Streetwise Professor

August 2, 2013

It’s Always Something

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 10:05 am

It’s all so confusing.  During the last spasm of Congressional criticism of the “financialization” of commodity trading, mainly during the Frankendodd “debates” over position limits, the target of criticism was evil speculators who trade commodities for purely financial reasons, and who have no involvement in the physical markets.

In the latest incarnation, the alleged problem is that financial firms that trade commodities paper do have physical commodity operations:

What concerns Brown and Senator Jeff Merkley, Democrat-Oregon, is that banks have numerous physical commodity holdings as well as the means to deliver those commodities, including oil tankers, transmission rights and pipelines, while they at the same time trade on energy prices in futures and swaps markets.

Big banks can buy “vast quantities” of commodities and pipelines, tankers and warehouses, said Merkley. This gives them “a huge amount of market information that’s very advantageous in trading” and gives them a “thumb on the scale in the terms of supply and demand and being able to have some influence over the price,” he said.

“If you’re simultaneously allowed to bet on the price and you’re allowed to have your thumb on the scale in reflecting the price it’s a huge conflict of interest,” he said.

“Financial institutions own fleets of oil tankers and can withhold delivery, while wagering on the price of oil or they can speculate on the price of energy while controlling supply,” Brown said.

This, the senators said, is a clear conflict of interest that is driving up commodity prices.

Make up your minds, people (which generously assumes you have them).  Is the combination of physical and financial trading a good thing, or a bad thing?

As someone who has arguably written more about commodity market manipulation than anyone alive, I can say definitively that the most costly manipulative strategies-corners and squeezes-involve trading of “paper” (e.g., futures contracts) and the physical commodity.  These strategies involve either taking excessive deliveries, or buying in excessive quantities in the physical market.  Engaging in a market power manipulation requires some involvement in the physical market.

Historically, many of the biggest manipulations have been undertaken by hedgers.

And that’s the key point that escapes the Washington hand-wringers.  On one of their wringing hands, they lament the involvement of non-hedgers in markets (let’s leave aside how you can have hedgers without speculators to take the other side of trades).  On the other, they bemoan the fact that those involved in both the physical and financial commodity markets-who are often hedgers-can sometimes exploit market power to enhance profits.  But if you believe that a primary function of commodity derivatives markets is to facilitate risk management by those involved in the producing, marketing, storing, and processing of commodities, you have to permit the physical traders to trade derivatives.

One of the consequences of that is that there will be manipulations by physical players.  But severing physical and financial trading in order to prevent manipulation, which is what Brown and Merkley and others are suggesting, is crack-brained.  It throws the hedging baby out with the manipulative bath.

And it is particularly crack-brained to focus on just one category of market participants, like banks.  The potential for manipulation exists due to frictions in the physical market, and the ability of some market participants to trade both derivatives and the underlying commodities.  Someone will step into the banks’ role if they are precluded from the market, and the potential for manipulation will remain.  Taken to its logical conclusion, the Brown-Merkley “conflict of interest” standard would preclude any entity-not just banks-from trading both commodity derivatives and the underlying physicals.

So what’s the best way to attack manipulation?  Not by destroying the ability of the markets to perform their vital risk transfer function.  Instead, as I’ve argued for going on 20 years, the best way is to impose penalties after the fact for manipulative conduct.  Thus, at least conceptually, I support FERC and CFTC enforcement efforts.  The problem is that practically their efforts are often misdirected and intellectually confused.

Congress should economize on its limited comprehension of these issues by focusing on the key problems, rather than throw around vapid phrases like “conflict of interest” and recommend policies that undermine the ability of financial and physical commodity markets to function effectively.  Better anti-manipulation laws predicated on a clear understanding of how manipulation works would be the place to start.  And no, this does not involve the Xeroxing of 10(b)(5) of the Securities and Exchange Acts and inserting it into commodity trading laws, which has been Congress’s default response for about a decade.  There is a complete mis-match between the fraud-based thrust of 10(b)(5) and the market power problems that sometimes arise in commodity markets.  I’ve made recommendations over the years on the right regulatory/legislative approach that would target market power problems more precisely.  This approach would permit the markets to exploit the synergies between paper and physical trading while at the same time improving the efficiency of these markets.

But instead, we get Congressional schizophrenia and meat cleaver approaches that would, if taken to their logical conclusion, destroy the markets in order to save them.

A further thought.  Those who have the ability to trade the physical, and who have extensive information and developed logistical capabilities are usually the best positioned to break corners, and to mitigate the frictions that make corners possible.  They also have the strongest incentive when they have a derivatives position that would be hurt by a manipulation.

I’ll post a link when I have a chance, but P.D. Armor’s breaking of the Leiter wheat corner in 1898 is a great example of this.  There are many others.

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  1. SWP, in 20 years I think you would update your view on regulation:

    “Instead, as I’ve argued for going on 20 years, the best way is to impose penalties after the fact for manipulative conduct. Thus, at least conceptually, I support FERC and CFTC enforcement efforts.”

    Why do you still have confidence in regulators? Can you detail one instance where regulatory enforcement of manipulative behavior has improved the market? I can detail thousands where enforcement of alleged manipulative behavior has damaged the marketplace, and only given more power to the incumbents. The last 5 years is particularly illustrative with FrankenDodd. My hope for benevolent regulators to police “fair” markets is destroyed.

    In my view regulators are much more than intellectually confused and misdirected. They are anathema to markets and their actions will inevitably lead to corruption (though granting of privileged access), less transparency (by cramming down strict reporting rules) and generally erode efficient market behavior.

    Yes, folks will try to corner physical markets, and profit from market power. But these forces (while not elimicated) are kept in check better through market discipline and for-profit participants, rather than regulators.

    Comment by scott — August 2, 2013 @ 4:01 pm

  2. @scott. I do not trust regulators. What I have proposed, and continue to advocate, is reliance on ex post adjudication, in federal court, of manipulation based on legislation that addresses specifically market power manipulation. Private right of action is an important part of this. Private litigants are likely to be far more competent and capable than the Feds.

    The ProfessorComment by The Professor — August 2, 2013 @ 7:28 pm

  3. @scott. I suggest that you read what I’ve written over the years about the deterrence of manipulation, rather than make a judgment on the basis of a brief summary in blog post.

    Your comment rightly points out one of the problems with manipulation enforcement: false positives. I have been involved in some litigation, namely the ETP case, which is a classic example of that. The outcome there was favorable: FERC pretty much folded its tent on that case. A few days after I was deposed, as it happened.

    My analysis of manipulation cases demonstrates that there are also many false negatives: stone cold manipulators have escaped punishment.

    It’s like the lawyer who said that he lost all the cases he should have won, and won all the cases he should have lost, so on average justice was done.

    Both the false positives and false negatives stem from a common source: imprecise legislation that is ill-fitted to address market power manipulation. The FERC anti-manipulation authority, derived from the Energy Policy Act is particularly problematic, based as it is on 10(b)(5). It is a fraud-based standard that is ill-adapted to market power manipulation, but FERC enforcement will go through extreme contortions to fit an in-your-face exercise of market power into the concept of “a deceptive contrivance or device.” That’s what happened in ETP. There was the theory of the week. It was like Maxwell Smart: “Would you believe . . . ?” Pounding a market power peg into a fraud hole. A recipe for legal confusion-and abuse.

    And of course, Frankendodd incorporated the same 10(b)(5) language into the Commodity Exchange Act.

    To correct these defects, it is necessary to replace the current, vague anti-manipulation statutes with legislation based on an understanding of market power manipulation, with language crafted to identify and define what is the precise nature of the offense and the types of proof that must be presented to reduce the incidence of type I and type II errors.

    As Frank Easterbrook has written, the undetected manipulation is an unsuccessful manipulation. Those harmed by it have the incentive to bring legal action if permitted to do so (through rights of private action). If they must pursue their actions under a statute that is crafted to reduce false positives and false negatives, the adversarial system will provide a valuable supplement to market discipline, which historical experience demonstrates (as documented in some of my research) is insufficient to reduce substantially this wasteful and opportunistic conduct.

    I can provide cites to my publications on these issues, and links to some of them, if you’d like to read further.

    The ProfessorComment by The Professor — August 2, 2013 @ 8:32 pm

  4. Your discussion here suggests that antitrust law might be the right way to go. All you would have to do is allow for the rapid acquisition and loss of market power, and then apply the usual rules about things that are not OK to do when you are a monopolist. OTOH, antitrust law is a mess of ex post facto squishiness.

    The other advantage of a market-power, antiturst orientation is that it makes more work for economists. That’s always a plus.

    Comment by srp — August 3, 2013 @ 1:22 am

  5. @srp. Yes, there are some similarities with anti-trust law. I discussed some of the parallels in my work in the 90s. Manipulation litigation should be much simpler than anti-trust, for a variety of reasons. The effects of manipulation are much sharper, and easier to test. The very short-lived nature of the market power leads to sharp price movements, and more importantly, movements in relative prices (over space and delivery month) that are easy to detect. One can test for distortions in quantities (e.g., inventories, commodity movements). There is also typically much more data to work with. Furthermore, it is a much narrower area than anti-trust. Issues like vertical restraints, for instance, are typically absent.

    This in part is what I have found so frustrating about manipulation law. It should be easy and clear, but courts and the regulators and legislators have succeeded in making it complex and abstruse. It is squishy, but it doesn’t have to be.

    Dealing with that abstruseness has made a lot more work for at least one economist 😉

    The ProfessorComment by The Professor — August 3, 2013 @ 11:26 am

  6. the best way to deal with this is transparency. Frankendodd makes every market less transparent. The CFTC under Gensler isn’t a regulator, it’s an agenda.

    Comment by Jeff — August 4, 2013 @ 7:02 am

  7. @SWP, I would like to read further on how statues and adversarial legal contests can rein in fraud. It is valuable in many other industries and endeavors, so i am prejudiced towards it. Perhaps I am a bit short-sighted living in the commodities industry, because I see the frankendodd destruction every day, and wonder what will remain in another 10 years. Energy, metals, Agriculture may very well all end up like the Onion futures market.

    Comment by scott — August 8, 2013 @ 12:57 pm

  8. @scott. I’ll put together a rather self-serving/self-referential set of references. More focused on market power manipulation than fraud, but the basic principles apply to both.

    The ProfessorComment by The Professor — August 8, 2013 @ 1:00 pm

  9. @SWP, Still hoping you will post the references. Nothing wrong with self-referential, given all the garbage that is written elsewhere.

    Comment by scott — August 27, 2013 @ 7:30 am

  10. @scott. Thanks for reminding me. Here’s a paper from the American Law and Economics Review which shows that corners can be detected with a high degree of confidence: few false positives, few false negatives. I critique manipulation law here. This article discusses issues related to market power vs. fraud-based manipulation. My 1996 book includes some formal models of manipulation that are the motivation for the more policy-oriented, empirical papers I just mention. (Such a deal! Buy 2! Also available on Kindle!) This Steve Shavell article lays out when ex post deterrence is preferred to prevention.

    The ProfessorComment by The Professor — August 27, 2013 @ 3:33 pm

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