CORNERS AND SQUEEZES:
A GUIDE TO COMMODITY MARKET REGULATION AND SUGGESTIONS FOR REFORM
JOHN KEMP
REUTERS
26 JULY 2010
John Kemp is a Reuters market analyst. The views expressed are
his own
Corners and squeezes are illegal in the United States
under Section 13 of the Commodity Exchange Act
“Section 13 (a) It shall be a felony punishable by a fine of not more
than $1,000,000 (or $500,000 in the case of a person who is an
individual) or imprisonment for not more than five years or both,
together with the costs of prosecution for: …
(2) Any person to manipulate or attempt to manipulate the price of
any commodity in interstate commerce, or for future delivery on or
subject to the rules of any registered entity, or to corner or attempt to
corner any such commodity or knowingly to deliver or cause to be
delivered for transmission through the mails or interstate commerce
by telegraph, telephone, wireless or other means of communication
false or misleading or knowingly inaccurate reports concerning crop
or market information or conditions that affect or tend to affect the
price of any commodity …”
(7 USC 13(a)(2))
Section 13(a)(2) creates three separate types of
offence
(1) General prohibition on manipulation or attempts to manipulate
commodity prices
(2) Specific prohibition on corners and attempted corners
(3) Specific prohibition on “fraudulent” reporting of crop and
marketing information likely to affect prices
Corners and squeezes distinguished – but in degree
not kind
“In its most extreme form, a corner amounts to nearly a monopoly of
a cash commodity, coupled with ownership of long futures contracts
in excess of the amount of that commodity, so that shorts – who
because of the monopoly cannot obtain the cash commodity to
deliver on their contracts – are forced to offset their contract with the
long at a price which he dictates, which of course is as high as he
can prudently make it” (Cargill v Hardin, 1971, U.S. Court of Appeals
for the 8th Circuit)
“Squeeze (congestion): These are terms used to designate a
condition in maturing futures where sellers (hedgers or speculators),
having waited too long to close their trades, find there are no new
sellers from whom they can buy, deliverable stocks are low, and it is
too late to procure the actual commodity elsewhere to settle by
delivery. Under such circumstances and though the market is not
cornered in the ordinary sense, traders who are long hold out for an
arbitrary price” (Senator Pope, 80 Cong. Rec. 8089)
Squeeze also known as a “little corner”
“There may not be an actual monopoly of the cash commodity itself,
but for one reason or another deliverable supplies in the delivery
month are low, while open interest on the futures market is
considerably in excess of deliverable supplies. Hence as a practical
matter, most shorts cannot satisfy their contracts by delivery of the
commodity, and therefore must bid against each other and force the
price of the future up in order to offset their contracts.
“Many squeezes do not involve intentional manipulation of futures
prices but are caused by various natural market forces, such as
unusual weather conditions … However, given a shortage of
deliverable supplies for whatever reason, the futures price can be
manipulated by an intentional squeeze where the long acquires
contracts substantially in excess of the deliverable supply and so
dominates the futures market … that he can force the shorts to pay
his dictated and artificially high prices to settle their contracts”.
(Cargill v Hardin, 1971, U.S. Court of Appeals for the 8th Circuit)
Supreme Court jurisprudence is very thin in this area
“Running a corner consists, broadly speaking, in acquiring control of
all or the dominant position of a commodity, with the purpose of
artificially enhancing the price; one of the important features of which
… is the purchase for future delivery, couple with a withholding from
sale for a limited period”
U.S. versus Patten, United States Supreme Court, 1913
Four conditions for proving market manipulation under
the CEA
(1) Price of the manipulated contract was “artificial” (known as “price
artificiality”)
(2) The accused had the ability to cause the artificial price
(3) The accused caused the price to be artificial
(4) The accused acted with intent to cause the price to be artificial
(Pirrong, Energy Market Manipulation: Definition, Diagnosis and
Deterrence, in the Energy Law Journal, 2010).
Reliance on fraud and deception rather than
dominance
Manipulation has become almost impossible to prove under the
very exacting standards developed by the CFTC from the 1980s
onwards (In re Indiana Farm Bureau, In re Cox, In re Cox and
Frey)
CFTC market manipulation cases increasingly rely on “fraud and
deception” rather than market dominance and manipulation
BP North America propane case
CFTC brought proceedings against both BP North America and individual
traders.
Proceedings against company discontinued as part of $303m settlement
Indictments against the employees were dismissed
Counts 1-19 were dismissed because the trades were bilateral deals
subject to individual negotiation that were not executed or traded on a
trading facility.
They were thus OTC swap deals that had been excluded from the normal
CFTC/anti-manipulation authority by the Commodity Futures
Modernisation Act 2000 (7 USC 2(g Sep 2009)
Miller’s judgement highlights loophole for OTC bilateral trading
BP North America propane case (cont)
Counts 1-17 were also dismissed because the government had not
shown manipulation:
“the government next implies that defendants’ actions were not legitimate
because they ‘took substantial pains to conceal from other market
participants as well as BP management not involved in the scheme, the
truth about their purchasing of TET propane’. Even though the
government alleges specific instances of defendants attempting to
conceal their actions, it never alleges that defendants lied about their
activity. Mere concealment is not sufficient to show that their actions were
not legitimate forces of supply and demand.
“Most of the government’s arguments regarding price artificiality center
on the implications created by reference to deception and questionable
motives. While these implications can be used to impeach a party’s
credibility, the actions which support the implications are not actually
illegal”. (U.S. v Radley, comments by Judge Miller, SD Tex 17 Sep 2009)
Derivatives-only squeeze not in fact a squeeze?
Judge Miller told the government it could not indict the BP traders
for cornering the market because it had not alleged all the
elements necessary to make out the offence. Counts 18-19 were
therefore dismissed
Among other things, Judge Miller noted since BP did not own any
of the deliverable propane when it was engaged in its alleged
manipulation, it could not, under the logic of Cargill have
cornered the market, where the court required a mix of futures
and physical positions
Note to traders: stay out of cash market; stick to a big derivatives
position
Has the bar for establishing manipulation become too
high? Successful prosecutions before 1980, not many
since
1.How to define deliverable supply for the purposes of measuring whether a
corner/squeeze is being attempted?
a.
Narrowest definition focuses on registered exchange stocks and stocks immediately on
hand (Cargill)
b.
Broadest definition includes all inventories and production capable of delivery (Indiana
Farm Bureau)
2.How to define “price artificiality”?
a.
Price differences between one contract month and the next (Cargill)
b.
Price differences with commodity in other markets (Cargill)
c.
Price differences with similar contracts on other exchanges (Cargill)
d.
Unusual rate of change in any of the above (Cargill)
e.
Historical experience with any of the above (Cargill)
f.
Complete physical/fundamental supply-demand analysis (Indiana Farm Bureau et seq)
3.How to prove intent?
a.
Inferred from behaviour and pricing patterns (Cargill)
b.
Specific proof (emails, telephone conversations)
CFTC precedents have substantially reversed Cargill
and make manipulation difficult (impossible) to prove
“To determine whether an artificial price has occurred one must look at aggregate
forces of supply and demand and search for those factors that are extraneous to the
pricing system, are not a legitimate part of the economic pricing of the commodity, or
are extrinsic to that commodity market” (In re Indiana Farm Bureau, CFTC, 1982)
CFTC dismissed historical price comparisons in Cox by saying “the prospective
behaviour of a ‘normal’ market is not bounded by the market’s historical experiences”
(In re Cox, CFTC, 1987).
Defendant blameless for “[seeking] the best price from the existing situation” and the
long “has a contractual right to stand for delivery or exact whatever price for its long
position which a short is willing to pay to avoid having to make delivery” (In re Indiana
Farm Bureau).
Positions initiated as a legitimate hedge given benefit of doubt even if conditions
subsequently developed that made market susceptible to squeeze (In re Indiana
Farm Bureau)
Current application of the U.S. law on squeezes and
corners is a mess
Perhaps the final word on the current state of U.S. commodity
trading law should be left to Judge Miller:
“The court’s dismissal of the superceding indictment [against the
individual propane traders] should not be taken as condoning the
defendants’ alleged actions in this case. Nor should it be considered a
statement regarding the propriety of such profiteering in the marketplace.
The court is not an arbiter of morality, economics, or corporate conduct.
Rather, it is an arbiter of the law. The court is sympathetic to the
government’s desire to discourage the types of behavior alleged here,
but its ability to do so is currently limited by a confusing and incomplete
statutory and common-law regime. Until such time as Congress or a
higher court speaks more clearly regarding the trading activities alleged
here, it is the finding of this court that they do not violate the CEA as
alleged in the superceding indictment.”
(http://www.justice.gov/criminal/vns/docs/2009/sep/09-17-09radleydismiss.pdf)
Wall Street Reform and Consumer Protection Act
attempts to remedy some problems with current law
PL 111-203, Section 753 Anti-Manipulation Authority tries to close the
OTC loophole identified by Judge Miller by extending anti-manipulation
rules to OTC swaps
‘‘(1) PROHIBITION AGAINST MANIPULATION.—It shall be unlawful for any
person, directly or indirectly, to use or employ, or attempt to use or employ, in
connection with any swap, or a contract of sale of any commodity in interstate
commerce, or for future delivery on or subject to the rules of any registered entity,
any manipulative or deceptive device or contrivance, in contravention of such rules
and regulations as the Commission shall promulgate by not later than 1 year after
the date of enactment of the Dodd-Frank Wall Street Reform and Consumer
Protection Act”
‘‘(3) OTHER MANIPULATION.—In addition to the prohibition in paragraph (1), it
shall be unlawful for any person, directly or indirectly, to manipulate or attempt to
manipulate the price of any swap, or of any commodity in interstate commerce, or
for future delivery on or subject to the rules of any registered entity.”
Section 753 also strengths and clarifies the CFTC’s rule-making authority over other
aspects of the OTC markets
EU definition of market manipulation set out in Market
Abuse Directive 2003/124/EC
Article 4: Following non-exhaustive price signals, which should not necessarily be
deemed in themselves to constitute market manipulation, [should be] taken into
account when transactions or orders to trade are examined by market participants
and competent authorities:
Extent to which trades/orders given represent a significant proportion of daily
volume, in particular when activities lead to a significant change in price;
Extent to which trades/orders given by persons with a significant buying or selling
position in a financial instrument lead to a significant price change;
Extent to which trades/orders include position reversals in a short period and
represent a significant proportion of daily volume, and might be associated with
significant changes in price;
Extent to which trades/orders are concentrated within a short timespan in the
trading session and lead to a price change which is subsequently reversed;
Extent to which trades/orders undertaken at or around a specific time when
reference prices, settlement prices and valuations are calculated and lead to price
changes which have an effect on such prices and valuations.
Transposed into UK law by Section 118 Financial
Services and Markets Act 2000
(1) For the purposes of this Act, market abuse is behaviour (whether by one person alone or by
two or more persons jointly or in concert)—
(a) which occurs in relation to qualifying investments traded on a market to which this section
applies;
(b) which satisfies any one or more of the conditions set out in subsection (2); and
(c) which is likely to be regarded by a regular user of that market who is aware of the behaviour
as a failure on the part of the person or persons concerned to observe the standard of behaviour
reasonably expected of a person in his or their position in relation to the market.
(2) The conditions are that—
(a) the behaviour is based on information which is not generally available to those using the
market but which, if available to a regular user of the market, would or would be likely to be
regarded by him as relevant …;
(b) the behaviour is likely to give a regular user of the market a false or misleading impression as
to the supply of, or demand for, or as to the price or value of, investments of the kind in question;
(c) a regular user of the market would, or would be likely to, regard the behaviour as behaviour
which would, or would be likely to, distort the market in investments of the kind in question.
(8) Behaviour does not amount to market abuse if it conforms with a rule which includes a
provision to the effect that behaviour conforming with the rule does not amount to market abuse.
FSA has elaborated on the question of market abuse
in its Code of Market Conduct (MAR)
MAR 1.6 (derives authority from Section 118 Financial Services and Markets Act
2000)
FSA views as evidence of market abuse (manipulative transactions):
(a) Buying or selling at the close with the effect of misleading investors who act on
the basis of closing prices
(b) Wash trades
(c) Painting the tape
(d) Transactions that secure a dominant position that have effect of fixing purchases
or sales prices or creating unfair trading conditions, other than for legitimate
reasons
(e) An abusive squeeze where a person has significant influence over the supply of
or demand for or delivery mechanisms for an underlying product of a derivative
contract and engages in behaviour with the purpose of positioning at a distorted
level the price at which others have to deliver, take delivery, or defer delivery to
satisfy their obligations.
But FSA has set out a generous list of factors that it
would consider legitimate reasons for behaviour
MAR 1.6.6 In the opinion of the FSA the following factors are to be taken into account when
considering whether behaviour is for "legitimate reasons", and are indications that it is:
(1) if the transaction is pursuant to a prior legal or regulatory obligation owed to a third party;
(2) if the transaction is executed in a way which takes into account the need for the market as a
whole to operate fairly and efficiently;
(3) the extent to which the transaction generally opens a new position, so creating an exposure
to market risk, rather than closes out a position and so removes market risk; and
(4) if the transaction complied with the rules of the relevant prescribed markets about how
transactions are to be executed in a proper way (for example, rules on reporting and
executing cross-transactions).
MAR 1.6.7: It is unlikely that the behaviour of market users when trading at times and in sizes
most beneficial to them (whether for the purpose of long term investment objectives, risk
management or short term speculation) and seeking the maximum profit from their dealings will of
itself amount to distortion. Such behaviour, generally speaking, improves the liquidity and
efficiency of markets.
MAR 1.6.8 : It is unlikely that prices in the market which are trading outside their normal range will
necessarily be indicative that someone has engaged in behaviour with the purpose of positioning
prices at a distorted level. High or low prices relative to a trading range can be the result of the
proper interplay of supply and demand.
Factors to be taken into account: abusive squeezes
(FSA Code of Market Conduct)
MAR 1.6.11 In the opinion of the FSA, the following factors are to be taken into account when determining
whether a person has engaged in an abusive squeeze:
(1) the extent to which a person is willing to relax his control or other influence in order to help maintain an orderly
market, and the price at which he is willing to do so; for example, behaviour is less likely to amount to an
abusive squeeze if a person is willing to lend the investment in question;
(2) the extent to which the person's activity causes, or risks causing, settlement default by other market users on a
multilateral basis and not just a bilateral basis. The more widespread the risk of multilateral settlement default,
the more likely that an abusive squeeze has been effected;
(3) the extent to which prices under the delivery mechanisms of the market diverge from the prices for delivery of
the investment or its equivalent outside those mechanisms. The greater the divergence beyond that to be
reasonably expected, the more likely that an abusive squeeze has been effected; and
(4) the extent to which the spot or immediate market compared to the forward market is unusually expensive or
inexpensive or the extent to which borrowing rates are unusually expensive or inexpensive.
MAR 1.6.12 Squeezes occur relatively frequently when the proper interaction of supply and demand leads to
market tightness, but this is not of itself abusive. In addition, having a significant influence over the supply of, or
demand for, or delivery mechanisms for an investment, for example, through ownership, borrowing or reserving
the investment in question, is not of itself abusive.
MAR 1.6.13 The effects of an abusive squeeze are likely to be influenced by the extent to which other market
users have failed to protect their own interests or fulfil their obligations in a manner consistent with the standards
of behaviour to be expected of them in that market. Market users can be expected to settle their obligations and
not to put themselves in a position where, to do so, they have to rely on holders of long positions lending when
they may not be inclined to do so and may be under no obligation to do so.
FSA requires exchanges to have rules for managing
dominant positions
Exchanges must adopt rules giving them the power to direct members to reduce or
close out positions when this is necessary to maintain orderly trading. For example,
LME Lending Guidelines (despite name actually an exchange rule)
“[a] If at any time a member or client holds 50% or more of the warrants and/or cash today/cash positions in
relation to stocks, he should be prepared to lend, if asked, at no more than a premium of ½% of the cash price for
a day
[b] If at any time a member or client holds 80% or more of the warrants and/or cash today/cash positions in
relation to stocks, he should be prepared to lend, if asked, at no more than a premium of ¼% of the cash price for
a day.
[c] If at any time a member or client holds 90% or more of the warrants and/or cash today/cash positions in
relation to stocks, he should be prepared to lend, if asked, at no more than the cash price.
[d] As with the publication of large position information, in determining the application of the guidelines, it would be
appropriate for the LME to aggregate the positions of a client across all brokers in reaching its estimate of
dominant positions. Likewise it would be appropriate to aggregate the positions of a member, its related group
companies and its clients unless the firm could demonstrate that the positions were independent.
.. . The effect of this banding is that where a person’s WTC position is above 90% of live warrants he should be
prepared to lend for a day:
(a) at no premium (i.e. “level”) a sufficient number of lots to reduce his position below 90%;
(b) at a premium of no more than ¼% of the cash price a sufficient number of lots to reduce his position below
80%; and
(c) at a premium of no more than ½% of the cash price a sufficient number of lots to reduce his position below
50%. “(Explanation of Metal Lending Guidance, Note to Members, LME, May 2010)
Is it possible to prove abuse under the standard set by
the FSA?
In the past five years, the FSA has only brought two successful actions for market
abuse in commodity markets
Kerr: manipulation of coffee prices around the window for options settlement
Perkins: manipulation of Brent crude oil prices while drunk
No successful actions for corners, squeezes or other large-scale attempts to
manipulate prices
Sign that there is no manipulation in commodity markets? Or sign that enforcement
regime is not rigorous?
However, some indications of intervention by exchanges under discretionary position
management powers
Can we define factors constituting an evidence of a
possible squeeze and/or congestion?
(1) Limits on the availability to the physical commodity for delivery
a.
Restrictions on ability to make or take delivery (storage and logistics)
b.
Tight supply-demand balance (successful squeezes are implemented with the grain of
the market not against it; no one tries to squeeze a market in over-supply; fundamentals
will always offer some support – and cover – to a squeezer – note for example the
physical market circumstances in Cargill)
c.
Mismatch between physical positions and futures hedges (dirty hedgers can be uniquely
vulnerable since they cannot hope to make delivery).
(2) Dominant position in physical commodity and/or futures and/or options close to
expiry
a.
Gives long position holder effective control over all or a substantial proportion of the
supply that is really available for delivery
b.
Long position holder able to demand delivery of more of the commodity than the shorts
can realistically deliver
c.
“Experience shows that the vast majority of market aberrations which have resulted in
specific regulatory interventions by the Special Committee have involved dominant
positons” Market Aberrations – the Way Forward, LME, 1998, para 13.11
Can we define factors constituting possible evidence
of a squeeze … cont
(3) Price dislocation – prices for cash/futures/option contract rise far above those for
other months, or for a substantially similar commodity in other markets, or a
substantially similar contract on other exchanges (ex ante test)
a.
Similar to the tests that the court employed in Cargill
b.
“Extent to which the spot or immediate market compared to the forward market is
unusually expensive or inexpensive or the extent to which borrowing rates are unusually
expensive or inexpensive” test codified by FSA Code of Market Conduct at MAR 1.6.11
(4)
(4) Futures market trades in substantial backwardation even though anticipated
shortages of a commodity are prospective rather than immediate
a.
Backwardation should be associated with immediate physical shortage, not a theoretical
forecast shortage in a year or more time
b.
Projected future tightness should see whole strip of prices lifted and the market continue
to trade in contango or at best a small backwardation
c.
When oil prices were peaking in 2008, the market was trading in small backwardations
or even contango structure, reflecting forecasts that supply-demand balance would
tighten in future and remain tight, even physical supply in the present was adequate
Can we define factors constituting possible evidence
of a squeeze … cont
(5) Price dislocation is rapidly resolved (prompt prices sell off sharply and the
backwardation eases or disappears completely) once affected futures/options
contracts have matured or the dominant position has been given up (ex post test)
a.
No obvious fundamental reason for the shift in prices other than the breakdown or end
of the squeeze itself
It is the presence of all five conditions (in some form) that tends to
indicate a squeeze or corner may have been attempted
Is there a need for regulatory reform?
In the United States,
Difficulty of bringing successful prosecutions or administrative actions for
market manipulation
Reliance on “fraud and deception” approaches which may not be appropriate or
winnable in court
Reliance on hard position limits in the run up to contract expiry
In the United Kingdom,
Discretionary position management provides flexibility but may foster
uncertainty about if and when authorities will intervene
Short and long position holders publicise grievances to find the exchanges’ and
the FSA’s pain threshold that triggers intervention
LME lending guidelines a model for other markets? Does they strike right
balance between interests of dominant longs and shorts?
Basic principles for a more effective regulatory regime
dealing with corners and squeezes
Revert to approach used by the court in Cargill. Begin with apparent distortions in
the structure of prices, then ask whether there is any fundamental factor other
than the presence of the dominant position itself that could explain them.
Opposite of the current CFTC/FSA approach, which starts with an (impossible)
study of fundamentals. No one can agree on what the fundamentals are (if they
could the market would not exist because there would be no diversity of views
between buyers and sellers). Starting from a study of “fundamentals” just dooms
the exercise to failure (some would argue that is the intention).
Reverse the reverse the burden of proof. During periods of tightness, put onus on
the holder of a dominant position to show it is not doing harm, not on the
regulator to show it was abusive.
Should “intent” matter? If the practical effect of a position/strategy is to cause a
squeeze, and they persisted in this course of conduct, should it matter what the
position holders “intent” actually was? Is intent an artificial standard?
Already accepted that dominant position holders have
special responsibility to avoid even unintentional harm
“[T]he general principle that if someone has a dominant position in the [inventory]
he incurs additional responsibilities to the market to avoid his inherent market
power resulting in market abuse, and this may mean that while he has a
dominant stock position he will no longer be able to undertake trading strategies
that would be acceptable in other circumstances.
“In particular … a dominant position holder would be abusing the market if it used
its dominant position to require other market users to pay more to meet their
needs than they would have had to pay had the market reflected the natural
interplay of supply and demand without any participants having a dominant
position
“The problem is that while this concept is clear, its application involves
considerable judgement. The outcome is that intervention to prevent abuse of
dominant positions tends to satisfy neither the market users nor the dominant
position holders.
“Market users criticise the lack of certainty and what they see – incorrectly – as
arbitrariness; while the dominant position holders seek definitive guidance on
what price they can charge” Market Aberrations – the Way Forward, LME, 1998,
13.13
Roadmap for future reform
Define and build consensus about what market behaviour regulators and broader
community want to encourage and discourage
Develop more effective legal and regulatory structure to ensure prohibitions on
certain types of behaviour are effective (an answer to Judge Miller’s criticism of
the current unclear and ineffective state of the law and practice)
Unless and until market abuse regime is clarified and strengthened, hard position
limits on contracts in the approach to expiry or automatic rules dealing with how
dominant positions will be managed may be only way to sidestep impossible
debate about “intention”
References
Commodity
Exchange
Act
prohibition
on
market
manipulation,
7
USC
13(a)(2):
http://frwebgate.access.gpo.gov/cgibin/usc.cgi?ACTION=RETRIEVE&FILE=$$xa$$busc7.wais&start=509712&SIZE=24087&TYPE=PDF
Cargill v Hardin, U.S. Court of Appeals (8th Circuit), 1971: http://openjurist.org/print/143164
U.S. v Radley, U.S. District Court for the Southern District of Texas, 2009:
http://www.justice.gov/criminal/vns/docs/2009/sep/09-17-09radley-dismiss.pdf
U.S. v Patten, U.S. Supreme Court, 1913, http://supreme.justia.com/us/226/525/case.html
Energy Market Manipulation: Definition, Diagnosis, and Deterrence, Energy Law Journal,
Pirrong,
2010:
http://www.felj.org/docs/elj311/13-01-Pirrong-EnergyMarketManipulation022510.pdf
EU Market Abuse Directive 2003/124/EC, European Commission, 2003: http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2003:339:0070:0072:EN:PDF
UK Financial Services and Markets Act 2000, Section 118 “Market
http://www.opsi.gov.uk/acts/acts2000/ukpga_20000008_en_10#pt8-pb1-l1g118
Abuse”:
Code of Market Conduct, UK Financial Services Authority, MAR 1.6 Market Abuse
(Manipulating Transactions): http://fsahandbook.info/FSA/html/handbook/MAR/1/6
Market
Aberrations:
The
Way
Forward,
London
http://www.lme.com/downloads/notices/marketabs.pdf
Metal
Exchange,
1998: