Streetwise Professor

The EU is proceeding with plans to take a much more aggressive regulatory approach in commodity markets.  The scheme will empower the to-be-established European Securities and Market Authority (ESMA) broad powers to intervene in commodity markets.  These powers would include the ability to impose “ex ante” position limits.  These proposals are included in a massive, sweeping proposal to regulate financial markets.  The new powers include:

— supervisors should have powers to intervene at any stage during the life of a derivative contract

— supervisors could require any holder of a contract to provide a full explanation for the position, provide all relevant documentation, reduce the size of the position in the interest of an orderly market and investor protection

— EU regulators to propose standards for setting position limits for derivative contracts traded on and off exchanges and define when such limits should be triggered

. . . .

— a separate “chapter” should be introduced into MiFID to “help ensure that sufficient clarity and regulatory focus are devoted to how commodity derivative markets function in the future”

— there is a need for a position-reporting obligation by categories for traders for contracts trade on all EU venues

— to avoid problems with convergence between futures and spot prices in commodity derivatives, a requirement could be added to the way commodity derivatives contracts are designed to ensure price convergence

— currently commodity trading for own account is exempt from MiFID rules but this waiver should be narrowed

— if an off-exchange, physically settled contract is like an exchange traded contract and standardised then it should also be centrally cleared

John Kemp of Reuters has more detail (sorry, no link: the story was emailed to me and I can’t find it on Reuters):

Under enhanced position management, position holders could be required to provide a full explanation for the position, including relevant documentation, to show whether the purpose is hedging or speculation. They could be required to reduce the position in the interest of an orderly market, investor protection or market integrity. The authorities could intervene at any time in the life of a derivative contract.

. . . .

But the consultation envisages that the future European Securities and Markets Authority (ESMA) would be given a powerful coordinating role and empowered “to propose technical standards to set ex-ante position limits both for derivative contracts traded on exchange and OTC [over-the-counter]” when necessary to address “risks to the overall stability or delivery and settlement arrangements of physical commodity markets”. That looks like a direct reference to preventing squeezes in the delivery mechanism.”New implementing measures could further define the details of when the powers to propose position limits may be triggered. For example, these could be triggered when conditions in a given market in terms of liquidity or market concentration jeopardise market efficiency or integrity,” according to the consultation document.

Decisions about when to invoke enhanced position management powers would be taken by the ESMA rather than left to exchanges. ESMA would set overall principles to be applied at national level. But it could also intervene directly when there is a threat to the orderly functioning and integrity of financial markets and national authorities have not taken sufficient measures to address the issue.

This implies a much bigger, more direct role for the regulator in handling the issue of dominant positions and market squeezes.

The Kemp piece, and some of the elements of the proposal (e.g., the focus on convergence) suggest that the focus of the new position control regime will be to prevent manipulation.  That focus is laudable, in contrast to the vague, obscure, untestable, theoretically and empirically unsupported goal of eliminating “excessive speculation” that underpins the CFTC’s authority to impose position limits (now vastly expanded).  (Give me a few minutes, and I’m sure I could come up with many more pejoratives.)  Manipulation (in its most important forms) is something, in theory and in practice, that can be defined, understood, and empirically identified.  In contrast, determining when speculation is “excessive” is a nebulous task, with no grounding in proper economics and impossible to implement in practice.  As a result, what happens in markets tends to be a Rohrschach Test, with some people (e.g., Bart Chilton, Michael Masters) seeing excessive speculation everywhere, and others not.

Kemp notes that the EC initiative is an implicit rebuke of Britain’s Financial Services Authority, which has argued that position limits are unnecessary. Kemp further notes that the FSA already has many of the powers outlined in the EC proposal, but delegates their implementation to exchanges.  As was seen in cocoa over the summer, and has been seen chronically in the metals markets for decades, that basically means in practice that “light touch” is a massive understatement, and that market participants can undertake some blatantly egregious–manipulative conduct–with little fear of hearing even a whispered “boo” from the exchange or the regulators.

Nor is it evidently much better on the Continent.  Although not related to commodities, the Porsche corner of VW shares, which I’ve written about extensively, was about as brazen and extreme as it gets, but the German regulators played Sergeant Schultz, and saw nothink.

So, in principle a manipulation-focused bolstering of regulatory powers is a good thing.  (See, I’m not an anarchist, despite what some think.)  That said, a highly discretionary system that relies on ex ante intervention is inefficient, compared to a realistic alternative.  I’ve written for what seems forever (although it’s only about 16 years or so) that an ex post regime that imposes sanctions on those that manipulate the market is highly preferable.  It economizes on resources committed to supervision.  Moreover, true corners and squeezes can be identified reliably ex post, and the perps are not judgment proof, and hence can be deterred by the prospect of severe sanctions imposed in the event of a determination that they have manipulated; a determination that can be made with considerable precision, and little likelihood of falsely convicting the innocent.

The EU/EC is in an excellent position here to do something constructive, because it starts with a blank slate.  Unlike the US, which is hamstrung by poorly crafted laws that provide little guidance to judges and regulators, thereby permitting the proliferation of economically deficient (and precedential) decisions, the EU has the ability to create an anti-manipulation statute that is grounded in economics, which provides specific guidance and tests to triers of fact.  My suggestions along these lines are here, amongst other places.  (Hint, hint, nudge, nudge.)

Permitting a private right of action would also be quite beneficial, because those harmed by squeezes are highly motivated to take action if they can be compensated for the damages that they suffered.  As the US experience shows, relying on regulators alone to punish manipulative conduct after the fact, even when they have the power, is all too often woefully inadequate.

Moreover, even if there is a focus on ex ante regulation, that regulation would be more effective, with lower probabilities of inappropriate intervention and inappropriate failures to intervene (cf. cocoa, July, 2010) if it were predicated on a firm economic understanding of manipulation, and if it were to set out in detail the indicia of manipulation and manipulative conduct that would attract regulatory scrutiny.  There is always a fear that a broad, vague grant of discretionary power to regulators can lead to a proliferation of both Type I and Type II errors.

Along these lines, although the descriptions of the EC consultation document suggests a focus on manipulation properly understood, the statements of the politicians in charge of the effort raise serious concerns that the regulation might be used to attack any form of conduct that doesn’t suit the person speaking at the moment.  For instance, EU commissioner Michel Barnier, who is driving the reform effort, has said:

If someone is doing something which affects the market then he or she must be held to account.  Hyper-speculation is scandalous.

“Affects the market” is pretty broad.  The broadside against “Hyper-speculation”–as opposed to manipulation–smells suspiciously like the pernicious “excessive speculation” language in the Commodity Exchange Act.  It doesn’t take too much of an imagination to picture that during some future energy or ag price spike, a regulator subject to political influence would intervene in a destructive way, chasing some chimera of hyper-speculation.  Politically influenced regulators (and there is no other kind) are great at killing the messenger.

Which all means that it is difficult to be too enthusiastic about the proposal.  Yes, a rule focused on manipulation, properly understood, would be an improvement.  But ex ante measures are inferior to ex post, and I strongly suspect that whatever emerges will give regulators a lot of discretion that can be abused–and will be abused, in the event, the next time developments in the commodity market leads to a popular and political hue and cry to “do something.”