I’m sure that no one would be surprised that CFTC Commissioner Bart Chilton was not pleased by my recent post that lambasted his equation of the activities of ETFs with manipulation. Well, the sarcasm was arguably overdone (that NEVER happens, I’m sure you’re saying), but I stand foursquare by the substance.
Well, now Commissioner Chilton penned an editorial in the Des Moines Register that lays out his argument for the need to restrict speculation. It is a very weak argument indeed, and it would be a tragedy if anything like it is the basis for major changes in the regulation of derivatives markets.
He starts with a wild mischaracterization of history:
For a hundred years, farmers in Iowa and around the nation have been able to hedge their business risks in the futures markets. The entire endeavor has worked well for farmers, futures exchanges and our economy. In the last few years, however, things have changed. New “non-traditional” speculators, such as hedge funds, index funds, pension funds and endowments, have all entered the futures markets, bringing with them massive new liquidity but also some very real concerns. Unlike commercial speculators - for example, farmers, processors and refiners who actually do business in the underlying commodity, be it corn or beans, natural gas or crude oil - the new speculators have no such similar interests. The new speculators are only interested in one thing: increasing long-term profits in their investment portfolios. Therefore, their trading strategy differs significantly from the commercial traders who move in and out of the markets on a regular basis, depending upon many market-based factors.
This is to suggest that speculators looking only to make money, without “do[ing] business in the underlying commodity” are a new phenomenon. I’m sure that readers of the Register in 1909 or 1899 or 1889 would have begged to differ. Moreover, speculators of whatever age “have moved in and out the markets on a regular basis, depending on many market-based factors.”
This argument seems to make motive the primary criterion for determining whether somebody is eligible to trade a futures market. This is truly disturbing. It also suggests that Commissioner Chilton believes that commodities should be fenced off from other financial markets. This is bad finance, and actually harms market users by interfering with the efficient transfer of risk.
Chilton also says: “The new speculators buy into the markets for years, and stay there.” And we are to conclude . . . ? And again, there have been many speculators that have made it their living for long periods.
As for evidence, Commissioner Chilton relies on one of the least creditable tropes: the “some suggest” argument:
Due to the influence some suggest the new speculators may be having on prices, however, there may be some changes on the horizon for these new players.
I (and others) suggest otherwise. So where does that leave us?
Then he pulls out the “it’s possible” justification:
Just as the tide raises all boats, it is possible that this massive influx of capital helped to raise commodity prices beyond what the simple forces of supply and demand would dictate. The crude oil “commodity bubble” is a good example. To date this year, crude oil is trading at roughly $70 a barrel. While that is a far cry from the incredible (and some say irrational) high of $147 last summer, the current price is still up over 60 percent from the beginning of this year. Does that make sense?
A lot of things are possible. Some evidence would be helpful. The role of evidence is to help sort out what’s probable from what’s possible. You can’t make policy on the possible, since so much of the possible is contradictory. X may be possible. Not X may be possible too. We’re right where we started. Reasonable analysis requires effort to determine which of these possible outcomes is more likely, and to estimate the costs of incorrect conclusions. Identifying the possible is the beginning of an inquiry. It clearly cannot be the end.
And note the second helping of the “some say” trope: “incredible (and some say irrational) . . .”
In fact, economists have known for a long time that commodities can exhibit substantial variability, and that in particular, in models where only fundamentals drive prices, prices spike and crash with regularity. That’s exactly what you’d expect in a market for a commodity like oil. There’s no reason to invoke the “bubble” word to explain big moves in commodity prices.
Indeed, the reason speculators are attracted to commodities is the volatility. That’s a lot more plausible statement than to say that the speculators cause the volatility.
Now we get to the punchline:
Supply is at a 10-year high and demand is at a 10-year low. You do the math; prices should be lower. And if the cause was uneconomic speculative activity (that is, not caused by the forces of supply and demand), then regulators have a responsibility to act.
There is no doubt that the current commodities market is more puzzling on the surface than what happened in 2008 or early 2009. But speculation by financial players in the US or the UK is hardly the first thing that bears scrutiny. Indeed it should be about the last. In all major commodities, the big buyers have been China, China, and China. China has engaged in a stimulus that beggars the imagination, and probably in part to reduce its exposure to the dollar, a lot of that money has gone into commodities from aluminum to zinc. The CFTC–with considerable Congressional cheerleading–is on a snipe hunt, and ignoring major factors in the market. If Commissioner Chilton is puzzled, he needs to read more.
And note the tricky segue in the argument: “if the cause was uneconomic speculation . . . then regulators have the responsibility to act.” But the “if” remains just that. Chilton certainly has not provided a scintilla of evidence to support that contention. He mentions the CFTC hearings on position limits, which generated zip, zero, nada in terms of anything that would pass the laugh test in terms of evidence.
And Commissioner Chilton then fails to man up and take a stand himself, instead invoking the “some say” argument yet again: he describes the hearings as a step in a process “to address what many call ‘excessive speculation’ in our futures markets.” Again. Many say it ain’t. ”Some say”–even “many say”–is hardly a legitimate basis for any major policy initiative.
Amazingly, Commissioner Chilton repeats the “unintentional manipulation” gaffe:
The clear message is that physical commodities - like those in the agricultural, energy and metals arenas - are too important to our nation to allow even the possibility of price manipulation, intentional or unintentional.
He will undoubtedly say that he is using the word “manipulation” in some common-sense use of the term to mean the actions of traders that affect prices.
That doesn’t cut it, for at least three reasons:
- First. There is no common-sense use of the term. That’s been a problem for a long time–and is exactly why I quoted the Texas cotton broker in my original post. Or to quote my book on manipulation, if Ambrose Bierce was writing the Devil’s Dictionary of Finance, I would define manipulation as anything that causes me to lose money.
- Second, this is sort of the immaculate conception theory of prices. If trading activity doesn’t affect prices, what does? Surely public information releases (e.g., a crop report) have an effect, but people still interpret those releases differently and trade on their interpretation. Moreover, some traders have private information, and trading on that information moves prices. That tends to make prices more informative. That’s a good thing. It’s called price discovery. How can you have price discovery if trades don’t affect prices? I should also note that hedgers’ trades can affect prices. Putting on a big hedge may require a move in price to find somebody willing to take the risk. Here the market is discovering the price of risk, and consenting adults will negotiate a mutually agreeable price. And such a price will almost certainly be different than if no such trade had taken place. Thus, hedgers can have a price impact. Are they manipulators too? (And, I might add, hedgers will have a bigger price impact if speculation is constrained. So, if trades that impact price are manipulative, and hedgers have a bigger price impact when speculation is constrained, wouldn’t that make the party that constrains the speculation an accessory in the manipulation? That question is only half in jest.) In other words, defining manipulation to mean any trade that has a price impact is complete non-sense, not common sense. Such markets exist in textbooks, and nowhere else.
- Third, and most importantly, Commissioner Chilton is one of those responsible for enforcing the anti-manipulation laws. These laws make manipulation a felony. They also subject manipulators to the prospect of heavy fines, and great reputational damage. As a result, no CFTC Commissioner should use this term imprecisely, or make statements using words that have legal meaning in such a cavalier way. In other words, I don’t believe that someone in the position of enforcing the law has the luxury of making such implicit distinctions on matters of potential legal import.
The term is provocative, and its use suggests that the markets have been manipulated. People believe that manipulation is wrong, and many know that manipulation is a crime. This creates a presumption that there is something wrong–manipulated–in the markets that need correction.
I would also suggest that this could lead to serious difficulties for the Commission, and for Commissioner Chilton, if the Commission ever has to rule on a manipulation case. I can see a defendant appealing an adverse Commission decision on manipulation by saying that one of the Commissioners had written in a way that could suggest ignorance of the law, and/or a prejudicial view of the activities of speculators.
It seems to me that Commissioner Chilton is attempting to have it both ways: to insinuate that the markets have been manipulated to persuade people of the need to regulate more aggressively and intrusively, while avoiding having to provide evidence to support his insinuation, escaping instead with evasions about how he’s not using the term in the legal sense, just in some “common sense” way.
But if the activities aren’t illegal, then what is the justification for the regulation? And if there is a justification other than manipulation as legally defined, why use such an inflammatory term that has a specific legal meaning, rather than explain precisely what that justification is? Why not set out in plain terms exactly what he thinks is wrong with the activity of speculators, and their effect on prices, and let people analyze that contention without waving the bloody shirt of manipulation to inflame passions? And maybe, just maybe, provide some reliable evidence in the bargain, rather than relying on the “some say” evasion.
I don’t think that’s too much to ask of those responsible for the regulation of markets with huge sums on the line. In fact, I think it’s far too little to ask. But I’ll take it as a start.