Investors aren’t limited to only investing in the S&P 500 and the Dow Jones Industrial Average. Every week we share the market trends we are following. We are interested in whether the trends in those markets are continuing or if they are experiencing a temporary or complete reversal.
When we identify trends, we are only concerned about the price data and what it says about any given market. We don’t need to know why a trend has formed to invest, but our human nature wants to understand what is driving them. Each week we try to offer some perspective on what we think the most substantial moves are and what critical drivers are behind them. Here we look at what is going in our globally diversified, non-correlated Crystal Bay Ubitrend strategy.
Last week’s continuing trends:
- Maize
- Wheat
- German Government Bonds
- Rubber
- Brazilian Real
Last week’s reversing trends:
- Indian Rupee
- Live Cattle
- Soybeans
- Tiwanese Equities
- New Zealand Dollar
What we are taking note of:
This week we’ll go on an excursion to the exciting world of commodity market regulation. If you frequently peruse the Federal Register, you surely noticed on p. 11,596 of volume 85, number 35 that the Commodity and Futures Trading Commission (CFTC), the main regulator of the commodity markets in the United States, had a lot on its mind. So much, indeed, that it took until p. 11,744 to get it all off its chest. Despite the restrained language of the unknown bureaucrats who penned it, this underappreciated work of art is just the latest installment of a soap opera that sweeps across centuries and continents. Teaching us the ingenuity of man, the depths of greed, and why what you learned in the U.S. Government class about our Constitution is a pile of rubbish.
The story starts in 6th century B.C. in ancient Greece. Thales of Miletus was a philosopher and a mathematician. He laid the foundations of the scientific method and discovered geometrical laws; the Thales’s theorem is named after him. However, his neighbors in the city-state of Miletus were unimpressed: “If you’re so smart,” they taunted him, “why aren’t you rich?”. A great man would surely ignore such taunts; Thales, however, was not such a man. He plotted revenge the best way he could: by science. His astronomical and weather observations gave him an insight into the annual productivity of the olive groves in the Eastern Mediterranean. One year, when he was certain that the harvest would be favorable, he raised a small amount of money and put deposits on all the olive presses of Miletus and Chios. After the abundant harvest poured in, there was a shortage of capacity for pressing olives; Thales jacked up the prices and became rich.
Thales was the first known speculator to create what we now call the commodity corner. He was not the last.
The commodity corner is an attempt to control the price of a commodity by buying up all the supply. It is harder than it seems: it requires a lot of money to pull off, and many corner attempts failed. It also angers other market participants who do not like falling victim to market manipulation. But the difficulty of the scheme seems to attract ambitious speculators eager to make their name.
The great commodity corners of the modern era start with the gold market corner of James Fisk and Jay Gould in September 1869. Both Fisk and Gould were among the original robber barons who made their money in railroads. They built a large holding of gold and bribed the United States Assistant Treasurer to give them inside information about upcoming government sales of gold. They managed to drive up the price from $132.50 per ounce to $160 within three weeks, but then-President Grant stepped in and released millions of dollars worth of gold from the U.S. Treasury, crashing the gold price back to $138 within minutes. That day, September 24th 1869, became known as the Black Friday on Wall Street. Stock prices dropped by 20 percent, trading dried up, and dozens of brokerage firms went bust. Gould and Fisk, however, escaped unharmed as they received a tip off from the Assistant Treasurer and they sold their positions in time. Gould retired wealthy, Fisk was shot to death by a jealous lover of his mistress, and the Assistant Treasurer was elected to the U.S. Senate.
In 1980, the billionaire Hunt brothers organized the largest corner of all time. The Hunts inherited their money: their father parlayed poker winnings into mineral rights covering most of East Texas and became the richest man in the world. He had fifteen children by three wives (two of the marriages were bigamous). Two of his sons, Nelson and William, bought silver worth $10 billion during 1979, driving up the price from $6 per ounce to $49. They held one-third of the total world supply. The directors of the Comex commodity exchange (now part of ICE) noticed that something fishy was going on and raised margin requirements on silver in January 1980. The Hunts couldn’t come up with the additional margin and had to start liquidating their position. Silver price dropped by 50% in four days, and the corner was broken. Both brothers were bankrupted by the losses and subsequent litigation.
Not all corners were failures. The most successful corner of all time was the perfectly executed onion market manipulation of 1955 and 1956. Two onion traders on Chicago Mercantile Exchange (CME) bought onions and onion futures to control 98 percent of the available inventory, totaling over 30m pounds. But that was just a diversion. While onion prices were rising, the traders built a large short position and dumped their inventory on the market in March 1956, driving prices almost to zero. They made millions. A Congressional investigation followed but couldn’t find anything illegal. Congressman Gerald Ford, the man who later pardoned Richard Nixon for Watergate, sponsored the Onion Futures Act that prohibited futures trading in onions. The only commodity market singled out in U.S. legislation. The successful onion trader, Vincent Kosuga, retired and opened a restaurant in upstate New York called The Jolly Onion Inn.
Commodity corners, while great fun for traders, cause painful disruptions to commodity producers and consumers. There are two main categories of participants in the futures markets: hedgers and speculators. Hedgers use futures to reduce the risk of price fluctuations to their primary business. For example, oil producers and oil refineries are both hedgers. Oil producers use futures to manage the risk of oil price falling while oil refiners use futures to manage the opposite risk of oil price increasing. Speculators provide liquidity to hedgers by taking on risk in hope of profiting from price movements. Hedgers are always suspicious of speculators, but they need them for proper functioning of the market. Tensions between hedgers and speculators are the main driver of commodity market regulation.
Hedgers have always been terrified of the prospect of market corners. They pressured commodity exchanges to adopt position limits so that a single market participant can never again build a dominant position and manipulate prices. The position limits, naturally, do not apply to hedgers.
Position limits differ from exchange to exchange and commodity to commodity. They are subject to whims of the exchange boards and can be raised or lowered at will. Existing legislation does not address position limits. At least, it didn’t until the passage of the Dodd-Frank Act in 2010. Well, it sort of does and sort of doesn’t. To understand why, we need to drop our preconceptions about the role of Congress in creating legislation.
In textbooks, we learn that voters elect representatives to Congress. That part is correct. It then says that Congress writes and passes legislation. That part has not been correct for decades.
A typical member of the U.S. Congress spends 6-8 hours everyday fundraising. The job is basically a mid-level telemarketing position. On average, it costs $20m to defend a seat in the Senate (every six years) and $1.5m to defend an average seat in the House (every two years). The politician is responsible for raising most or all of the money. The “model daily schedule” given to the incoming class of representatives suggests not wasting more than 2 hours per day on actual legislative activities. How on earth can that be enough to even read the 400+ separate pieces of legislation passed every Congress term, let alone write them? Some of these bills are thousands of pages long.
The answer is, of course, that our elected representatives rarely read the laws they pass and most certainly don’t write them. And more importantly, modern legislation has a peculiar form that would be unrecognizable to the founding fathers. Most modern legislation consists of instructions to the regulatory agencies, technically the executive branch of government, to write the actual laws. Yes, the legislative branch has delegated its power to legislate to unelected bureaucrats.
A classic example of the genre, the Affordable Care Act of 2010, is 2300 pages long. You’d think that should be enough the settle the rules, but actually, the majority of the Act creates countless regulatory powers to be filled in by agencies. Within two years, 20,000 pages of regulations with the power of federal laws were issued. Uncountably more came out since then.
The Dodd-Frank Act followed the same template. By itself, it is merely 848 pages long. But those 848 pages pack a punch: they authorize regulators to create 243 rules, conduct 67 studies, and issue 22 periodic reports. By one count, there were 27,278 new regulations issued under the authorization of the Act. And the work is not finished. It brings to mind the famous anecdote from 2010: when Republicans challenged Nancy Pelosi to let them read the Affordable Care Act before they voted on it, she memorably replied, “You’ll have to pass it first if you want to read it.” Oh, sweet innocent child! It’s been ten years since the Dodd-Frank Act passed, and we still don’t know what’s in it! Dodd and Frank are both long retired while the bureaucratic machinery grinds on, filling in the blanks.
Which brings us full circle to the Federal Register volume 85 number 35. The 148 pages of prose culminate in a ten-year effort to settle just one of the 243 rules left unspecified in Dodd-Frank: commodity futures position limits. The CFTC first attempted to write position limit rules in 2011. That version was shot down by the D.C. District Court in 2012. CFTC created new proposals in 2013 and 2016 but couldn’t find enough courage to actually pass them, with hundreds of comments pouring in both opposing and supporting new rules. Only in February 2020 did it venture again and delivered to us whatever it is that sits here. And on October 15th, 2020, the CFTC Commissioners finally approved the 2020 proposal. The vote was split on partisan lines.
Was it worth the trouble? Looking at the text of the proposal, one cannot fail to notice something remarkable. The new position limits are almost all exactly the same as the old exchange limits! In the few places where they differ the new limits are higher than exchange limits and therefore irrelevant. All of this effort made absolutely no difference!
In my opinion, this proves that the American system of government works. Commodity exchanges have already thought about the problem of preventing commodity corners. Meddling politicians, mistaking activity for progress, demanded new laws. Thankfully, they realized that the task of writing such laws is beyond their capabilities and punted the responsibility to regulators. They, in turn, just copied what the exchanges already do. We ended up no worse than how we started, which can be considered a victory.