By Chris Cook, former compliance and market supervision director of the International Petroleum Exchange
A generation of markets is dying and the era of the Middleman is coming to an end. The ‘Bezzle’ – as J K Galbraith described financial misbehaviour in a boom, revealed by a bust – is now coming to light.
We now see a wave of popular rage against the freshly revealed manipulation by banks of LIBOR, the London Interbank Offered Rate benchmark for interest rates which is the cornerstone of the money market.
This manipulation in the financial world is being augmented by a groundswell of protest against manipulation taking place in the real world. Here, the allegation is that the Brent/BFOE (Brent, Forties, Oseberg, Ekofisk) crude oil benchmark price, against which global crude oil prices are set, is the subject of routine manipulation by market participants, particularly investment banks and traders of physical oil.
In both cases, the popular outcry is based upon misconceptions as to what has actually been going on. The good news in the oil market at least is that the manipulation which is being revealed is nowhere near as serious in its effects on the general public as is believed. The bad news is that the true manipulation, as yet still concealed, is far more serious than anyone has yet conceived.
They Shoot Horses, Don’t They?
The current LIBOR pogroms are the regulatory equivalent of flogging a dead horse. The Interbank money market in wholesale lending had a heart attack in 2007 and essentially died in October 2008 with the collapse of Lehman Brothers. The money market is now on life support directly to central banks and to all intents and purposes there is no independent Interbank Market in money and there never will be again.
LIBOR is dead, and the markets are moving on.
The Brent/BFOE crude oil market benchmark, on the other hand, has been in failing health for a long time as the North Sea oil production upon which it is based has been in secular decline. Despite the best efforts of Platts – the Price Reporting Agency who are getting most of the flak – the market is at the point where if it were a horse it would be put down.
A regulator friend of mine used to joke that since excessive market manipulation is a US felony, the implication is that there is such a thing as ‘acceptable’ market manipulation. My response was that trading might be defined as ‘acceptable market manipulation’.
While producers desire a stable high price, and consumers desire a stable low price, for a trading intermediary who aims for transaction profit, price stability is Death, and the only bad news is no news at all.
I am not familiar enough with the endemic LIBOR manipulation to say much about the victims and their losses. But I can say that from its inception in the mid 1980s crude oil trading and the associated fun and games in the Brent/BFOE complex of contracts have taken place entirely among consenting adults. The outcome of the routine short term ‘micro’ manipulation by oil market participants has been pretty much a zero sum game between trading intermediaries.
Some of these middlemen are traders of physical oil like Vitol and some of them are the ‘Wall Street Refiner’ traders in investment banks such as Goldman Sachs. There have been no direct effects from these continuing trader games on the man in the street, but there are indirect effects such as the higher cost of energy investment arising out of unnecessarily high market price volatility.
Whenever producers or consumers can gain market power, through some kind of leverage, to either support or suppress prices in the medium and long term, then they will. The history of markets is full of examples of such ‘macro’ market manipulation and while LIBOR is among them, that is only now of historic interest, now that the market is dead. In crude oil, on the other hand, we are approaching the end of the greatest macro market manipulation in the history of commodity markets, by comparison to which Yasuo Hamanaka’s $2bn manipulation of the copper markets through Sumitomo is a car boot sale.
Ask yourself who benefits from high oil prices? It’s the producers, stupid. From 2005 onwards a market bubble in crude oil has been deliberately created. This has been achieved opaquely through use of the Prepay funding used by Enron to sell commodities at a discount for cash now, and deliver them later.
Creditors and investors who were unaware of Enron’s ‘off-balance sheet’ liabilities were misled as to the true financial position and were thereby defrauded. Most oil market participants have been similarly misled as to the true position in the oil market through the use of prepays by producers, funded by passive investors.
In simple terms, risk averse investors have lent dollars to producers, and producers have lent oil to investors. None of the resulting changes of ownership of oil in the physical market were visible to other market participants, and the price has become a completely distorted and financialised bubble as a result.
The bubble first collapsed during the second half of 2008 from $147 to $35 per barrel and it was then re-inflated in 2009 through the use of prepays, facilitated by US investment banks to the benefit of producers. Oil prices have since been kept pegged as far as possible between levels which: (a) do not endanger US presidential re-election; and (b) enable producer populations to be financially anaesthetised.
A key element in the evolution of this macro manipulation has been that banks as financial intermediaries are no longer capitalised to take risks in the way that they could and did prior to the collapse of the banking system. The outcome has been that market risk – ie the risk that the oil price will fall – is no longer held by the banks but has been transferred to passive and risk averse investors.
The motive of passive investors is not the speculative desire of active investors to make a transaction profit, but its very opposite: the desire to avoid loss. So they invest in oil funds in order to offload the risk that the dollar will depreciate in value relative to oil. Unfortunately, they are blithely unaware that they have a massive market risk if the oil price falls in a market ‘bust’, as it did in 2008; has recently been doing; and will continue to do at least until the end of the year. This is a regulatory accident waiting to happen.
The direct ‘Peer to Peer’ connections between producers and consumers which were first demonstrated by the music file-sharing phenomenon Napster have also been evident in the financial markets for some time through Peer to Peer lending businesses such as Zopa, and the new phenomenon of ‘crowd-sourcing’ of investment and donations.
But it is not widely understood that in financial services, the transition of middlemen to a role as service providers managing risk, business platform and direct P2P relationships is actually in the interests of the middlemen themselves. The reason is that when credit or market risk is with end users, then the only capital needed by service providers is the limited amount necessary to cover operating costs.
This is precisely why investment banks starved of capital have since 2008 been originating and selling the new generations of funds responsible for the bubbles, where the market risk is with the investors, and not the banks. Unfortunately they have also been able to prey upon end users through their privileged ‘asymmetric’ access to markets and market data and through trading such as ‘High Frequency Trading’ (HFT).
Intermediaries are also responsible for short term micro manipulation, but they are not directly guilty of the macro manipulation of markets which has inflated the medium and long term market price because they simply do not have the capital to invest in this way any more, even if regulators allowed it.
The End Game
Once the current bubbles collapse, which is only a matter of time, I believe that we will see markets evolve to the next ‘adjacent possible’, which will be the widespread – and necessarily transparent – use of direct Peer to Peer relationships through a new generation of market instruments, of which Enron’s Prepay was the first.
This return to what is in fact an ancient form of financing and funding will complete a cycle which began some 300 years ago when modern money and capital markets began with the foundation of the first Central Banks and the wave of Joint Stock Companies which financed and funded the Industrial Revolution.