naked capitalism

In less than a month, NYMEX crude oil futures have dropped about 15% in value. Other commodities ranging from precious metals to agriculture have had significant drops as well. Even for the traditionally volatile commodity markets, this is somewhat unusual and has led many people to scratch their heads to figure out what’s happening. Is this simply a pause before the inexorable rise continues? Were there speculators that blew up and are rapidly unwinding their positions? Was there indeed a commodity bubble that has now been pricked? Or are market forces acting the way they’re supposed to, with demand declining as the world’s economies slow down?

Despite the confusion of what exactly is going on in the commodity markets, one point bears mention: no one is worried about what the true value of the September NYMEX CL contract is, or whether the counterparty to their future will be able to deliver as contracted. You can find out the price to the penny, and if you buy and hold a contract, you will get your 1000 barrels of light, sweet crude in Cushing, OK come hell or highwater. In other words, despite an impressive and unexpected 15% drop in a month, the normal market functions of price discovery, liquidity, counterparty guarantees, etc, exist and continue to work fine.

Contrast this with OTC derivatives such as CDO/CDS/MBS securities where the biggest problem has been the lack of a functioning market at all. Much of the turmoil in these markets is not because there are no investors interested in these securities per se as that in the absence of fundamental market infrastructure such as accurate prices, counterparty guarantees, and standardized, easily understood contracts, not even vulture investors want to touch this stuff, even if there might be money to be made.

So why have futures markets survived such volatility while OTC markets have essentially been destroyed? IMHO, it’s not for these reasons:

1. Market size. The notional value of the CDS market has been estimated in the tens of trillions. Far in excess of the notional value of commodity markets. Yet CDSs collapsed while futures haven’t.
2. Liquidity. OTC securities had large dealers and bankers who were contractually obligated to make a market in the securities they created.
3. Leverage. Both OTC securities such as CDOs/MBS/CDSs and futures are highly leveraged.

Thus, I’d argue that there is no reason intrinsic to the nature of either OTC securities or futures that would naturally make one instrument more susceptible to market breakdown than the other.

I would assert that the difference lies soley with the differing regulation of these markets. The regulation and oversight of futures has created a market for highly levered securities that is able to continue to function despite large, rapid, unexpected, and unexplained changes in price (such as we have been seeing this past month). In contrast, OTC security markets collapsed (by which I mean the market itself, not the price) by last year when price declines were less than 15% (remember when it was shocking that some AAA tranches may sell for <95% of par?).

So far, the collapse in oil prices has not required emergent Fed intervention to maintain the stability of the strategically important oil market. In contrast, the collapse of OTC security markets has necessitated the creation of several emergent lending facilities, the bailout of BSC, and now possibly the GSEs. And markets still remain frozen after nearly a trillion dollars of government liquidity and direct intervention.

Stephen Cecchetti made a similar observation last year in the Financial Times:

In September 2006 Amaranth Advisors, a US-based hedge fund specialising in trading energy futures, lost roughly $6bn (£3bn) of the $9bn it was managing and was liquidated. With the exception of its shareholders, most people watched with detached amusement. Eight years earlier, reaction to the impending collapse of Long-Term Capital Management was very different: people were horrified and the financial community sprang into action. One big difference is that Amaranth was engaged in trading natural gas futures contracts on an organised exchange, while LTCM’s exposures were concentrated in thousands of interest-rate swaps.
. . .
The difference between futures and swaps is that futures are standardised and exchange-traded through a clearing house. This distinction explains why Amaranth’s failure provoked a yawn, while LTCM’s triggered a crisis. It suggests that regulators, finance ministries and central bankers should be pushing as many securities on to clearing house-based exchanges as possible. This should be the standard structure in financial markets.

While Amaranth and LTCM were individual firms, I believe Mr. Cecchetti’s observations are generalizable to the behavior of their respective markets as well. Standardized contracts, exchanges, and clearinghouses are three of the primary institutions through which the government regulates and supervises futures trading. They have been successful in maintaining functional markets despite tremendous leverage and volatility. Perhaps it’s time to bring them to the rest of the derivatives world…