Arithmetic Masquerading as Analysis

Numerous futures markets heavyweights, including CME, ICE, and BlackRock are up in arms over a CFTC rule that would require delisting of a futures contract that had more than 15 percent of its volume traded outside the exchange’s central order book.  Their opposition–anger, really–is justified.

The Commission’s logic is that it wants to protect the price discovery process in centralized markets.  It recognizes that block trades and other off-exchange trades can mitigate price impact on large transactions, e.g., in hedging trades.  Verifiably uninformed traders have an incentive to trade off exchange because this allows them to avoid paying the adverse selection-related costs incurred in an anonymous market; it can also reduce execution risk.  Loss of some uninformed order flow reduces liquidity on the centralized market, and can reduce the informativeness of the prices on that market.

Quantifying the impact of all these changes is impossible.  Much of the effect is to transfer wealth from one group of uninformed traders (those who trade on the centralized market) to another (those who can avail themselves of the block market or other off-exchange trading venues.)  In my JLEO “Market Macrostructure” paper I demonstrate that the net effect can bet positive, i.e., the benefit to the latter can exceed the loss suffered by the former.  The cost of a decline in price informativeness cannot be quantified.  Period.  Moreover, even here things are ambiguous.  A decline in the amount of uninformed trading on the central market tends to reduce the amount of informed trading–that’s why price informativeness declines.  But some informed trading is rent seeking–it involves spending real resources to acquire information in order to achieve a transfer of wealth.  This is inefficient.  Reducing this activity actually improves welfare.

In other words, nobody knows how much block trading/off-exchange trading activity is the right amount.  Least of all the CFTC.

One thing is for sure, though.  The marginal cost of block trading doesn’t become infinite when block trading volume is 15 percent of the total.  But that is what the CFTC rule implicitly assumes.  Moreover, even if the marginal cost (including all relevant costs and benefits) of block trading is positive when it totals 15 percent of volume, shutting down the centralized market if block volume exceeds 15 percent makes no sense at all.  A market with “too much” block trading activity still contributes to price discovery.  It still provides a cheaper place to trade than no centralized market at all.  Maybe its value isn’t maximized when there is too much block trading, but shutting it down sure does minimize its value.  It’s like cutting of your nose to spite your face.

Presumably the CFTC believes that no market will ever be shut down.  That any exchange facing delisting of a contract will change the block rules (e.g., increasing the minimum block size) in order to reduce block trading and avoid a shutdown.

But in adopting this change-your-rules-or-the-contract-gets-it strategy, the CFTC presumes that it knows the right amount of block trading.  It knows no such thing.  Indeed, the basis for its threshold is purely arbitrary–a joke, actually:

In the second largest category, involving 128 contracts from all asset classes which included contracts with large and small open interest, the average amount of off-exchange trading over the three-month period ranged from 0% to 15%. The Commission believes that this second category of contracts, where there was actual centralized market trading to observe, provides a reasonable basis for establishing a minimum centralized market trading requirement. Accordingly, from this second category the Commission took the upper range of the maximum average amount of off-exchange trading, and proposes that a maximum of 15% of total trading volume of a contract would be an allowable amount of off-exchange trading in order to protect the price discovery process of trading on the centralized market.

So, the staff looks at some historical numbers for historical off-exchange trading activity (including, apparently, exchange for physicals and exchange for swaps, etc.), the Commission picks a number at the top of the range, and declares it “reasonable” to apply this number to all markets going forward.  That’s not analysis: that’s arithmetic.  It involves no serious consideration of any of the relevant issues and trade-offs relating to on- and off-exchange trading.

The opposition of the exchanges is particularly interesting here.  Exchanges internalize many of the effects of their block trading and EFP rules.  To the extent that block trading reduces liquidity on the centralized market, it reduces the derived demand for trading on that market–and hence reduces the fees an exchange can charge and the quantity of trades there, which combine to reduce the exchange’s revenue from that source.  It can collect revenues from block trades; these revenues reflect the benefits that block trading provides.   Through the effects of its rules on these different revenue streams, the exchange internalizes, albeit perhaps imperfectly, the costs and benefits of those rules on execution costs and liquidity for alternative ways of completing trades.  (This is different, I would add, from internalization or third markets, where a third party “skims” uninformed order flow and does not internalize the effects on the liquidity of a central market.)  Thus, the exchange is in a much better position to know, and has a stronger incentive to know, the liquidity effects of block rules than does the CFTC.  It can balance and has the incentive to balance these effects to craft an efficient rule.  This argues strongly in favor of letting the exchanges make their own rules.

Exchanges don’t directly internalize any benefits flowing from more informative prices.  Nobody does–including the CFTC.  The rent seeking argument I mentioned above means that these benefits may not even be positive–they may be negative, once the costs of information are taken into account.  Imposing an entirely arbitrary standard based on a calculation that a fifth grader could make, and which cannot–cannot–quantify even approximately the benefits and costs at issue is an act of regulatory overstretch that is far too characteristic of this Commission.  It denies those who have some information about some relevant costs and benefits–the exchanges, with regard to the effects of the rules on trading costs–from taking that information into account when establishing their rules.  It substitutes its own judgment for what is the “right” amount of off-exchange trading when that judgment is predicated on complete ignorance.

The Commission has a lot on its plate.  The Commissioners, with some justice, complain about their crushing work load repeatedly.  Here’s a suggestion: they can lighten their burden by avoiding dealing with issues about which the Commission completely lacks the information necessary to craft constructive regulations.  The off-exchange trading rule is a perfect example of that.  One can have nice philosophical arguments about these issues, but a rational regulatory triage strategy would relegate such debates to academics and focus on more pressing matters about which it is possible to get enough information and knowledge to craft sensible rules.

I’m not holding my breath.

About Craig Pirrong 223 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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