Streetwise Professor

April 6, 2009

Today’s Congressional Comedy Break–The Energy Market Manipulation Routine

Filed under: Commodities,Derivatives,Economics,Energy,Politics — The Professor @ 7:37 pm

Last month Senator Maria Cantwell (Duh-W) announced two pieces of legislation to ”  help prevent future energy price bubbles and market manipulation“:

The first, S. 672, which she introduced on Mar. 24, would give the Federal Energy Regulatory Commission authority to issue cease-and-desist orders against manipulative schemes in progress. The US Securities and Exchange Commission and Commodity Futures Trading Commission already have this authority, she noted.

She said the bill also would make FERC able to freeze the assets of any entity suspected of market manipulation. It would give the commission authority to temporarily change or suspend power rates for up to 30 days during an energy emergency caused by market manipulation. And it would have any potential natural gas refund accrue from the time FERC brought a case (an approach currently used in electricity markets, according to Cantwell) instead of when it actually proves it.

“It will allow FERC to act more like a cop catching a robbery in progress instead of trying to piece together what happened at a crime scene after the fact,” she said.

Yes, we are expected to nod and trust the formulation of rules regarding the operation of our vast, and enormously complex financial markets to the likes of Senator Cantwell, who is apparently rather ill-informed about ordinary policing activities, let alone about the relevance of the possibility that cops may now and again interrupt an armed robbery at the Quickie Mart (Apu! Duck!) to the determination of the efficient way to reduce the frequency of manipulation and “excess speculation” in energy markets.  

First off, the premise of Cantwell’s analogy is wildly inaccurate.  Just how often do cops intervene while felonies are in progress?  Virtually all police work is done after the crime has been committed.  Cops respond to the calls of victims, or alarm calls, and in the vast majority of cases arrive after the perpetrators have fled.  Then begins the arduous process of “trying to piece together what happened at a crime scene after the fact.”  That’s exactly what cops spend most of their time doing.  Either Senator Cantwell watches way too much TV, or not enough.

Second, even if one were to grant that cops have the authority to intervene in crimes in process, and sometimes utilize that authority, that does NOT imply that this is the best way to fight market manipulation.  The law and economics of the trade-off of prevention vs. deterrence is very well understood.  (Steve Shavell wrote a very thorough article on the subject in the JLE in the early-90s.)  Deterrence–piecing together what happened after the fact, and imposing sanctions on those found to have committed harms–works best exactly in conditions like those that characterize a market manipulation.  Specifically, a real manipulation is readily detectable after the fact.  As Judge Easterbrook has written, “an undetected manipulation is an unsuccessful manipulation.”  Moreover, manipulators are typically not judgment proof.  That is, they are typically quite wealthy, and can afford to pay fines or other punishments equal to the harm they inflict.  Those that aren’t judgment proof are the firms whose manipulations failed spectacularly, and ruined the perps financially.  From a deterrence perspective, that isn’t a big deal, because fining successful manipulators can make the payoff to manipulation negative in every state of the world (fines when your manipulation succeeds; financial ruin when it doesn’t).  These are the conditions that make deterrence preferable to prevention.

Indeed, information considerations strongly favor ex post deterrence (as I argue in my 1996 book on manipulation).  Manipulations often unfold very quickly.  Moreover, the most distinctive effects of manipulation, such as the collapse in prices that follows the end of a corner (the “burying the corpse” effect), are virtually unmistakable after the fact, but cannot be observed while the corner is in progress. As a result of this fact, and others,  regulators necessarily have far less information about whether prices are distorted while a manipulation is in process, than after the fact.  Due to this information disadvantage, both “false positives” (intervening when a manipulation is not in reality occurring) and “false negatives” (failing to intervene in a real manipulation) are more likely when one attempts to act during an alleged manipulative event, than to wait and impose damaging sanctions after the manipulation is over.  Indeed, given that a mistaken intervention in a market would be extremely disruptive, false positive interventions are very costly.  That is, mistakes are much more likely, and the costs of mistakes are higher, when regulators attempt to intervene in real time, rather than to deter manipulation through the imposition of penalties.  (Moreover, private actions by those harmed by manipulation also have a strong deterrent effect, can rely on the superior information available after the fact, and can also fill the deterrence gap when regulators fail to act even after the end of a manipulation, as is too often the case.)  

Moreover, the costs of ex post deterrence only need be incurred when a manipulation has actually occurred, whereas maintaining a “police force” and surveilling every market is quite costly, and these costs must be incurred even when no manipulation is occurring.  

In other words, Cantwell is only 180 degrees off.  But it was one of her better days, I’m told.  

A couple of other entertaining thoughts.  First, the article states:

FERC would welcome this additional authority, according to one of the hearing’s witnesses, Anna Cochrane, acting director of the commission’s enforcement office. “Congressional action to give the commission cease-and-desist authority for violations of the [Federal Power Act] and [Natural Gas Act] and the ability to freeze assets of entities that violate the market manipulation rules would give the commission the same enforcement tools that both the SEC and CFTC have long possessed. In addition, authority to temporarily suspend market rules on file under the FPA when necessary to protect against potential abuse of market power could be useful,” she said in her written statement.

Imagine that.  A government agency that would “welcome . . . additional authority.”  Shocking.

Second, the article notes that CFTC and SEC have this authority.  With respect to market manipulation, it is seldom used.  

More humor:

Cantwell said the second legislation the hearing would examine would establish an office within EIA to collect and analyze information from physical and paper oil markets. This would improve EIA’s ability to predict future energy prices and help regulators police markets more effectively, she said.

In his written testimony, McCullough said no federal agency has been directed to investigate and explain last year’s extraordinary crude oil price changes despite oil’s arguably being the US economy’s most important commodity.

“The inability of the federal government to fully investigate oil price behavior in 2008 is fundamentally a data problem. Perhaps it is not a coincidence that oil is the most opaque of our nation’s energy supplies. The transparency legislation that you are discussing today is a step in the right direction because it will expand EIA’s ability to track oil inventories within the US by owner,” he said.

Sure.  EIA will be just dandy at forecasting energy prices.  And how is EIA, which has no enforcement authority, supposed to coordinate with CFTC and FERC (and perhaps soon, the FTC, when it puts its oil manipulation rule into effect), which do?  

“McCullough,” by the way, is Robert McCullough, Jr.  He is one of several people, e.g., Michael Masters, who routinely testifies before various House and Senate committees on energy market speculation and manipulation issues, and just as routinely parrots exactly what Cantwell, et al, want to hear.  The regular presence of this tiresome cast of courtiers, who IMO have little if any demonstrated expertise, and who routinely make idiotic arguments unsupported by logic or evidence, make the hearing process look like Kabuki theater, or a show trial.  It’s not intended to raise issues, find facts, sift evidence, or air serious disagreements.  Instead, it’s purely a theatrical production, with a pre-scripted outcome, intended to convey the impression of investigation, inquiry, and debate.

In the scheme of things, manipulation should be one of the easier things to regulate and deter in financial markets.  Nonetheless, Congress and various alphabet soup regulatory agencies (GFA, CEA, SEC, FERC, and probably soon, FTC) have made a complete botch of it for going on 87 years now.  (Yeah, I know.  But I’m feeling generous today.)  Yet we’re supposed to have confidence that that same Congress and same array of regulators (plus some more) have the knowledge, competence, and incentives to legislate and regulate much more complex and arcane aspects of the operation of the financial markets (e.g., clearing, “excess” speculation, product design).

Just remember the three big lies.  The check is in the mail.  I’ll respect you in the morning.  And the biggie: I’m from the government, and here to help you.

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