Monday, October 22, 2007

Regulating Speculation

The front page of the Sunday Washington Post featured an article on the perils of speculation on under-regulated energy futures exchanges. The Post cites the cost to consumers from speculators driving up the cost of these commodities and makes a case for expanding both the powers and budget of the Commodities Futures Trading Commission (CFTC), the federal body established to regulate such transactions. However, the article also describes how further regulation might drive this trade off the regulated exchanges and deeper into the unregulated and much less transparent over-the-counter markets (OTCs.) While all of this is interesting, it reflects the typical shortfalls of coverage that treats futures markets as black boxes. The reality is more complex and less nefarious--and the likely solution much simpler--than the Post suggests.

Futures markets offer important benefits for all participants, particularly for those seeking to manage the price risks of the physical oil positions intrinsic to their operations. That includes oil, gas and electricity producers, refiners and large consumers. The fixed-price heating oil contracts that have become so popular with consumers would not exist without thriving futures markets. Purely financial participants play an essential role in these markets, providing liquidity and taking offsetting positions that the physical players might eschew on any given day. Pegging the price of physical transactions to the settlement prices of these exchanges became popular starting in the late 1980s, because their liquidity and transparency was impossible to match for all but a few high-volume physical trades. The other main benefit for exchange participants is the virtual elimination of counter-party risk, the risk that when the time comes to collect the oil or money owed at the settlement of the transaction, the other party won't be able to make good.

The OTCs serve a different, but complementary role, facilitating transactions that are too specialized or thinly-traded for the established futures exchanges to take on. These can be very lucrative deals for market makers, because transparency is low and transaction costs are often very high. The frontier between the exchanges and OTCs is dynamic, with the former periodically offering new products that encroach on the turf of the latter--sour crude, fuel oil, etc. Anything that made the futures markets less useful or more expensive for their participants would drive trade toward the OTCs, and that's the chief risk of over-regulating these exchanges.

Several months ago I wrote a lengthy posting concluding that it was plausible that speculation had contributed to the dramatic increase in oil prices over the last four years. I took a lot of flak for that suggestion, which I still find eminently defensible on fundamental economic grounds. Notwithstanding expanding global demand for oil and the sharply increased marginal cost of bringing new supplies to market, along with a wide array of "above-ground" risks, financial speculation in oil by non-industry players represents a growing source of demand in the virtual markets that set the price for much of the physical trade in oil and petroleum products. But commodity markets, either regulated formal exchanges or unregulated OTCs, are not responsible for this phenomenon. They are merely the conduit for the impulses of an increasingly securitized financial economy that bets on every aspect of life, down to the weather. The pitfalls of some of these complex bets often don't become apparent until after they go bad, as we are witnessing on a large scale today.

Now factor in the legitimate national interest of the US government and the public it serves to minimize the impact of financial speculation on the final cost of petroleum products and the other forms of energy upon which the real economy depends. There is no corresponding national interest in allowing speculators to profit from these commodities, beyond a practical interest in allowing enough liquidity to ensure that these markets work smoothly for of all participants, especially those with physical exposure to hedge. If speculation in oil commodities drove their price up by $10/barrel, that would cost businesses and consumers $70 billion/year and increase the US trade deficit by about $40 billion. On that basis, I believe there is a solid argument for new regulation. The trick is ensuring that the treatment doesn't kill the patient.

That's where I think the Post and various members of Congress pursuing tighter scrutiny of commodity exchanges are on the wrong track. The issue here is not the exchanges, or even the OTCs, but rather the investors using them. The challenge for an external party trying to piece together all of the market positions taken across various futures exchanges and OTC markets by a party such as Amaranth, the new poster-child for commodities excesses, looks truly daunting, even for auditors examing them after the fact. The most sensible alternative to such a regulatory nightmare would be to require investors themselves to disclose aggregate positions exceeding some threshold to federal regulators, just as the SEC requires the disclosure of any stake over 5% in the equity of a traded company.

While journalists and the public may regard such speculators as undisciplined cowboys, every one of them has internal controls that require daily or real-time "mark-to-market" trading reports, tallying the entity's current exposure to each commodity. Reporting that exposure to the CFTC whenever it exceeded 10 million barrels of oil or the equivalent in gas or other energy commodities could be accomplished with minimal new bureaucracy or accounting burden, and without distorting the relationship among the physical, futures and OTC markets. That would provide the over-the-shoulder scrutiny that the Post and others advocate, but at a much lower cost to the economy.

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