Extending Principles for Price Reporting Agencies to All Assessments[†]

Allegations of price manipulation in UK wholesale natural gas prices by some major power companies and financial institutions could not have come at a worse time for price reporting agencies (PRAs). Less than a month after IOSCO’s publication of principles for oil price reporting agencies, a price reporter at energy‐ industry data provider ICIS went public with the charge that natural gas prices are regularly manipulated by physical and financial traders, and that prices assessed by price reporting agencies do not accurately reflect the underlying physical market. Furthermore, he argued that poorly trained price assessors often developed close relationships with traders, which led them to routinely engage in Libor‐style price fixing exercises. Immediately following these allegations, UK Financial Services Authority (FSA) and energy regulator Ofgem launched investigations into the claims.

Market participants have long claimed that selective reporting by traders and inconsistent methodologies used by price reporting agencies can distort reported prices. These concerns were the basis of a report published by IOSCO in early October, to which the IEA, OPEC and the IEF, responding to a request from the G20, provided input.* The report suggested that “ the ability to selectively report data on a voluntary basis creates an opportunity for manipulating the commodity market data that are submitted to PRAs” and “the need for assessors to use judgement under some methodologies creates an opportunity for the submitter of data to deliberately bias a PRA’s assessment in order to benefit the submitter’s derivatives positions.”

A New Era in Swaps Markets?*

US CFTC Chairman Gary Gensler declared last month that a new era for the swaps marketplace would start on 12 October 2012, the effective date of the new US swap definition rule. This marked the beginning of the process of swap dealer registration and swap data reporting. Mandatory clearing by swap dealers and major swap participants is expected to follow in February. The new rules are intended to bring transparency to the swaps markets and lower their risks. While the 12 October date may indeed be remembered as a milestone, a close look at the new rules suggests that lingering difficulties remain and that the process of regulatory swaps market reform may still be undergoing teething pains.

Those difficulties should not come as a surprise. There is an inherent tension between, on the one hand, the political clarity of the perceived need for, and urgency of, financial‐market transparency and regulatory reform and, on the other hand, the very complexity of those market’s financial instruments, and hence the great difficulty of regulatory adjustments. When G20 leaders set the broad reform agenda to be implemented by the end of 2012 to reduce systemic risk and increase transparency in the OTC derivatives markets, they might not have fully appreciated the complex nature of the instruments they were dealing with. They might also have held exaggerated hopes that new rules could easily achieve consistency across nations and win consensual international support. Instead, regulators in different countries followed their own paths in designing the rules that were supposed to govern global swaps markets, without engaging into much‐needed cooperation among themselves.

Forecasting Price on Opaque Oil Markets*

The summer of 2008 saw a spike in crude oil prices to $147/bbl, followed by a steep correction in late 2008/early-2009.  A subsequent rebound over the last three years has brought the question of whether it is possible to accurately forecast prices over the medium and longer term.

Speculation Demystified: Virtuous Volatility

In recent years, the oil market has been characterised by rising, and at times, rapidly fluctuating price levels. From April 2012 to June 2012 alone, Brent crude oil prices gyrated between USD 125 and USD 89 per barrel. Higher volatility adversely affects oil exporting countries’ fiscal revenues and investment, reducing confidence in the economy, while it worsens inflation and growth prospects for oil importers.

In 2011, the Group of 20 (G20) nations called for policy options to combat increased volatility in commodity markets in general, and in oil markets in particular. In response, a G20 experts group emphasised the importance of improving data transparency in both financial and physical markets as well as phasing out inefficient fossil fuel subsidies. The experts group also urged the use of country-specific

monetary and fiscal responses to support inclusive growth in order to mitigate the impacts of excessive price volatility.

However, it is important to note that volatility itself is not the main problem. Instead, the main challenge would be elevated price levels combined with higher volatility. ...

My article appeared in print on September 20, 2012, on pages 34 and 35 of the IEA Energy Journal-Issue 3, Autumn 2012. You can read this article here (SSRN)

Treatise on the Definition of Swap*

Almost two years after the Dodd-Frank Act was enacted into law, on 10 July 2012 the US CFTC voted 4-1 to approve a 600-page final rule, jointly developed with the US Securities and Exchange Commission (SEC), to further define the statutory term “swap”.  Not only does the definition provide greater clarity on which financial products can be expected to fall within regulatory oversight, and thus become subject to reporting, clearing, capital and margin requirements, but passage of the rule also sets the compliance dates for a string of other Commission rules governing the $650 trillion over-the-counter global swaps markets. Those include rules on swap dealers (SD) and major swap participants (MSP) registration, SD and MSP swap data reporting and recordkeeping, registration of swap data depositories, large trader reporting for registered SDs and MSPs, real time reporting of swap transactions and pricing data, internal and external business conduct standards and position limits.

Volatility vs. Price*

In recent years, the oil market has been characterised by rising, and at times, rapidly fluctuating price levels. In the last three months alone, Brent crude oil prices have fluctuated in a wide range from $125/bbl to $89/bbl. Higher volatility will certainly impact both consumers and producers. Oil exporting countries can be negatively affected by the impacts of high volatility in oil prices on fiscal revenues, investment and confidence in the economy. Higher volatility can have negative impacts on inflation and growth prospects in oil importing countries as well. As a response to observed higher prevailing volatility, for example, G20 leaders called for policy options to combat excessive price volatility in commodity markets in general, and in oil markets in particular. In order to reduce volatility in oil markets, the G20 experts group emphasised the importance of improving data transparency in both financial and physical markets as well as phasing out of inefficient fossil fuel subsidies. They also urged the use of country-specific monetary and fiscal responses to support inclusive growth in order to mitigate the impacts of excessive price volatility.

Bank Losses Sharpen Focus on Proprietary Trading*

On 10 May 2012, JP Morgan, the largest US bank by assets, announced that poorly designed and executed hedging strategies had caused more than $2 billion in derivatives trading losses from transactions in London. Even more worrying is the fact that some regulators, including the US Commodity Futures Trading Commission (CFTC) and the US Securities Exchange Commission (SEC), have argued that since they do not yet monitor JP Morgan as a swap dealer, they became aware of the trading losses after JP Morgan’s announcement despite earlier media reports at the beginning of April that raised red flags over the London Whale’s $100 billion notional exposure in one credit index. Even the regulators, the US Office of the Comptroller of the Currency (OCC) and Federal Reserve Bank, failed to detect the risk posed by the massive hedging strategy, despite having more than 100 of their own staff embedded at JP Morgan, up until April, around the same time that Bloomberg and Wall Street news reports suggested that the UK-based trader at the bank was playing a dominant role in certain markets and distorting prices.

Margin Requirements in Futures Markets*

Despite scant evidence of a negative impact of speculation in the oil market, in seeking to prohibit excessive speculation and its possible effect on price volatility in futures markets, the US CFTC approved final rules on federal speculative positions limits on commodity futures, options and swaps positions of speculators for 28 commodities in October 2011. As we reported in previous OMRs, position limit rules are being challenged by the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (SIFMA) in court. They are challenging the final rule based on whether the Commission overreached its mandate by pre‐emptively setting a position limit on derivatives contracts, amid almost non‐existent cost‐benefit analysis in the final rulemaking, as well as insufficient review of some of the comment letters, which they argue that the Commission was bound to take into account. The court still has to deliver its decision on the speculative position limit rule.

Speculation and Oil Prices

On 17 April 2012, Obama Administration proposed new initiatives to strengthen oversight of energy markets.   

The President's plan call on Congress to:

•  Increase funding to increase the number of surveillance and enforcement staff charged with oversight of the oil futures market;
• Allow the Commodity Futures Trading Commission (CFTC) to upgrade the technology used to monitor the energy markets;
• Increase the civil and criminal penalties for those convicted of manipulating the oil futures market;
• Provide the CFTC with additional the authority to raise margin requirements in oil futures markets to limit disruptions in the oil market; and
• Expand access to CFTC data so that analysts can better understand trading trends in the oil markets.

Here are some initial reactions from economists on the impact of speculation as well as on the possible impact of Obama’s proposal on oil prices:

John Cochrane: http://johnhcochrane.blogspot.com/2012/04/speculation-and-gas-prices.html
Jim Hamilton:    http://www.econbrowser.com/archives/2012/04/a_ban_on_oil_sp.html
Scott Irwin:        http://www.farmdocdaily.illinois.edu/2012/04/speculation_and_gasoline_price.html
Lutz Kilian:         http://www.cnn.com/2012/04/19/opinion/kilian-oil-speculation/index.html
                            and
                            http://www.voxeu.org/index.php?q=node/7892

Do Exchange Rates Matter?*

Oil prices have experienced large fluctuations in recent years.  The spike in crude oil prices in mid-2008 to more than $140/bbl, followed by a steep correction in late 2008/early 2009 and subsequent sharp rebound over the last two years have jolted the world economy and pinched consumers at the fuel pump. US dollar weakness in recent years is frequently cited as one reason for high oil prices. It is very common to see the financial press suggesting that a weak dollar has pushed oil prices higher. However, this explanation is challenged by the empirical observations that (a) a change in oil price tends to lead to a change in the exchange rate as predicted by economic theory and (b) the oil price has risen regardless of what currency unit one uses to measure the price of oil.

High Frequency Traders: Flash Crashers or Liquidity Providers?*

On 6 May 2010, major American stock indices and stock index futures nosedived by more than five percent before sharply recovering in less than 30 minutes. Since that infamous flash crash, high frequency traders (HFTs) have drawn the attention of regulators, exchanges and market participants, despite the fact that the crash was not triggered directly by HFTs, according to an official joint report released by the US CFTC and SEC. Nonetheless, fragmentation of trading venues and the establishment of the US Regulation National Market System and the European Union’s Markets in Financial Instruments Directive (MiFID) in 2007 requiring brokerages to find the best execution for customers, have led to the explosive growth of HFTs.

Who is Going to Regulate the Regulators?*

Considering the CFTC's policy on position limits, there are actually two questions that need to be answered.

The first is whether it is true that speculative positions affect prices. There are good economic reasons to reject this notion.  A futures position is a commitment to deliver a commodity by the short side and a commitment to take delivery of that commodity by the long side.  Those commitments are distinct from demand or supply of the product.  This is because the long side can immediately sell the commodity received to someone who wants to consume it.  Likewise the short side can buy the commodity immediately before delivering it per their contract.  For the long side, these constitute transfers of the commodity as opposed to demands for the purpose of consuming it.  Likewise, generally the short side satisfies its delivery requirement via a transfer rather than through engaging in its actual production.  Examinations of the effect that undertaking positions has on prices have consistently found no relationship between position changes and subsequent price changes.  This is precisely the result that the above economic reasoning predicts.  That is, unless long positions actually shift commodity demanded or short positions actually shift commodity supplied, then trading in futures should have no effect on pricing fundamentals.

Volcker Rule: Grounds for Divorce?*

In a narrow 3-2 vote on 11 January 2012, CFTC Commissioners proposed their own version of the Volcker Rule, which prohibits proprietary trading activities of banks and limits their investments in private-equity and hedge funds in line with the restrictions already proposed by the Federal Deposit Insurance Corp., the Federal Reserve, the SEC and the Comptroller of the Currency in October, 2011. The intent of the Volcker Rule is to reduce risk in the US banking system by limiting the excessive risk-taking activities of banking entities, defined as any insured depository institutions and their subsidiaries.

Blame Game Continues: Speculators v Regulators

On January 13, 2012, I presented at the International Workshop on "Financial Speculation in the Oil Market and the Determinants of the Oil Price", organised by the Fondazione Eni Enrico Mattei in Milano, Italy. My presentation was entitled "Blame Game Continues: Speculators v Regulators."

My presentation was based on the following articles that I co-authored:

• Fundamentals, Trader Activity and Derivative Pricing
• The Prevalence, Sources, and Effects of Herding
• The Role of Speculators in the Crude Oil Futures Market
• Speculators, Prices and Market Volatility
• Commodities and Equities: 'A Market of One'?
• Speculators, Commodities and Cross-Market Linkages
• Does 'Paper Oil' Matter? Energy Markets’ Financialization and Equity-Commodity Co-Movements

Swap Execution Facilities*

Regulatory bodies on both sides of the Atlantic will be busy in 2012 finalising rules on one of the most important requirements for bringing pre- and post-trade transparency to the over-the-counter derivatives markets by ensuring prices are posted to a wide variety of market participants, not just among dealers. Initially set by the G-20 leaders at their Pittsburgh Summit in September 2009 and later adopted in reform packages in the US and Europe, transparency would be achieved through the requirements that “all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.”