Streetwise Professor

November 1, 2009

Let’s Play Concentration

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Financial crisis,Politics — The Professor @ 11:11 am

CFTC Chairman Gary Genlser continues to make concentration and diversity his primary justifications for expanding position limits:

I believe we should consider setting position limits to guard against excessive concentration in the energy futures market,’ said Gensler at a luncheon held by the Natural Gas Roundtable, a nonprofit organization.

The CFTC is weighing whether to set position limits — a maximum market share — for oil and other energy products. The agency already sets limits on agricultural contracts.

‘When the CFTC set position limits for certain agricultural commodities, the agency sought to ensure that the markets were made up of a broad group of market participants with a diversity of views,’ said Gensler.

This raises several questions.

First, what is the statutory basis for position limits designed to reduce concentration and increase diversity? I see none whatsoever.

The relevant statute–available right there on the CFTC’s website–makes it clear that position limits are for the purpose of reducing “excessive speculation” that causes unwarranted price changes:

Excessive speculation in any commodity under contracts of sale of  such commodity for future delivery made on or subject to the rules of  contract markets or derivatives transaction execution facilities causing  sudden or unreasonable fluctuations or unwarranted changes in the price  of such commodity, is an undue and unnecessary burden on interstate  commerce in such commodity. For the purpose of diminishing, eliminating,  or preventing such burden, the Commission shall, from time to time,  after due notice and opportunity for hearing, by rule, regulation, or  order, proclaim and fix such limits on the amounts of trading which may
be done or positions which may be held by any person under contracts of  sale of such commodity for future delivery on or subject to the rules of  any contract market or derivatives transaction execution facility as the  Commission finds are necessary to diminish, eliminate, or prevent such  burden.

It couldn’t be much clearer.  Congress has authorized the CFTC to fix trading limits “for the purpose  of diminishing, eliminating,  or preventing such burden [of “sudden or unreasonable fluctuations or unwarranted changes in the price  of such commodity”].”  Period.  Full stop.  Not a word about “concentration” or “diversity.”  Like Bart Chilton’s musing about “unintentional manipulations,” Gensler’s advocacy of position limits based on these concepts is completely unmoored from the law.

That is, “excessive speculation” that distorts prices can provide a legal basis for position limits; Gensler’s “excessive speculation” (with no attempt to connect such concentration to price distortions) cannot.

Second, what is the evidence that variations in concentration across markets affect market quality?  I am not aware of any.  That is, what constitutes “excessive” concentration?: how would we know when this level is reached?

Third, what does Gensler believe causes variations in concentration across markets?  Could there be fundamental economic considerations that affect the level of concentration?  Could it be that trying to micromanage concentration through position limits would impose costs because these limits conflict with these fundamental economic considerations.

Fourth, more generally, what are the costs of position limits (e.g., in terms of constraining risk transfer)?  Has Gensler made any effort to weigh the costs against his estimates of the benefits?

Fifth, what levels of concentration are problematic?  Under what theory?  What is the evidence that supports this contention?

Sixth, are there any markets that have reached this level of concentration?

Seventh, is there any evidence that position limits materially impact concentration?

In terms of what concerns concentration poses, concentration levels (per CFTC data) are not large as compared to, for instance, industrial concentration in most markets.  In crude and nat gas, 4 firm concentration ratios range between 25 and 40 percent, while 8 firm ratios are in the 30-50 percent range.

I think that Gensler’s clear desire to shift the grounds of the debate from the (legally required) “excessive speculation” issue to something else (the legally meaningless idea of “excessive concentration”) reflects the fact that there is clear lack of both logic and evidence to support any claim that “excessive speculation” has, in fact, caused “unwarranted” price fluctuations.  Lacking such evidence, Gensler is attempting to hitch a ride on the financial crisis.  As the article quoted above says,  “Chairman Gary Gensler of the Commodity Futures Trading Commission said the financial crisis last fall showed the risk posed by ‘large concentrated actors on the financial stage’.”  He provides no evidence that this concentration caused problems in the futures market even during the height of the crisis (which would, interestingly, undercut his argument that clearing is a panacea to systemic risk).  And even if it did, it still provides no legal basis for position limits, which must as noted above, can be imposed only “for the purpose  of diminishing, eliminating,  or preventing” undue price fluctuations caused by excessive speculation.

By repeatedly invoking “concentration” and almost completely ignoring the sole legal basis for position limits, Gensler may actually call into question the legitimacy of any position limit regulation the Commission does pass.  If Gensler really believes that concentration is a problem, he should advocate amendment of the Commodity Exchange Act to make concentration a justification for imposing limits.  By straying from statutory authority in his advocacy for position limits, Gensler risks becoming another out of control regulator attempting to ensure that no good crisis goes to waste.  He has a lot of company in that, but that’s no excuse.

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  1. Hit the nail on the head! Evidence in building (from his own economists, among others) that excessive speculation was not and is not a problem.

    Comment by Scott Irwin — November 2, 2009 @ 11:09 am

  2. Thanks, Scott. Stay tuned. Just finishing up some cross sectional empirical evidence on the effect (or lack thereof) of index trading on prices. Brief summary of the results so far: volatility not higher during roll periods, nor is there evidence of price/spread reversals in the week after a roll (as would be expected if the rolls are overwhelming liquidity); moreover, correlations across commodities did rise in the 05-09 period (when index investing was increasing in importance), but significantly, this effect as high or higher for commodities not included in indices. Increased correlations between commodities and stocks and the dollar explains some, but not all, of the increase in correlations in the 05-09 period. Thus, the correlation increase is not plausibly attributable to the effect of index trading, which would be expected to have a more pronounced effect on commodities in indices than those that aren’t. My interpretation is that there was some factor other than index trading that affected all commodities in this period. Most likely source–burgeoning Chinese demand.

    The ProfessorComment by The Professor — November 4, 2009 @ 10:53 pm

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