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The Manipulation and Distortion of The Stockmarket

What I look at in this article is how equitable the market place is for Futures and stock trading in commodities raising the question of how equal are the opportunities ?  The idea of protection feature strongly in economic discussions and can cover a multitude of sin from obstruction of data resulting in imperfect information to insider trading, to barriers created around the market place and red tape.  Understanding what manipulation and distortion happens in the marketplace is a critical issue if we are to understand the existing influences on the food prices.

Like bank traders, fund managers often use computerized high frequency ‘algorithmic trading’ to make gains from miniscule price movements. High-frequency trading is based on information that reaches insiders a fraction of a second ahead of everyone else – just long enough to cash in, while raising costs for ordinary investors. Michael Lewis wrote Flash Boys in which he describes the construction of a secretive 827-mile cable running from Chicago to New Jersey which would reduce the journey of data from 17 to 13 milliseconds. The speed of data is a major theme in the book; essentially, the faster the data travels, the better the price of the trade.

high frequency trading

Lewis describes how access to this fiber optic cable and other technologies, presents an opportunity for the market to be controlled even more by the big Wall Street banks. New York State Attorney General Eric Schneiderman addressed his own reservations about some uses of the practice following a “60 Minutes”‘ report that showed how a few stock market insiders are making billions in high-frequency trading:

 

Schneiderman said “Some of it, I believe, may be illegal, our offices had an investigation for over a year into some practices related to high-frequency trading…. There are situations where there really may be some illegal conduct and we are looking at it under New York securities laws.”

The day after the book’s release the Federal Bureau of Investigation announced an investigation into high frequency trading, frontrunning, market manipulation, and insider trading. New York Attorney General Eric Schneiderman also commented on his ongoing investigation into HFT and Flash Boys.

The Commodities Futures Trading Commission (“CFTC”) became more involved in insider trading actions. Under the Dodd-Frank Act, a new Section 6(c)(1) has been added to the Commodities Exchange Act prohibiting any deceptive device or contrivance in connection with a swap, future or cash contract in contravention of CFTC rules. The Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into federal law by President Barack Obama on July 21, 2010 at the Ronald Reagan Building in Washington, DC.

Unlike securities markets, futures markets do not have corporate issuers. Thus, the new rule prohibits trading on the basis of material nonpublic information obtained through fraud or deceit or in breach of a pre-existing duty; the rule does not create a new duty to disclose.

Flash Boys

Under the new Rule 180.1, trading on one’s own, material nonpublic information is permitted. However, trading on information that was inappropriately obtained or used in breach of a duty created by the circumstances under which it was obtained, is not.

[Insider Trading: New Developments and How to Deal with Them By John H. Sturc and Adam Chen; Taken from Internet 27.10.2013 – http://www.gibsondunn.com/publications/Documents/SturcChen-InsiderTrading-NewDevelopments-PracticalCompliance.pdf]

The market is controlled by those who are best advantaged by it.  This privileged position is protected to maintain the profits which come of it.  The protection of the advantaged comes at the price of things like food commodities having their price artificially inflated through trades. Ironically, the deregulation of the market has led to the control and protection of it. The profit motive now drives the price of life sustaining commodities such as wheat up due to the control which is exercised.  In a healthy market, there is theory which suggests competition would bring down prices; however this is not the case when cartel like formations form.

 

Joseph Stiglitz suggests that intelligent industrial policy has to be formed to regulate the markets. 51 minutes into the following video he starts talking about market failures and industrial policy:

 

Economists discuss moral hazard in terms of information asymmetry.  This refers to a situation in which one party in a transaction has more information than another. In particular, moral hazard may occur if a party that is insulated from risk has more information about its actions and intentions than the party paying for the negative consequences of the risk.  This is where the concept of exploitation comes into play, in that the stocktraders are exploiting the markets to get the best possible price; however, this behaviour is done usually in a vacuum of a marketplace abstracted from the realities of the effects visited upon the world.

Gaining a greater market share means that one can effect greater control over prices overall.  One mechanism by which the price can be effected is by holding back the sale of the commodities thus creating scarcity.

The Commodities Futures Trading Commission chief Gary Gensler addressed Congress about insider trading possibilities in the commodities market: “We have recommended banning using misappropriated government information to trade in the commodity markets. In the movie “Trading Places,” starring Eddie Murphy, the Duke brothers intended to profit from trades in frozen concentrated orange juice futures contracts using an illicitly obtained and not yet public Department of Agriculture orange crop report.

Characters played by Eddie Murphy and Dan Aykroyd intercept the misappropriated report and trade on it to profit and ruin the Duke brothers. In real life, using such misappropriated government information actually is not illegal under our statute. To protect our markets, we have recommended what we call the “Eddie Murphy” rule to ban insider trading using nonpublic information misappropriated from a government source.”

Gensler raises an interesting issue. Under the regulations of the time, the CFTC did not ban trading on inside information. The Wall Street Journal explained it thus:

“Unlike most stock markets, insider trading isn’t generally illegal in commodities trading. An oil company can take advantage of inside information about its production outlook when it makes trades. However, if traders intentionally create an artificial price and use it to make money, charges of manipulation may arise.”

[First the Volcker Rule, Now the Eddie Murphy Rule! March 4, 2010, 3:49 PM By Matt Phillips; Taken from Internet 27.10.2013 – http://blogs.wsj.com/marketbeat/2010/03/04/first-the-volcker-rule-now-the-eddie-murphy-rule/]

Technically a food speculator bets on the prices of staples such as wheat, soya and oilseed, to make a profit. They are investors who trade in ‘agricultural derivatives’ based on ‘futures’ – or agreements to buy or sell food stuffs at a certain price for delivery at a later date.

Originally farmers and food companies traded futures contracts as a way to secure supply and income over the year. Later commodities were traded on public exchanges. These ‘agricultural derivatives exchanges’ such as The Chicago Board of Trade – are where financial speculators get involved, where they bet on the future price of grains, pigs, chickens, cows etc. This is a cursory involvement where the finance manager does not take delivery of a tonne of wheat e.g. for making into flour or bread but simply to pass on for a higher price.

Bankers and food speculation

Banks are involved in this speculative investment of food futures. As institutions which administrate much of the exchange systems, they transformed edible ingredients into the ‘commodity index’ . This turns food futures into an asset like a stock or a share that anyone can buy or sell in an attempt to grow their cash.

Investment banks charge for administrating and enabling this new passive way to speculate on food stuffs whilst also actively ‘playing the markets’ with their own ‘in-house’ fund managers/traders (which is called ‘proprietary trading’).

 

History of the Commodity Index

The ‘commodity index’ was pioneered in 1991 by the canny and opportunistic investment bank Goldman Sachs. [‘The Food Bubble; How Wall Street starved millions and got away with it’ by Frederick Kaufman; Taken from Internet 27.10.2013 – http://frederickkaufman.typepad.com/files/the-food-bubble-pdf.pdf]

The index brought together 24 different raw materials – agriculture, energy and metals – transforming into ‘assets’ that performed like as a stock or a share. The index tracked futures prices on the commodity derivatives exchanges. When these markets were tightly regulated they functioned well in terms of reflecting demand and supply – the real price of wheat declined.

commodities

After intense lobbying, the US Commodity Futures Trading Commission relaxed the rules in 1999. Banks such as Barclays, Deutsche Bank and JP Morgan, could now hold as large a ‘position’ in food futures as they liked. Previously they could not. A traders ‘position’ is the balance of (long futures contracts) ‘promises to buy’ minus ‘promises to sell (short contracts). This lead to manipulation and volatility of the staple foods market:

“The 200 million person increase in global food insecurity since 2006 — over one billion according to UN Food and Agricultural Organization (FAO) — did not result from global production failure or a shortage of supply. Global food production increased on a per capita basis throughout the past decade and 2008 saw a record global cereal harvest.1 The trigger for food riots in at least 30 net food import dependent developing countries in 2008 was due to extreme spikes in food and energy prices. A major driver of these price spikes was the overwhelming market domination of financial firms over traditional traders in commodity futures markets.”

[Commodity Market Deregulation and Food Prices By Dr. Steve Suppan; Institute for Agriculture and Trade Policy, Published March 1, 2010; Taken from Internet 28.10.2013 – http://www.iatp.org/documents/commodity-market-deregulation-and-food-prices-0]

 

Nearly everyone is in some way connected to the manipulation and distortion of the commodities market.  It is very hard to escape some involvement, if it is from buying products made by large unsustainable multinational businesses which have bought up the supply chain, or from investing in a hedge fund via a stockbroker:

pension fund

Pension Funds

Many people put money aside to provide for themselves in later years. This sensible practice is managed by pension fund managers who invest the pension money in food exchanges through the commodity indexes. Indexes became dramatically populated when various investment areas dried up. Trading in commodiites indexes increased 50 fold in a decade reaching $376 billion by 2010:

“Commodity investing through tracking indexes such as Standard & Poor’s Goldman Sachs Commodity Index (SP-GSCI) and Dow-Jones UBS Commodity Index (DJ-UBS) rose to $376 billion by the end of 2010, according to Barclays Capital, triple the amount in 2005. Commodity index returns were accessed using index swaps, medium-term notes and commodity exchange-traded products (ETPs).”

[Are speculators to blame for high commodity prices? 02 September 2011 Taken from Internet 12/11/2013: http://www.fow.com/article/2894454/are-speculators-to-blame-for-high-commodity-prices.html?ArticleID=2894454]

Global food prices in July hit the highest levels ever recorded, with staples such as wheat and sugar a third more expensive than a year ago. In the face of the global economic slowdown, the commodity price spiral shows no signs of abating, and as policy makers seek an explanation, the derivatives market is again in the spotlight. David Wigan looked in to whether accusations that speculation pushes up prices are justified.

This was led into by the dotcom crash in 2000, the US property meltdown in 2006, the global financial crisis in 2008 which sent pension fund managers on the hunt for new, safe places to grow their financial returns.

Exchange Traded Funds

Members of the Public

Members of the public, with the development of technology, are enabled now to become ‘Retail investors’ buying into ‘structured investment products’ that teack the price of food stuffs such as wheat and maize. Banks and investment companies offer hundres of these ‘Exchange Traded Commodiites’ which are based on the banks’ commodity indexes.

A vast range of products have popped up to allow investors to gamble on index funds. Many of these are done by swaps or ‘Over The Counter’ deals which are private arrangements between banks and clients that are not open to public scrutiny.

The main route into food derivatives for consumers and institutional investors are Exchange Traded Funds (ETFs, such as Deutsche Bank’s Agriculture Booster. The agricutlrue elements in ETFs leapt by 35 per cent in six months to reach $15.7 billion at the end of June 2011.

“Commodities such as grain, which are vulnerable to supply shocks linked to macroeconomic events such as poor weather conditions and increased supply demand, have proved to be of interest for investors, with ETFs linked to wheat reaching $72 million and US$77 million respectively…

Exchange-traded funds linked to some agricultural commodities such as wheat have seen the strongest investment inflows over the first part of the year, with soft commodities presenting low or stretched inventory levels leading the trend…”

[ETFs Linked Agricultural Commoditie Surge Supply Tightens; Risknet.com; Taken From Internet: 12/11/2013: http://www.risk.net/structured-products/news/2093259/etfs-linked-agricultural-commodities-surge-supply-tightens]

Institutional Investors

Corporate Producers

Powerful, commercial firms deal in the real business of busying and selling food goods such as grains’ but many also get involved in speculating in the abstract spaces of the markets. Using ehir inside knowledge of the market and acting like quasi-hedge funds, they aggressively punt on the price of commodities such as grain. There is a rumour that they had a hand in Russia’s recent wheat export ban (2011) and profited from it.

When a critical amount of investors keep on buying, it creates a ‘demand shock’ in the commodities exchanges, pushing up the cost of futures. This was the opinion of the Hedge Fund Manager Michael Masters whilst giving testimony before a US Senate Committee addressing The Food Crisis in 2008:

“What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant”

[Page 2, Testimony of Michael W. Masters Managing Member / Portfolio Manager, Masters Capital Management, LLC before the Committee on Homeland Security and Governmental Affairs United States Senate, May 20, 2008; Taken from Internet 12/11/2013: http://www.hsgac.senate.gov/public/_files/052008Masters.pdf]

 

Creation of Bubbles

The Creation of Bubbles

The City of London is the world’s second largest agricultural commodities market. The banks argue that a bet on the price of something cannot influence the real price. The City of London is called the ‘square mile’. Here we can see on large screens the London International Financial Futures and Option Exchanges (LIFFE). Some ‘agricultural boosters’ are not displayed publically as they are traded electronically on desks. You would have to download an app such as Bloomberg App to see it on your mobile phone.

Hazel Healy (New Internationalist) interviewed a commodities trader to explore if derivatives could drive up the price of food. She reports that this independent commodities trader, who ran a sugar hedge fund in the 1980s, said that in his opinion there is no doubt that commodities funds and ‘agricultural boosters’ are pushing up prices “because it’s pushing demand and that pulls supply out of the chain”.

Examining the small print of some ‘Agricultural Booster’, which Hazel Healy bought, he notes that “before my futures contracts expire, they will be ‘rolled over’ into a ‘longer dated contract’. This, she suggests, is a key piece of information in understanding the ‘artificial pull on prices’. It means that the index is structured to buy futures automatically with the assumption that prices will rise.

When investors take their price signals to buy or sell from the exchange, traders on physical markets delay sales and hoard reserves in anticipation of higher prices. This, Healy suggests, results in panic buying and countries impose export bans.

Thus the index fund manager is effectively hoarding futures contracts consequently triggering real life hoarding that fulfills the bet on rising prices. There is an artificial inflation of the prices, which means that the prices administered in the virtual environments of the computer, internet and bureaucracies non-representative of the physical world – i.e. the real value of the product.

These self fulfilling trends of ever upward moving prices are described as ‘bubbles’ which eventually ‘burst’. There was a famous ‘bubble’ with the property market, which burst, and one with food that burst in 2008. When they burst, the process starts again leaving behind carnage.

“We are in another commodity price run up, like that experienced in the 2005-2008 period.  Such commodity price frenzies have devastating consequences for the world’s poor who, in some instances, already spend half of their income on food. “

[Commodity Bubble Redux In Full Effect by Robert Barone; www.forbes.com; 4/25/2011; Drawn from Internet: 12/11/2013: http://www.forbes.com/sites/greatspeculations/2011/04/25/commodity-bubble-redux-in-full-effect/]

 

Question One: Identify and write about three different ways that the market can become distorted

Question Two: Explain what a bubble is and use the internet to find the details of a stockmarket bubble

 

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