|
I
recently read some of the work of Craig Pirrong, a recognized expert on
commodity markets and market manipulation. In an article published in 1994 he
discusses some of the major issues of futures market manipulation. See
"Squeezes, Corpses, and the Anti-Manipulation Provisions of the
Commodity Exchange Act":
http://www.cato.org/pubs/regulation/regv17n4/reg17n4c.html
Despite
Pirrong's alleged expertise in commodity markets, he considers that
manipulation is mainly instigated by the "long" market participants
in what is colloquially called a "corner." He writes:
"Other
speculative activities sometimes called manipulative are far more ephemeral
than corners, and are of dubious practical relevance. For example, farm
interests and farm state legislators frequently assert that large short sales
of futures contracts by speculators are manipulative, and cause prices to
fall below their 'true' value.
"Such
'bear raids' are profitable for the raiders only under very restrictive
conditions. In order to realize a profit, it is necessary to sell high and
buy low -- that is, the short seller must eventually buy back his positions
at a price which is lower than the price at which he initially sold. Since
the number of contracts sold is equal to the number of contracts subsequently
bought, this can happen if, and only if, the futures price responds
asymmetrically to the speculator's purchases and sales. That is, the price
decline caused by the speculator's sales must exceed the price rise caused by
his subsequent purchases.
"There
is no credible evidence that such an asymmetry exists or has existed in
futures markets. Moreover, it is even difficult to construct a theoretical
model that exhibits this property. As a result, it is highly unlikely that
short manipulations of the type that is criticized so vigorously by the
opponents of futures markets are a practical concern. Indeed, futures
industry experts have been nonplused by the allegations of widespread
'downward' manipulation as far back as 1921, when there was no regulation;
most recognized the real danger of squeezes and corners, but were deeply
skeptical of the possibility of short manipulations.
"Nonetheless,
the primary impetus behind the regulation of futures markets in the early
1920s was the collapse in agricultural prices after the end of World War I.
Despite the skepticism of the industry witnesses, the promoters of the
legislation regulating futures markets, such as Senator Capper and
Representative Tincher, both of Kansas, were convinced that short-selling
speculators were largely responsible for this collapse. As a result, Congress
was intent upon preventing manipulative short selling. However, since it
could not distinguish legitimate short selling for hedging purposes, for
instance, from illegitimate short selling, Congress simply proscribed
'manipulation' and passed the buck to exchanges by requiring them to prevent
what Congress could not define -- or face the closure of their markets."
I find
it astonishing that an alleged expert could make such a claim. In the futures
market there has to always be a buyer and a seller for every contract; that
is, a "long" for every "short." This means that there are
as many longs as shorts. Whatever model can be proposed for long-side
manipulation must, by symmetry, be possible for the short side. If one can
drive prices up by buying a large amount of contracts, one can also drive the
market down by selling a lot of contracts.
The
prejudice that manipulation cannot be effectively carried out on the short
side is a fundamental barrier to any intelligent and productive discussion of
manipulation of the precious metals markets.
Governments
favor low commodity prices because this masks their intrinsic tendency to
debase the national currency. As the United States is a net importer, it is particularly
advantageous to the country to have cheap commodities. Therefore, there is an
inherent conflict of interest in that government regulators police the
commodities markets and the principal short sellers are financial
institutions that enjoy special privileges such as being "primary
dealers" that execute market operations on behalf of the Federal Reserve
or the U.S. Government.
Pirrong
notes that the law (the Commodities Exchange Act) has been largely
emasculated to the extent that manipulation is difficult to prove.
"Unfortunately,
courts and regulators in the U.S. have failed to exploit the potential
advantages of harm-based penalties for manipulation. In fact, a series of
court and CFTC decisions have completely undermined the felony and civil damage
provisions of the CEA. As a result of these decisions, it is almost
impossible to find a genuine manipulator guilty.
"Several
features of these decisions are responsible for this state of affairs. In
order to prove manipulation under current law, it is necessary to show that:
"1)
Market prices were artificial during the alleged manipulation, and
"2)
The accused had the power to cause this price artificiality, and
"3)
The accused intended to cause the price artificiality.
"These
are referred to as the 'artificial price,' 'causation,' and 'intent' tests.
"The
reasoning in several cases makes it virtually impossible to meet any of these
three standards, let alone all three simultaneously. The CFTC decisions in
the In re Indiana Farm Bureau (1982) and In re Cox (1983) cases make it
difficult, if not impossible, to show that any price is artificial even if
there is pronounced evidence of manipulative distortions. In each case, price
relations differed dramatically from past experience. Moreover, price patterns
were clearly symptomatic of a market power manipulation.
"The
evidence in Indiana Farm Bureau is particularly striking. The price of corn
rose 30 percent on the last day of trading of the July 1973 corn futures
contract; immediately after the end of trading, corn cash prices were 30
percent lower than the closing futures price. Nonetheless, the commissioners
considered this evidence unpersuasive.
"In
Indiana Farm Bureau, the majority decision stated that, instead of focusing
on prices alone, 'One must look at aggregate forces of demand and supply and
search for those factors that are extraneous to the pricing system.'
"In
Cox, the majority asserted that the 'prospective behavior of a 'normal'
market is not bounded by the market's historical experiences.' In dissent,
Commissioner Fowler West argued that this interpretation severely compromises
the ability of adjudicators to rely upon any data in manipulation cases.
These precedents make it nearly impossible to prove price
artificiality."
Currently
the CFTC is asking for public comment on the imposition of position limits on
the precious metals markets.
The
CFTC has been investigating the gold and silver markets for potential
manipulation for almost a year and a half. Why is the CFTC looking to impose
limits? Is this because manipulation is tacitly acknowledged?
The
imposition of limits will be largely impotent in stopping manipulation
because as it is occurring on the short side the commercial traders will no
doubt be afforded exemptions to the limits as they have been in the recent
limits imposed on the energy markets.
But we
should not be discussing the merits or otherwise of the imposition of
position limits. We should instead be addressing the fundamental issues that
plague the futures markets.
Gradualism
is the major enemy of accurate problem diagnosis. When changes happen rapidly
we can immediately associate the change with the problem. When changes happen
slowly an entirely incorrect diagnosis can be made.
When
we look at ourselves in the mirror each day we never notice that we have
aged. It is only when we see a photograph of ourselves from our younger days
that it becomes obvious how we have changed. And so it is with the futures
markets.
The
futures markets were conceived to allow commodity producers to reduce risk by
being able to contract to sell their yet-to-be-produced commodity at some
time in the future. By the same token, it allowed commodity users to reduce
risk by being able to contract to buy a yet-to-be-produced commodity in the
future. The futures markets also served to perform the function of price
discovery by matching future demand with future supply at a market-clearing
price.
However,
gradualism has resulted in the futures markets morphing into giant casinos
where less than 5 percent of contracts get settled with a physical commodity
delivery. The futures markets are now totally divorced from their intended
function. The futures markets have become such a farce that the delivery of
physical commodities has become an inconvenience that hinders speculation and
market manipulation.
The
ultimate poster child for the ridiculous state of affairs of the futures
markets is the Nymex Uranium futures contract. It is a
"non-deliverable" contract! This means that traders pretend to sell
uranium and buyers pretend to buy uranium and without a single gram of
uranium ever changing hands the price of uranium is "discovered"!
It is difficult to keep a straight face about this. I have wondered why a
non-deliverable heroin contract is not introduced, since in this way we could
have the opportunity to make a fortune trading virtual heroin and never have
to worry about being arrested by the Drug Enforcement Administration because
not a gram of heroin would ever be involved.
Craig
Pirrong testified before the House Committee on Agriculture in November 2008
and identified as to what should be the central target of regulation:
http://www.ftc.gov/os/comments/marketmanipulation2/538416-00018.pdf
"In
particular, the Proposed Rule completely ignores the most important form of
market manipulation. In its focus on fraud and deceit, the Proposed Rule
overlooks the kind of manipulative conduct that has bedeviled commodity
markets from time immemorial, and which is a serious concern today -- the
exercise of market power by traders holding positions in derivatives
contracts. Indeed, in my opinion, market power manipulation is the most
important form of manipulation of petroleum markets, and should be the focus
of the commission's scrutiny. Instead, it is completely absent from the
Proposed Rule.
"There
are some forms of conduct that distort markets that (a) are properly
considered 'manipulation,' and (b) result from fraud or deceit. For instance,
making false price reports to industry publications is fraudulent, deceitful,
and manipulative, and can distort prices and the allocation of resources. Similarly,
the spreading of false rumors is manipulative conduct that relies on deceit.
But the most important form of manipulation in commodity markets in general,
and petroleum markets in particular, is related to the exercise of market
power intended to enhance the profitability of derivatives positions."
Currently
JPMorgan Chase holds $80 billion in gold over-the-counter derivatives out of
a total of $102 billion. The third quarter 2009 Office of the Comptroller of
the Currency report on derivatives held by U.S. banks does not list HSBC's
position separately. See:
http://www.occ.treas.gov/ftp/release/2009-161a.pdf
From
the first quarter 2009 report where the HSBC gold derivatives position is
listed as $19 billion and HSBC and JPMorgan Chase are shown to hold together
96 percent of all the gold derivatives, it can be inferred that HSBC now
holds approximately $18 billion:
http://www.occ.treas.gov/ftp/release/2009-72a.pdf
The
entire open interest of the gold market on the New York Commodity Exchange
represents notionally $52 billion of gold. The two largest shorts on the
COMEX are almost without any doubt JPMorgan Chase and HSBC. These two banks
control upwards of 60 percent of the commercial net short position in gold on
the COMEX at any time.
Bucket
shops were outlawed in the 1920s, yet the massive unregulated derivatives
market that has a nominal value of more than $600 trillion is nothing more
than a monumental bucket shop. But the fraud is much more sophisticated than
it was in the 1920s, because by manipulating the tiny futures market, the
profitability of the massive bucket shop of a derivatives market is
guaranteed.
This
fraud has the effect of suppressing commodity prices, and in particular gold
and silver. Because the outcome of this fraud is in the best interests of the
U.S. government and the Federal Reserve in masking inflation, keeping a
strong dollar (in spite of promiscuous money creation), and maintaining low
interest rates, the U.S. government only toys with the idea of introducing
regulation that would in any way impede or halt this perpetual distortion of
free markets. In fact every measure is taken to handicap the participants on
the long side of the market.
I urge
the CFTC to take a close look at the absurdity of the markets it supposedly
regulates. We are beyond the stage where cosmetic changes will suffice. The
CFTC needs to wake up and acknowledge that gradualism has allowed free
markets to be hijacked from under its nose. They are no longer markets for
the future exchange of physical commodities between producers and users and
mechanisms to provide price discovery. They are nothing more than casinos
where players can place a bet on future prices and where those future prices
are rigged with impunity by the house.
The
CFTC may choose, as it has so frequently done before, to look the other way.
However, if it refuses to properly regulate the markets under its
jurisdiction, the markets eventually will impose their own will anyway. The
distortion of commodity markets by price suppression abnormally reduces production
and abnormally increases demand, leading to shortages and sudden price
dislocations.
There
are already signs of acute shortages of precious metals, as evidenced by,
among other things, the rationing of the U.S. government's own minting of
gold and silver eagle coins.
Central
banks have become net buyers of gold and sovereign states are ever more eager
to diversify out of U.S. dollars into gold as demonstrated by India's
purchase of 200 metric tonnes of International Monetary Fund gold.
Meanwhile
global gold production has peaked and is in terminal decline.
The
CFTC has the option of attempting to make the transition of gold to a free
market price to be somewhat orderly through appropriate regulatory change or
having the market impose a disorderly readjustment. There are no other
options, as the burgeoning demand in the physical market is soon to denude
the fraudulent fractional reserve banking extensively employed in gold and
silver trading.
Adrian Douglas
Marketforceanalys.com
Adrian
Douglas is proprietor of the Market Force Analysis newsletter (www.marketforceanalysis.com) and a member of GATA's Board of Directors.
|
