Editorial comment

	Vol. 230 No.10
PERRY A. FISCHER, EDITOR

New rules for traders, gamblers and capitalists

In the last 10 years, the rules under which all things are traded have changed considerably. Many would argue that these changes are responsible for the bubbles in prices for commodities, housing and a host of other “hockey sticks”—you know, those graphs that tread along for decades more or less at one level, then suddenly climb upward, forming a hockey stick—of the sort that we’ve seen in the last six years. Well, if the politicians follow through with their plans, the rules in trading and related banking practices will soon change radically. And it won’t matter whether you are reading this in the USA or are one of our 24 readers in Mongolia; you will be affected. Here’s the plan.

The Commodities Futures Trading Commission (CFTC)—the watchdog agency for trading commodities on US markets—is quasi-political. Its five commissioners are chosen by the US president, three of whom can be from his party, including the chairman. The new chairman is Gary Gensler, a former partner at Goldman Sachs who spent 18 years at the firm before taking a post at the US Treasury, and who once argued that swaps and some other derivatives should be free from regulation. Apparently, he’s had a change of heart.

First on his list is reporting transparency. Previously, the COT (Commitment Of Traders) had two categories, Commercial and Non-Commercial, which made it hard to tease out the gamblers from the Farmer John hedgers. So the definition of “legitimate hedging” was blurred. But as of September, there will now be four categories of traders: Producer/Merchant/Processor/User; Swap Dealers; Managed Money; and Other Reportables.

In a speech before the IEA in Paris on Sept. 23, Gensler said, “Nearly 70 parties exceeded accountability levels on the four major energy contracts in the last 12 months.” The exchanges currently set position limits on energy, not the CFTC, but the CFTC has the authority, and will likely implement these limits on energy in the near future. Position limits should help prevent market manipulation. A small 1991 decision by the CFTC allowed position limits to be avoided by laying the risk off in a swap. There are more than a dozen types of these side bets on bets, or derivatives. This became a popular practice, but because the swaps market was (and still is) “dark,” what the real aggregated positions are, as well as who holds them, is unknown.

Also on the list of changes are higher margin requirements in general. This means that the amount of actual cash a trader has at risk will increase, which should decrease leverage. During the run-up to $145 oil, the margin got as low as 7 cents on the dollar.

Virtually all national agencies worldwide are committed to creating a new regulated market, the swaps market, which will be transparent and have position limits. In the US, the CFTC wants to be the primary regulator of this new swaps market, but there might be a turf war with other agencies. It is interesting that, to my knowledge, nothing is being done about the $50 trillion in current swaps, nor the “net zero” strategy that causes most of them to form an interrelated house of cards. Thus, you have such things as an insurance swap on an insurance swap—a second- or third-order derivative. This was a major cause of the credit freeze among banks earlier this year. By way of these swaps, they all owed each other billions, but who would, or even could, actually pay? And, in any event, they never intended to pay, anyway. They still don’t.

Legitimate hedging—the insurance policy that airlines use to set a future cost for fuel, or that Farmer John has traditionally used to guarantee a price for his beans—will still be available, of course. But will all of these changes increase the cost of that hedge? The biggest concern is reduced liquidity—the pool of money that allows one to easily find a counterparty to a trade. Theoretically, if liquidity decreases, the bid-ask spread increases. Position limits can enhance liquidity by promoting more market participants.

At a recent meeting at the Houston offices of Deloitte & Touche, senior manager Howard Friedman said, “For every person that claims this [liquidity change, increased spread] will result in upward pressure on prices, there is someone who says the opposite; I know of no definitive study that answers the question.”

However, by most measures, lack of liquidity is not a problem today. Did we need more liquidity back in the 1980s? Sure, and maybe even in the ’90s, but not today; some of those hockey sticks show the enormous increase in traders and trading volumes in recent years. Airlines, for instance, like to cite the statistic that there are 22 “paper” barrels of oil traded for every physical barrel traded. That’s over 95%. More conservative measures put the figure closer to 80%. Moreover, those in the trading business and others who benefit from it would say that the ratio of paper-to-physical barrels is not a good measure of liquidity, and that, today, “sophisticated” hedging could require hundreds or even thousands of trades.

But do markets really need too-big-to-fail “investment banks” like Golden Sacks (sic) buying millions of barrels of physical oil and storing it, then making hundreds of paper barrel trades, all for the supposed purpose of legitimate hedging(!)? Markets worked fine before a change in law in 1999 allowed these behemoths to form. Most of their trading departments operate as profit centers in their own right, anyway.

Finally, there is a real concern in the London and NYMEX exchanges that traders will just move to Bongo Bora or some other island that will guarantee secrecy for traders. London and New York are pushing for the International Organization of Securities Commissions to get all its members to adopt these new rules and prevent such an offshore migration.

President Obama and most of the other leaders of the 20 richest nations (G20) think that they can keep the financial institutions in check by requiring higher cash buffers, limiting executive bonuses and improved reporting—in short, by out-financial-engineering the financial engineers. I’m not so sure. Wouldn’t it be easier and more failsafe to just reestablish the rules as they were in 1990, before these financial megaliths were too big to fail? I doubt that consumers, oil companies and Farmer John need second-order derivatives and investment banks to survive.

I am sure that what the world needs are more civil engineers, not more financial engineers.