is benign at worst, and beneficial at best, and hence most of the resources devoted to oversight are wasted.

In sum, Harry Reid’s pet energy speculation bill is a disastrous piece of legislation. It is built on a foundation of anti-speculation animus that has no basis in economic theory or empirical evidence. It mandates a tremendous expansion of regulatory authority that cannot be used for good, but which has the potential to be used to distort markets, to intervene when intervention is unjustified, and compromise the surety of contract. Hopefully the bill is dead. But just to make sure, let’s drive a stake through its heart and shoot it with a silver bullet and repeatedly drive an M-1 Abrams over it repeatedly.