Streetwise Professor

October 7, 2014

Manipulation Prosecutions: Going for the Capillaries, Ignoring the Jugular

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 7:32 pm

The USDOJ has filed criminal charges against a trader named Michael Coscia for “spoofing” CME and ICE futures markets. Frankendodd made spoofing a crime.

What is spoofing? It’s the futures market equivalent of Lucy and the football. A trader submits buy (sell) orders above (below) the inside market in the hope that this convinces other market participants that there is strong demand (supply) for (of) the futures contract. If others are so fooled, they will raise their bids (lower their offers). Right before they do this, the spoofer pulls his orders just like Lucy pulls the football away from Charlie Brown, and then hits (lifts) the higher (lower) bids (offers). If the pre-spoof prices are “right”, the post-spoof bids (offers) are too high (too low), which means the spoofer sells high and buys low.

Is this inefficient? Yeah, I guess. Is it a big deal? Color me skeptical, especially since the activity is self-correcting. The strategy works if those at the inside market, who these days are likely to be HFT firms, consider the away from the market spoofing orders to be informative. But they aren’t. The HFT firms at the inside market who respond to the spoof will lose money. They will soon figure this out, and won’t respond to the spoofs any more: they will deem away-from-the-market orders as uninformative. Problem solved.

But the CFTC (and now DOJ, apparently) are obsessed with this, and other games for ticks. They pursue these activities with Javert-like mania.

What makes this maddening to me is that while obsessing over ticks gained by spoofs or other HFT strategies, regulators have totally overlooked corners that have distorted prices by many, many ticks.

I know of two market operations in the last ten years plausibly involving major corners that have arguably imposed mid-nine figure losses on futures market participants, and in one of the case, possibly ten-figure losses. Yes, we are talking hundreds of millions and perhaps more than a billion. To put things in context, Coscia is alleged to have made a whopping $1.6 million. That is, two or three orders of magnitude less than the losses involved in these corners.

And what have CFTC and DOJ done in these cases? Exactly bupkus. Zip. Nada. Squat.

Why is that? Part of the explanation is that previous CFTC decisions in the 1980s were economically incoherent, and have posed substantial obstacles to winning a verdict: I wrote about this almost 20 years ago, in a Washington & Lee Law Review article. But I doubt that is the entire story, especially since one of the cases is post-Frankendodd, and hence the one of the legal obstacles that the CFTC complains about (relating to proving intent) has been eliminated.

The other part of the story is too big to jail. Both of the entities involved are very major players in their respective markets. Very major. One has been very much in the news lately.

In other words, the CFTC is likely intimidated by-and arguably captured by-those it is intended to police because they are very major players.

The only recent exception I can think of-and by recent, I mean within the last 10 years-is the DOJ’s prosecution of BP for manipulating the propane market. But BP was already in the DOJ’s sights because of the Texas City explosion. Somebody dropped the dime on BP for propane, and DOJ used that to turn up the heat on BP. BP eventually agreed to a deferred prosecution agreement, in which it paid a $100 million fine to the government, and paid $53 million into a restitution fund to compensate any private litigants.

The Commodity Exchange Act specifically proscribes corners. Corners occur. But the CFTC never goes after corners, even if they cost market participants hundreds of millions of dollars. Probably because corners that cost market participants nine or ten figures can only be carried out by firms that can hire very expensive lawyers and who have multiple congressmen and senators on speed dial.

Instead, the regulators go after much smaller fry so they can crow about how tough they are on wrongdoers. They go after shoplifters, and let axe murderers walk free. Going for the capillaries, ignoring the jugular.

All this said, I am not a fan of criminalizing manipulation. Monetary fines-or damages in private litigation-commensurate to the harm imposed will have the appropriate deterrent effect.

The timidity of regulators in going after manipulators is precisely why a private right of action in manipulation cases is extremely important. (Full disclosure: I have served as an expert in such cases.)

One last comment about criminal charges in manipulation cases. The DOJ prosecuted the individual traders in the propane corner. Judge Miller in the Houston Division of the ┬áSouthern District of Texas threw out the cases, on the grounds that the Commodity Exchange Act’s anti-manipulation provisions are unconstitutionally vague. Now this is only a district court decision, and the anti-spoofing case will be brought under new provisions of the CEA adopted as the result of Dodd-Frank. Nonetheless, I think it is highly likely that Coscia will raise the same defense (as well as some others). It will be interesting to see how this plays out.

But regardless of how it plays out, regulators’ obsession with HFT games stands in stark contrast with their conspicuous silence on major corner cases. Given that corners can cause major dislocations in markets, and completely undermine the purposes of futures markets-risk transfer and price discovery-this imbalance speaks very ill of the priorities-and the gumption (I cleaned that up)-of those charged with policing US futures markets.

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  1. Corners are in the ‘too difficult’ box. In commodities a corner typically involves taking control of most of the supply of something and then either sitting on it, deliberately congesting the delivery mechanism for it, or moving it elsewhere; in all three cases so as to dislocate price.

    The payout comes from previously-taken positions in derivatives whose final price depends on the price of the physicals you screwed around with.

    It follows that to prove manipulation, a regulator must prove the playa had no rational reason for the physical trades he did. Dodd Frank can say what it likes about intent, but if a regulator cannot

    1) understand physical flows well enough to explain them to a judge and hence
    2) show that a set of physical deals had no goal other than to alter the derivatives price

    then s/he is sucking on the hind tit.

    If you made it a strict liability offence like illegal parking, i.e. all they need show is that you did it and you are guilty, you still have to do 1). And this is still just as hard. You’d have to show that the playa’s movement of a million tonnes of stuff from A to C caused the price dislocations seen in A, B, C, and D.

    As you say, if you can’t catch criminals, make criminals of whoever you can catch.

    Comment by Green as Grass — October 9, 2014 @ 8:55 am

  2. @Green. Oh, I know all about corners. I like to say I wrote the book on them. Yeah, it’s #5,747,000 on Amazon, but I did write the book. (And it’s almost 20 years old.) I have also published 10 articles on manipulation, and testified in several corner cases.

    One of the things that drives me mad is that it is able to prove, to a high degree of confidence, whether the accused had a non-manipulative, commercially reasonable reason for the derivatives and physical trades (including the deliveries taken). I analyzed this extensively in the Ferruzzi soybean episode. I also did it in a blog post on the Armajaro cocoa corner back in 2011.

    I also have a very amusing story about the time I was retained by the Winnipeg Commodity Exchange to investigate an alleged canola corner. This culminated in my giving a presentation before the WCE board, which included the alleged manipulator. He thought he could brow beat the 30-something professor. Wrong. After an hour, he gave up, and the rest of the board was fully in agreement with my assessment.

    Insofar as judges are concerned, I was able to walk a federal court judge through the Ferruzzi case, and by the end of my testimony, he clearly got it.

    It’s commonly believed it’s hard to get into the mind of a manipulator. But big price distortions necessarily require a manipulator to take actions that are clearly irrational for a competitive commercial firm. In Ferruzzi’s case, it said it needed beans to meet an export order to the Soviets. But it took delivery of beans in Chicago, and ended up paying $.35/bu more to use those beans for export than it would have had to pay to buy them at NOLA. In a business where people will sell their mother for a half cent a bushel if the volume is big enough, nobody leaves 35 cents on the table.

    The problem is that the CFTC made some incredibly stupid decisions in the 1980s, notably Indiana Farm Bureau and Cox & Frey (and in re Cox). This has given legal loopholes that manipulators can waltz right through. I’ve been on a 20 year crusade to try to correct these errors.

    The ProfessorComment by The Professor — October 9, 2014 @ 3:09 pm

  3. @Green-I used your catch/criminals quote in a response to a press inquiry about the spoofing prosecution story, and it made it into print: Second page (or just search on Pirrong).

    The ProfessorComment by The Professor — October 10, 2014 @ 4:37 pm

  4. […] government enforcers-including not just CFTC but the Department of Justice as well-is spoofing. As I discussed late last year, the DOJ has filed criminal charges in a spoofing […]

    Pingback by Streetwise Professor » The Clayton Rule on Speed — March 1, 2015 @ 1:12 pm

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