The Financial Times’ Energy Source Blog was kind enough to publish a piece I wrote that discusses the dangers inherent in overspeculated commodity markets. Click on the title to read “Why Commodities Regulation is Different.”
Posts Tagged ‘overspeculation’
Today’s Wall Street Journal features a misguided editorial blasting the CFTC for considering constraints on oil speculation. The piece serves as a good reminder of how often those schooled only in the stock and bond world misunderstand the function of the futures market and the role of speculators within that arena. The Journal’s editors and others are trying to apply the rules of those capital markets to contract markets like commodity futures. This makes no more sense than trying to play a game of baseball by the rules of football. In real life, as in the sports analogy, playing by the wrong rules leads to chaotic consequences.
Misconception #1: who should determine price? In the capital markets, speculators and investors determine the price of securities. This is not the way the commodity futures markets are supposed to operate. Commodities are consumables, not investment vehicles. Economic efficiency demands that the price be determined by those that produce or use these resources. The role of the speculator in price discovery should only be on the margin, testing the limits to see when commercial demand or supply enters the market. Speculators in these markets should not be the primary determinants of price.
“Overspeculation” or “excessive speculation” exists when speculators become primary drivers of price. When this happens, commodities are no longer efficiently allocated — if prices are driven below the point where commercial supply and demand meet, shortages result. When prices are driven to excessively high levels, economically wasteful inventory buildup is created; Nobel laureate Paul Krugman recently reversed his opinion on the impact of speculation, pointing to huge oil stores as evidence that oil prices have been artificially inflated. More dire consequences also can be the result of these price distortions, including unnecessary and economically damaging price volatility and even the potential for a systemic crisis in the oil industry and it financiers.
Misconception #2: We need all this speculation for liquidity. The commodity futures markets absolutely need a healthy amount of speculation to bridge the gap between commercial interests who may not be in the market at the identical time. But just like any powerful medicine, an overdose causes more harm than good. Speculation is good only up to the point where speculation becomes the main determinant of price.
There has been a great amount of confusion between volume, open-interest and liquidity. Traditional speculators are short-term traders who are indifferent to being long or short the market — such volume indeed creates liquidity. Much of the problem has been created by the new breed of non-commercial participant, particularly the commodity indexed funds which are long term holders and are overwhelmingly oriented to the long side of the market. They represent not liquidity, but a big fat bid, which actually drains liquidity from the markets by crowding out long commercial interests.
Misconception #3: Investors need unconstrained access to the commodity markets to protect against inflation. The idea that commodities are the only inflation hedge available to investors has been heavily promoted by those that profit from selling commodity-linked products. This is simply a myth promulgated by Wall Street marketing departments. As I’ve written about before, investors have very real, and possibly superior, alternatives, from TIPS to commodity linked equities.
Misconception #4: Position limits are an abridgement of free market rights. The confusion of capital markets with contract markets comes into play here. The imposition of constraints on non-commercial participation is not about heavy-handed regulation, but about appropriate market governance. In the capital markets, I know of nobody who complains about rules against front-running, touting or insider trading. Those are rules designed to protect the integrity of capital markets. Contract markets like futures exchanges need rules to protect their integrity as well. It’s just that different markets require different types of rules. In the futures markets, integrity implies that commercial interests determine price, and this requires governance that restrains non-commercial participants. Speculative position limits are one of the time-tested ways to ensure this critical integrity.
Informed people of good will can argue whether the markets are indeed “overspeculated” at this point. We can reasonably debate whether position limits are the appropriate response, or whether whole different types of governance are needed. One can perhaps even argue whether the risks of overspeculation to the economy should be balanced against the risks to Wall Street profits from curtailing their activities. However, those that argue that the futures markets should play by the rules of the capital markets merely reveal their ignorance.
The Commodity Exchange Act was passed in 1936. The legislation mandates that regulators prohibit “excessive speculation,” but never defines the term. In the current public debate about the role of speculation, there’s been some understandable unease as we all should feel discomfort at the thought of prohibiting any transactions in a free market system. It’s important to move towards a definition of “excessive speculation” if our policymakers are going to comply with existing law properly and if we are going to have functioning commodity markets.
It should be understood that “speculation” in the commodity world is a specific, technical term which has no ethical connotations. Speculation is simply those transactions entered into by entities with no legitimate commercial interest in the underlying commodity (or related commodity – e.g., an airline might legitimately hedge jet fuel costs with heating oil futures). The university endomwent manager making a permanent allocation to a commodity index is just as much a “speculator” as the day trader trying to make a quick buck in pork bellies. In other words, if you’re not a bona fide hedger, by definition you’re a speculator.
The introduction of OTC commodity swap contracts puts a slight twist on this definition. Wall Street’s swap desks are essentially “pass through” entities — if a swap desk is offsetting risks underwritten to a legitimate hedger, then their futures positions should be viewed as hedge positions; conversely if they are offsetting risks to say, an indexed endowment or to a commodity ETF, these should be considered non-commerical, speculative positions. The swap industry has tried to argue that every position they take is a hedge for some contract they’ve written — to my thinking this is an intellectually dishonest argument; the key factor is the commodity exposure of the end client, not the intermediary.
So just when is speculation “excessive”? In theory, the price of futures and derivatives should be a reflection of physical market pricing. That is, the price of consumable, commercial goods should be set by the consumers and users of such commodities. This makes good economic sense for allocating resources. The activities of non-commercial futures and OTC derivatives market participants should not determine the pricing. The reality has always been more complex — traditional speculators have served to bridge the momentary lack of a match of commercial interests (i.e., buyers and sellers not coming together at the exact time), and in doing so, set a market price. Speculators have also served to push the boundaries, finding out where commercials will enter the market, thus performing a price discovery role. However, in each of these traditional roles, commercial interests are “in the drivers seat” and the prime, long-term actor in setting price.
A good definition of “excessive speculation” is the market condition where non-commercial interests set the price. This occurs when speculative interests dwarf commercial volume and crowd out commercial transactions at a given price. The textbook belief is that this can never happen on the assumption that commodity prices are extraneous to derivatives market activity, and that there is an infinite supply of capital on both side of the market. Under such a theoretical system, when long speculators push up the price above the “true” level, for example, an adequate number of shorts will come in to stabilize prices. This is clearly an idealized and inaccurate set of assumptions as there is no known “true” price, speculative capital is not infinite, nor is it now neutral (many new entrants, e.g., institutions indexing, have a long bias). In the real world, speculation can be excessive.
Many commodity markets today display symptoms of excessive speculation. The breakdown of the basis (relation between physical and futures prices) and lack of convergence (cash and futures prices aligned at time of delivery) in certain agricultural commodities, the unusually high corellation with financial assets, and the huge buildup in oil inventories all bear witness to prices being distorted by non-commercial interests. The Wall Street firms that have profited from promoting and facilitating this participation are steadfastly denying the obvious evidence — they know that the simple recognition of this excessive speculation would compel regulators to act.
The crafters of the Commodity Exchange Act were right to worry about excessive speculation. When commodity prices are distorted by speculators, we all bear the economic burden – prices set too low cause disruptive shortages, those set too high result in wasteful inventory buildup. Distorted prices can send the wrong signal to the Federal Reserve and to investors. Erratic basis and convergence can financially ruin commercial participants and render the markets commercially unusable. The United States built up a huge competitive advantage in credible commodity exchanges — all this could be lost, too.
There are few higher economic callings for our regulators than ensuring the integrity of our financial markets. The policymakers of 1936 understood the dangers in “excessive speculation.” The CFTC begins public hearings on rules designed to protect against just this danger today. Let’s hope they get it right.
Going through the report, one of the footnotes briefly references an op-ed of mine that appeared in the Boston Globe last August and can be found here.
It’s interesting to see the Senate report touch upon the crude oil/wheat connection — the authors are absolutely right to see linkage. That connection is the fact that we are treating contract markets (whether exchange trades futures or OTC swaps) as if they were capital markets. These markets were designed with different ends in mind (contract markets are designed for risk transference, while capital markets are designed for investment), and require different rules of governance.
Whenever I write about the need for regulatory reform in these markets, I get some responses accusing me of everything from gross ignorance of the commodity markets to Marxism. The need for reform is consistent with broad free-market beliefs, but recognizes that those markets need governance (not necessarily governmental) to protect their integrity. In the capital markets, everyone accepts the need for prohibitions against front-running customer orders or trading on inside information. Contract markets need rules, too, (e.g., speculative position limits) and while these rules differ from those that govern investment markets, we should accept that they are no less critical.
Last week the Senate released a report that concluded that non-commercial participants, particularly index speculators have been disrupting the wheat futures market (for those not inclined to read the 247-page report, there’s a good summary in this BusinessWeek article). The term, “index speculators,” refers to that new breed of market participant that treats commdodities as buy-and-hold investments rather than as short-term trading vehicles. Index speculators are often people and institutions one would not associate with speculation — endowments and pensions, for example. They generally have bought into the notion that a basket of commodities (or commodity futures) is a legitimate investment asset class; this is a view I dispute — I know of no other “investments” where the inherent value can only be realized in the consumption and destruction of the asset.
The wheat report highlights one of the dangers of “overspeculated” futures markets, a condition where non-commercial interests so outnumber commercial participants that the relationship between cash and futures prices (the “basis”) breaks down. An erratic basis in a commodity futures contract is more than a mere curiosity: it can mean that the futures markets no longer offer reliable risk mangement tools for producers and users. It’s worth remembering that these markets were never intended to serve investors, but were chartered from the begining to serve the commercial commodity industry. Dramatic shifts in the basis can also cause severe financial problems for commercial hedgers who must meet margin calls.
A spike in the cotton basis in March of last year was devastating for that industry. I’ve often thought that the cotton problem was the “canary in the coal mine,” warning us of dangers ahead. Wheat going down the same path is troubling indeed. From the standpoint of greatest economic risk, one must wonder whether crude oil is also heading in this direction. If crude oil is “overspeculated,” there’s a particular vulnerability given the geopolitical risks that can crop up with oil. My sense is that much of the oil in storage is part of a cash/futures arbitrage play which means, as I believe happened with cotton, a sudden influx of futures buying would have no natural constraints, sending futures prices soaring. With the central role energy prices play in the economy and the heavy participation in the crude oil markets by our wounded financial companies, a price disruption of this nature could have far reaching consequences.
Last year there was a great debate about the role of index and other speculators in disrupting commodity prices. Unfortunately, too much of this debate centered on the oil industry, not only one of the deepest markets, but also one of the most opaque. It’s simply hard to get the data needed to see the risks in crude. Looking at smaller markets like cotton, it is easier to grasp that treating commodity futures as investment assets can cause grave problems. Although the debate is still tainted by politics, it’s good to see that these dangers are getting the recognition they deserve.
If we’re going to trade crude oil like a currency, we should regulate it like a currency, too.
I hold an apparently quaint and obsolete belief: “Not everything that can be traded should be traded. ” Specifically, there’s great danger in using long-term, long-only commodity futures positions as an investment asset class. The same is true of the derivative baskets of commodities that replicate such futures position. Please note that I’m not talking about futures funds (which trade both sides of the market and are generally in positions only for the short term), but rather the way that commodities are increasingly being used by pensions, endowments and hedge funds as investments rather than short term speculations; this has sometimes been called “index speculation,” to distinguish it from the traditional variety.
Investment flows into the futures market can distort the pricing that should instead be determined by producers and users of commodities. Price distortions of this type cause enormous economic inefficiencies, are deeply injurious to the world’s poorest, and create significant structural risk in the markets. The chart below is a good illustration of just how “financialized” energy prices have become, charting the trade-weight U.S. Dollar index (the dashed line) versus the DJ-UBSCI Energy Spot index (the solid line) since the beginning of the year:
As emphasized by the arbitrarily drawn horizontal line, these plots are virtually mirror images of each other (running a regression results in a correlation of -0.88). This corresponds to the type of linked price action we saw during the buildup to the commodity frenzy last year. It’s interesting to note that commodities like gold show nowhere near the correlation (-0.177) with the dollar over this same period. Clearly, the pricing of crude oil and energy products have become dominated by financial, not commercial interests. Specifically, oil is being treated as a currency and not as a commodity. This is a terrible idea, but apparently a terrible idea whose time has come.
While using crude oil as a currency/asset class is a bad idea, there are some good (or at least interesting) ideas on how to address the associated risks. I have been a fan of applying speculative position limits to energy contracts, importantly including the OTC swaps market. This approach has some downsides: a) it may be ineffective since the problem is really that all the positions in aggregate are dangerously large, but perhaps not on the individual basis constrained by position limits, and 2) it may simply migrate investment interest away from futures and into hoarding physical oil. In some ways this has already happened, as the speculative interest in crude oil (“virtual hoarding”) has created a cotango market that has resulted in a massive, arbitrage-induced inventory buildup (physical hoarding).
Last July as crude was peaking, my friend, Tom Rooke, submitted an alternative idea to the House Committee on Agriculture, the Congressional committee which oversees the Commodity Futures Trading Commission. With the bust in crude prices in the latter half of 2008, this whole issue was put on the back-burner. With energy prices once again being pushed up by speculative forces, it’s worth reexamining Tom’s idea. By way of credentials, Rooke has extensive experience in the world of commodities, having served as the head of UBS PaineWebber’s futures division for many years. He is an expert in the term structure of futures contracts and in cash/futures arbitrage.
Rooke’s proposal, in essence, regulates crude oil much like some of the ways that money supply is regulated. In his creative structure, the U.S. would require that holders of crude be required to maintain a reserve requirement which would be controlled by a central governmental authority, much like the Federal Reserve can change reserve requirements for banks. This would raise the costs of hoarding crude (probably not a bad thing), represent a second, private strategic petroleum reserve in event of national emergency (definitely a good thing), and provide a stabilizing buffer in crude oil pricing (much like what OPEC used to do when it had more market power). In the proposal, the initial transition period and reserve buildup would be eased through using depository receipts issued by the Strategic Petroleum Reserve. Tom’s submission can be read here: TWR Letter. The specific proposal starts on page 10, although the earlier pages include a discussion of index speculation and the evidence that it was impacting crude oil prices. It’s worth noting, that at the time the crude oil futures were in clear backwardation and the impact of speculation was more muted (Tom estimated 10% of price increases, I guessed around 20%); with the cotango markets we’ve seen more recently, speculation plays a more direct and potentially greater role.
It is critical that this issue be addressed. Rooke’s proposal may not be the right way to go, but it deserves serious consideration. On the third page of his letter, Rooke outlines just one type of structural risks we could face. We’re flirting unnecessarily with danger. What’s truly amazing is that without greater regulation of the commodity swap market, we won’t even know how close to the precipice we are or how far the fall might be.
Last year, in preparation for my July Capitol Hill testimony on the role of pension and index investing in the commodities market, I examined the much discussed relationship between the dollar and commodity inflation. I never published the work although I shared it privately with a few people involved in the policy debate. Frankly, I thought the bursting of the commodity bubble and the reversion to costly (from the standpoint of long indexers) contango markets would demonstrate the ultimate problems with viewing commodity futures as an asset class, but apparently here we go again…
With the short dollar/long oil trade once again rearing its ugly head, I thought it would be worthwhile to put the work out there with the write-up I did at the time. I concluded that the correlation was due to the financial trade rather than fundamentals. I was tentative in my assessment then, but feel more strongly about now with the benefit of hindsight.
I do believe that over the long term we are in for a good run of fundamentally justified hard asset inflation. However, some (not all) of the current runup in oil reflects the influence of financial players in the market place — once again, this market is becoming overspeculated with the “tail wagging the dog,” as financial flows overwhelm fundamental concerns. A renewed tight inverse relationship between the dollar and oil is evidence of this problem, not a rationale for the continued distortion of our commodity markets. Here’s what I wrote up then:
The Dollar and Commodities
June 20, 2008
Observers of commodity inflation often point to dollar weakness as a critical component of the price increases. While currency movements are an important factor in commodity pricing, it is only one of many influences. We use the $/Swiss Franc as a proxy for broad currency moves, since actual trading data for this preexists the Euro. We compare the Dollar/Franc series to the Goldman Sachs Spot Commodity Index both in aggregate since 1987, and broken into discreet 2-year increments. This produces some surprising results. For one, the correlation between commodities and currencies has not only been weak historically, it has also changed direction at times. This suggests that commodity pricing is generally dependent on a multiplicity of factors. More puzzling is the very strong correlation which has developed over the last 18 months. One possible explanation is that, given that this period coincides with an explosion of investment (index speculation) capital in the futures markets, commodity pricing is being driven by factors divorced from traditional physical supply and demand considerations.
Washington is starting to get serious about the regulation of Credit Default Swaps. Via the internet, I caught some of the testimony before the Senate Agriculture Committee. I particularly enjoyed Rick Bookstaber’s assessment, “Derivatives are the weapon of choice for gaming the system.” After acknowledging the original economic purpose of derivatives, i.e. risk managment, he continued:
As time progressed, however, derivatives found use for less lofty purposes. Derivatives have been used to solve various non-economic problems, basically helping institutions game the system in order to:
- Avoid taxes. For example, investors use total return swaps to take positions in UK stocks in order to avoid transactions taxes.
- Take exposures that are not permitted in a particular investment charter. For example, index amortizing swaps were used by insurance companies to take mortgage risk.
- Speculate. For example, the main use of credit default swaps is to allow traders to take short positions on corporate bonds and place bets on the failure of a company.
- Hide risk-taking activity. For example, derivatives provide a means for obtaining a leveraged position without explicit financing or capital outlay and for taking risk off-balance sheet, where it is not as readily observed and monitored. Derivatives also can be used to structure complex risk-return tradeoffs that are difficult to dissect.
These non-economic objectives are best accomplished by designing derivatives that are complex and opaque, so that the gaming of the system is not readily apparent.
For a balanced and thoughtful view of the regulation of derivatives, you might want to read his entire written testimony here (pdf file). His piece offers an excellent summary of the uses and misuses of derivatives and how that can spill over into market and economic consequences.
Another witness before the committee, Professor Lynn Stout of the UCLA Law School, pointed out how Credit Default Swaps have become overwhelmingly used as speculative tools, not risk management tools:
[I]t is clear that by 2008, the market for CDS, for example, was primarily a speculative market…. We know this with mathematical certainty because by 2008, the notional value of the CDS market (that is, the dollar value of the bonds on which CDS bets had been written) had reached $67 trillion. At the same time, the total market value of the underlying bonds issued by U.S. companies outstanding was only $15 trillion. When the notional value of a derivatives market is more than four times larger than the size of the market for the underlying, it is a mathematical certainty that most derivatives trading is speculation, not hedging. And both economic theory and business history associate speculative markets with serious negative economic consequences.
The overwhelming speculative volume in the Credit Default Swap marketplace is a good example of “overspeculation,” an excessive diversion of investment capital away from traditional vehicles and into pathways that ultimately distort and undermine the markets.
The hearings were quite interesting in tone as well. As opposed to many of the hearings last year (like the one I participated in with the House Agriculture Committee), the financial services industry seemed very much on the defensive yesterday. Hopefully, this will allow some of the much-needed reform of the derivatives market to proceed.
Bloomberg carried a story the other day citing Brooksley Born in dicussing the way that major derivatives trading firms are fighting the administrations efforts to govern the over the counter (OTC) derivatives markets, particularly the swaps market. Born has credibility on this issue. In 1998, as the head of the Commodity Futures Trading Commission, she fought unsuccessfully to regulate the growing swaps market. In truth, Born’s efforts were focused on regulating the interest rate swaps market which has not played any meaningful role in the present crisis. However, governance of the OTC swaps market would have eventually included both the credit default swaps and the commodity swaps that have played such a destructive role.
As the battle over establishing proper governance gets going, I’ve found an insightful article on Rick Bookstaber’s blog. Rick is a seasoned Wall Street risk management veteran and author of the prescient book, “A Demon of Our Own Design.” In his latest post, he argues that many of the industry’s arguments against regulation are (unsurprisingly) false.
What went so wrong in the OTC derivatives market? Contrary to the revisionist history being promulgated, I would argue that the initial deregulation of these markets in 2000 was well intentioned and reasonable. Interest rate swaps dominated these markets and were being used as risk reduction tools by bona fide institutional hedgers — i.e., sophisticated institutional investors who had offsetting real positions in traditional securities. Over the last few years, however, certain derivatives instrument were used in ways never imagined a decade ago, and these markets became dominated by speculators — those taking on risk in what is essentially a “bet,” whether on a company’s credit quality, on the price of food or energy, or other metrics. In another post, Bookstaber lays out some of the new applications for these instruments:
They are used to: avoid taxes (for example, total return swaps are used to take positions in UK stocks in order to avoid transactions-based taxes); take exposures that are not permitted in a particular investment charter (for example, index amortizing swaps were used by insurance companies to take mortgage risk); speculate (for example, the main use of CDSs is to allow traders to take short positions on corporate bonds); lever beyond an allowed level; and take risk off-balance sheet, where it is not as readily observed and monitored.
All this allowed for an explosion of this marketplace. The problem with all this massive expansion is that these are not traditional investment markets, but rather contract markets, akin to the futures exchanges. And just like the futures markets, the OTC derivatives market would benefit from some of the tried and true governance of those markets: a clearinghouse structure, margin requirement to ensure contract performance, and, for underlying markets with limited liquidity, speculative position limits to ensure that these side bets don’t end up distorting underlying prices.
The regulatory battle will be hard fought. These are complex issues where most (but not all!) of the knowledgeable players work for firms that are making a lot of money from these transactions, no matter the risks they pose to the economy in aggregate. The credit default swap mess is contained for now by the general industry disarray. However, given continued indications that commodity inflation is resurfacing, I believe we may well see the commodity problems of last year return, and potentially with greater magnitude. The only way to prevent more damage is with appropriate market governance. The administration has taken a good first stab at this issue; let’s hope that Congress can follow through.
I had the pleasure of attending a discussion as part of the Alvin Hansen Symposium on Public Policy series at Harvard this afternoon. The topic was “Re-Regulating the U.S. Financial Markets.” I thought my readers might be interested in some of the remarks.
I was unable to stay for the broad panel discussion at the end, but heard presentations from the two main speakers, Robert Shiller and Randall Kroszner. Shiller’s name may be more familiar, as the author of “Irrational Exuberance,” the co-creator of the Case-Shiller Home Price Index, and the Arthur M. Okun Professor of Economics at Yale. Kroszer’s career is equally impressive, both as an academic, serving as the Norman S. Bobins Professor of Economics at the University of Chicago Booth School of Business, and as a former Governor of the Federal Reserve.
The two distinguished presenters approached the regulatory challenges differenty, Shiller from a largely philosophical/ethical viewpoint, and Kroszner from a “nuts and bolts” policy standpoint. The areas of common conclusion were particularly interesting. A few highlights:
- Both speakers viewed the crisis as a worldwide failure of risk management, both on the part of individuals as well as institutions.
- Both emphasized the need for better consumer protections for users of financial services. Shiller suggested that fees associated with financial advice be hourly and consumers be given a tax credit.
- Both suggested that better structure be in place for when things go wrong. Shiller suggested that mortgages have automatic (and ongoing) workout provisions, while Kroszner discussed the need for better resolution structures for non-bank financial institutions that get in trouble.
Kroszner went on to outline some specific areas of concern: 1) the need for private sector solutions, not just government regulations, 2) reducing the “pro-cyclicality of regulation” (regulations should slow the excesses at the frothiest tops, not clamp down when times are toughest), 3) eliminate the too-big-to-fail and too-interconnected-to-fail risks. He spent a great deal of time reviewing the last risk, particularly the regulatory void deailing with long-dated financial contracts like the swaps market. Kroszner supported many of the reforms that have been discussed elsewhere: a move to a central clearinghouse for swaps and standardization of contracts.
I thought Kroszner had some interesting observations about the ratings agencies. He pointed out that the ratings agencies had actually been very successful in being discriminating about traditional corporate credits, giving only about 12 U.S. companies the top “AAA” rating versus 1,000s of different securitized mortgage issues that got the same top rating. This is not a completely legitimate comparison for many reasons, but Kroszner made a good case that we should not “throw the baby out with the bathwater” — the credit ratings agencies can provide value, and he argued that they work best when transaparency allows third parties to verify their work. The analogy would be the role that the fixed income research departments at investment banks play in keeping the rating agencies honest by offering competing insight into coporate credit quality.
Both speakers conveyed a strong sense that capitalism and belief in free markets were being tested, and that regulatory reforms had to answer to a standard of “fairness.” Shiller spoke explicitly about “democratizing and humanizing” finance. These are important considerations — but also represent a few slippery slopes — one person’s “fairness” is another’s tyranny. That being said, I appreciated the focus on the free markets and the financial industry being in the service of society and individuals. I can only hope that our public policymakers engagement with the regulatory challenge will be even half as thoughtful as today’s discussion. My appreciation to Harvard for allowing the public to attend.