Last year, when oil prices were at about $140 (around Rs6,720 today) per barrel, various conspiracy theories were floated about the reasons for the surge. The US Commodity Futures Trading Commission (CFTC) then argued that the price spike stemmed simply from the forces of supply and demand. The explanation was reviewed after a new administration took over, and the CFTC, showing more courage than it did last year, has now suggested that speculators played a major role in the oil market volatility.
Having arrived at this conclusion, the CFTC has suggested putting position limits on all kinds of speculation. It also concluded that while it is difficult to quantify how much of the price rise was caused by speculators, there was evidence that it was substantial. A regulator adopting the Heisenberg uncertainty principle (you can’t see it, but we know it’s there) is disquieting.
Somewhat surprisingly, Nobel Prize-winning economist Paul Krugman concluded that there hadn’t been a lot of speculation in the oil market, a view at variance with the CFTC’s. What is puzzling in this particular situation is that a powerful government-sponsored body and a Nobel laureate came up with two polar opposite positions on the same issue, based on essentially the same data. Information is at the heart of efficient markets. If the level of transparency is so low that neither the regulator nor a Nobel Prize winner can explain what is happening, one can only conclude that the market for traded commodities needs more openness.
On a slightly different but still related note, The Wall Street Journal recently published a report about the dilemma faced by Citigroup Inc. when its lead energy trader pressed the financial services firm to honour a pay package that could total $100 million in the same year that it received $45 billion in bailout funds. It is likely that the trader in question is exceedingly skilled and his contribution to Citigroup was very tangible.
At the same time, shareholders and lenders provided funds for his trading, based not on his personal reputation but on Citigroup’s goodwill. The trader in question now seems to be prepared to sue Citigroup to receive what he believes is a contractual bonus. If senior managers in companies see themselves as distinct from their organizations to the point where they cannot share in the organization’s travails even during an extreme financial crisis, it raises some questions. Should public funds be used for activities where corporations are unable to fully control the action of their managers. If a financial services organization is just a loose confederation of individuals with little central control, should there be different rules for them?
The Wall Street Journal reported that the trader in question leaves his office most afternoons to go ballet dancing. This colourful lifestyle also appears to support the image of these individuals not being a part of the mainstream of the bank. Although, like other companies, many banks continue to take their employees on team-building activities, which include cross-country hikes and bungee jumping, it’s pretty clear that the banks’ ability to make team players out of their trading desks stops when their contracts are in question.
Of late, several economists, including Krugman, have written about the fact that speculation need not be presented as an unmixed blessing for free markets (as indeed it has for much of the past decade). In one instance, Krugman indicates that financial institutions such as Goldman Sachs have used super-fast computers to buy into stocks a fraction of a second before the rest of the markets and profit from the arbitrage.
He enquires, very correctly, as to what public purpose is served by exploiting the superfine differences in information. Furthermore, there is a lack of unanimity on how to really measure the value added by such speculative activity. Intriguingly, Goldman Sachs chief executive officer Lloyd Blankfein also recently questioned the value added by some parts of the trading business.
An attempt to eliminate speculation in any market can frequently distort the markets and this article does not recommend that. Financial markets operate precisely because there are people prepared to take a counter position. At the same time, we seem to face two challenges in the area of trading. Firstly, most regulators and experts do not seem to really have enough information to understand what is happening, as evidenced by the continuous reinterpretations of the cause of volatility in oil prices.
Secondly, a combination of contractual law as well as a lack of political will to enforce a better risk culture means that traders within financial services will continue to have substantial leverage to take risk with public funds, with little ability on the part of their employers to control incentive mechanisms. It is worth noting that the value of “at risk”, which measures the likely losses financial firms are exposed to, is presently higher than it was before the financial crisis erupted. Moreover, the public seems unable to truly measure the efficiency of many of these activities.
Speculating: A file photo of traders at work on the floor of the New York Mercantile Exchange. Daniel Acker/Bloomberg
It is worrisome that we have a situation where there exists a large number of traders with little accountability to their companies, a system with little ability to measure the true risks they are taking, and regulators who seem, sometimes, not to have enough information even a year after Lehman Brothers Holdings Inc.’s bankruptcy.
These issues can, at least partly, be addressed by making every traded position taken on these exchanges much more visible. Give that the very high volatility in many markets has perhaps affected the public good adversely, nothing is lost by putting limits on the extent of speculation as well as seeking disclosure about trading positions, and seeking higher margins for short-term positions etc. The CFTC proposed such controls several times in an attempt to regulate the now disreputable credit default swaps, only to be out-lobbied on Capitol Hill. Hopefully, things will be different this time. At least the next time there is rampant speculation, we will know who is causing it and why.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He writes every other Friday on issues related to governance. The views expressed here are personal. Write to him at email@example.com