We’ve come a long way since the days when futures exchanges were marketplaces for negotiating formal contracts between sellers and buyers of commodities, haven’t we? Wheat Farmer A wants to lock in a price for his crop next fall while flour mill B wants to ensure it has a supply of wheat and also lock in a price. Presto, there’s the Chicago Board of Trade, and later the Butter and Egg Board, which became the Chicago Mercantile Exchange. Simple, efficient.

Nowadays, futures exchanges like the combined CBOT-CME entity—CME Group Inc.—trade so much more than commodities. And their sophistication in the form of high-speed electronic trading has far exceeded the old open-outcry trading pits. Better price discovery, more transparency, less inefficiency. Everyone should be happy.

Except, since MF Global collapsed and $1.2 billion or so in supposedly segregated and protected customer margin funds went missing, it seems nobody is happy. Not the farmers. Not the brokers. Certainly not the exchanges.

In everything I have read about MF Global’s collapse and the fallout from that, it’s the plight of the farmers, and their perspective, that has intrigued me the most. They are, after all, the primary reason these futures exchanges exist in the first place. Or they were. During the rise of what I’ll call the “speculative culture” some exchanges seem to have become preoccupied with providing products to suit and access for traders whose only interest is exploiting price moves and profiting from those exploitations. Up to a point, such interest can create better price discovery and reduce market inefficiencies. Beyond that point, however, the markets become hugely distorted and wildly inefficient. We seem to be there now. MF Global is just an example.

“CME—all the exchanges have focused on contracts, more growth, all these hedge funds, private equity funds that are getting into these markets. They are focused on that instead of their base business,” said Lance Holden, senior vice president with Wells Fargo Bank, the largest private lender to agribusiness that had customers who lost funds in the MF Global Collapse, in a story on how upset exchange customers are over the lack of oversight they see the CME exercising in the MF Global fiasco.

How have speculators, and the futures exchanges’ efforts to cater to them, hurt or helped the futures markets? Discuss.

Commodity Customer Coalition founder James Koutoulas is requesting that MF Global bankruptcy Judge Martin Glenn investigate three potential legal issues that are said to have occurred in transferring of MF Global assets.  The key issues include the fact that JP Morgan was able to purchase MF Global bonds at a discount without any open bidding process and the assets were apparently sold without disclosure to or approval from the U.S. bankruptcy court or trustees.  The third issue centers on JP Morgan seeking special favors from the Federal Reserve to receive priority treatment over investor segregated fund accounts.

The first such non-transparent movement of assets occurred when JP Morgan is said to have purchased MF Global’s Sovereign Debt at a significant discount without an open bidding process, paying $0.89 and later selling that debt to investor George Soros for $0.95.  No one is going to complain about JP Morgan generating profit.  However, purchasing assets of a bankrupt firm without an open bidding process or disclosure to the bankruptcy court and trustees is where JP Morgan may be in trouble, according to Mr. Koutoulas.  This sale could be subject to clawback provisions, legal experts speculate.  (On December 9, 2011 The Wall Street Journal reported the fact that bonds were moved to KPMG London office, which was the bankruptcy administrator, but at the time the article did not discuss sale details or approval through the bankruptcy process.  See “Corzine’s Loss May Be Soros’s Gain” by Gregory Zuckerman and Dana Cimilluca.)

The key issue is that such transfers is the bonds were purchased at a discount without open bidding and the process was not disclosed to or authorized by the U.S. Bankruptcy Court, according to Mr. Koutoulas.  “Who gave JP Morgan permission to purchase those bonds at a discount without open bidding?”

The second questionable movement of assets is said to have occurred when JP Morgan purchased MF Global’s stake in the London Metals Exchange (LME) without proper disclosure.  The event was widely reported at a basic level on November 28, 2011.  The larger issue, however, appears to center on the fact that such a transaction was not approved by the U.S. bankruptcy court and trustee.

“Was this disclosed in court?” Mr. Koutoulas rhetorically asked.  “No.  Was their trustee approval?  No.”

The third issue occurred in congressional testimony Thursday, December 15, 2011 where it was discovered JP Morgan asked the Federal Reserve to write a letter claiming that the segregated funds should not be categorized as client money.

“How many letters like this have they asked for in the past?  I want all the statistics regarding the number and content of letters,” Koutoulas questioned.  “JP Morgan wanted a ‘get out of jail free card’ from the Fed.  Guess what?  That doesn’t fly with me.”

“Their hubris is so severe.  They think we don’t know the industry, like we are Occupy Wall Street radicals or something and don’t have a clue or message,” Mr. Koutoulas said, noting that the CCC is comprised of experienced industry participants who understand the financial services industry from the inside.

Mr. Koutoulas seeks to solve the problem with JP Morgan without dragging the issue through court.  In speaking to JP Morgan, Mr. Koutoulas said “Listen, you are buying vulture MF Global claims at $0.86 Âœ on the dollar.   Why don’t you pay a fair price of $0.97 Âœ take the customers out of the bankruptcy and we will indemnify you from any class actions resulting from this.”  A vulture claim occurs when an MF Global claimant such as a farmer or small business person is in desperate need of cash and sells their claim to someone such as JP Morgan, who purchases the claim at a lower rate than the value at maturity.  In this example if JP Morgan purchased the claim at $0.87 and all clients were eventually “made good” JP Morgan would receive the par value of $1.00.  With the MF Global bankruptcy proceedings apparently moving along much quicker than expected, JP Morgan stands to potentially make a quick 13% return on such vulture claims.

Mr. Koutoulas reports that JP Morgan would not even discuss the issues.  “I can see that you disagree with me,” said Mr. Koutoulas, whose organization represents over 7,000 MF Global clients, mostly professional investors.  “They won’t even meet with me and talk with me.”

Mr. Koutoulas is currently working Pro Bono and many of the lawyers are working at a highly discounted rates and requested that industry participants donate to help .  “I need professional litigators and bankruptcy attorneys backing me up,” said Northwestern Law School grad Koutoulas who also operates Typhon Capital Management, which is an NFA-registered Commodity Trading Advisor and Commodity Pool Operator.  ”We’ve had an outpouring of lawyers who want to help,” Mr. Koutoulas said, sitting with a young Yale Law School grad as we spoke.

In calling on MF Global presiding bankruptcy Judge Glenn to investigate these issues, Mr. Koutoulas is rallying the futures industry to boycott use of JP Morgan.  “Call your FCM and if they are using JP Morgan say ‘We won’t do business with you if you work with JP Morgan,’” he said, requesting that industry participants get on Twitter and follow the #BoycottJPM hash tag.

For additional information on the Commodity Customer Coalition visit www.CommodityCustomerCoalition.org and on Twitter use hash tag #boycottJPM

For a related radio interview: http://bit.ly/vGsnh2

Mark H. Melin is author / editor of three books, including High Performance Managed Futures (Wiley, 2010) [http://amzn.to/vyonBA] and was an adjunct instructor in managed futures at Northwestern University.  Follow him on Twitter @MarkMelin or visit www.Go2ManagedFutures.com for additional information.

Risk Disclosure: Managed futures can be a volatile investment and is not appropriate for all investors.  Past performance is not indicative of future results.

The opinions expressed in this article are those of the author, may not have considered all risk factors and may not be appropriate for all investors.

David Cay Johnston is a Reuters columnist. The opinions expressed are his own.

A superb example of a sound rule in law and economics that needs reviving, because it can halt the rampant speculation in derivatives, is the ancient legal principle that gambling debts are not enforceable through court action.

Not so long ago—before casinos, currency and commodities speculation, and credit default swaps became big business—U.S. courts would not enforce gambling debts.
Restoring this principle offers a simple way to shrink the rampant speculation in derivatives that was central to the 2008 meltdown on Wall Street.

Professor Lynn Stout, a deeply principled Republican capitalist who teaches corporate law at the University of California, Los Angeles, raised this issue at a conference where we both spoke about the 2008 Wall Street meltdown.

“Derivatives are gambling,” she said, referring to credit default swaps, at the University of Missouri-Kansas City law school conference on the financial crisis. “They are a zero-sum game in which one side loses the bet and one side wins,” Stout said.

Actually they are worse than that, since the hefty fees Wall Street pockets for arranging the bets result in a less-than-zero-sum game.

As Wall Street fights meaningful financial regulations, and draft regulations remind us how complex and unfathomable regulations can be, this is a good time to remember the basic principles that served society so well until Chicago School theorists, and casino corporations, together with commodities and currency traders convinced us we were too modern to need them.

Unenforcable Gambling Debts

Stout recounted the history of unenforceable gambling debts back to the Romans. She cited an 1884 Supreme Court case on what were then called “difference contracts” to show that derivatives have a long history of being treated by the law as unproductive at best and often damaging to society, just as we saw in 2008.

“I have not found a successful economy that did not have legal restrictions on bets,” she said.

She said that in addition to being nonproductive, such bets add risk to the system, invite bad conduct because bets can be rigged and foster asset bubbles, which are inevitably followed by crashes like the one from which we still have yet to recover.

As the author of a book on the gambling industry’s rise, Temples of Chance, and as a lecturer at Syracuse University on the regulatory law of the ancient world, I recognized Stout’s points were spot on. But her warnings are being drowned out by radical anti-regulatory rhetoric, the army of Capitol Hill lobbyists working for derivatives sellers and the politicians to whom they donate.

Stout noted that speculators these days like to call themselves by other names—for instance, hedge fund managers. But hedging suggests engagement in a business such as oil or grain and buying or selling contracts backed by assets you have or will use.

Pure Speculation

Most of the bets on Wall Street were pure speculation. Against $15 trillion of mortgage bonds, Stout said, Wall Street marketed credit default swaps in 2008 with a notional value of $67 trillion. Worldwide, traded swaps at their peak equaled $670 trillion or $100,000 for each person on the planet, vastly more than all the wealth in the world. Those numbers make it a mathematical certainty that the swaps were mostly speculation, not hedging.

Stout likened some derivatives to a market in fire insurance in which you buy coverage not for your own home, but for those of strangers. Such insurance would create an incentive to commit arson for profit. Yet we allow speculative derivatives that melted the housing market.

Stout’s approach would not stop derivatives that are backed by hard assets, such as a mortgage whose interest rate is derived from an index like the London Interbank Offered Rate or Libor and thus varies over time.

But credit default swaps that are just bets on which one party wins and which one loses would vanish if we restored the ancient, time-tested and therefore profoundly conservative rule that government will not enforce the collection of gambling debts.

Making gambling debts unenforceable produced its own problems. For one, it created work for people like the late Harry Coloduros, who sat in my kitchen 25 years ago, bouncing my little Molly on his knee as I made coffee, and told me about gamblers he beat up to make them pay up.

I cannot imagine Goldman Sachs hiring the likes of Harry to collect on bets when the losing party fails to pay up. So, unless taxpayers cover the bets, as they were forced to at 100 cents on the dollar in the AIG wagers, Goldman would likely get out of speculative bets and stick to actual hedging.

And that shows the immense value of restoring the sound policy of making losing bettors suffer their losses without any help from government.

—David Cay Johnston

Another month yet another debt-inspired volatility spike hit equity markets, as the contagion spread to commodity markets as well.

In managed futures this volatility spike appeared to be generally positive for trend followers and reasonably neutral for spread traders. Many short volatility programs were hard hit, with some notable exceptions being the diversified short volatility programs that hedge their risk exposure. Those diversified managed futures programs that included a long gold volatility hedge to short volatility option selling programs encountered degrees of temporary difficulty.

To provide context, managed futures projections are eyeing positive performance near up 1% during the 9/20-22 volatility spike. Overall managed futures performance in September is estimated to potentially end the month up near 2%, boosted largely by the performance of trend followers.

For many short term trend following systems the volatility spike may have created opportunity, as negative downward trends over the few days of the volatility spike were generally powerful and consistent across the board markets.

To read the full article, click here.

About the Author: Mark Melin is a managed futures specialist. An industry practitioner and consultant, he has taught managed futures at Northwestern University / Chicago and has written or edited three books, including High Performance Managed Futures (Wiley 2010) and The Chicago Board of Trade’s Handbook of Futures and Options (McGraw-Hill 2008). Mark writes about managed futures investment performance and uncorrelated portfolios based on a performance driver method of diversification. For institutional investors and high net worth individuals, he assists in building managed futures investment portfolios. He also consults with financial services firms, helping them integrate appropriate managed futures programs into their traditional product offerings, and assists Commodity Trading Advisers in clearing and execution of their trading programs. Currently a registered associated person at Peregrine Financial Group, his National Futures Association ID number is 0348336. Mark has also worked as an independent consultant to various broker dealers and futures exchanges, including OneChicago and the Chicago Board of Trade. For further information visit www.Go2ManagedFutures.com or e-mail info@Go2ManagedFutures.com

All contents copyright 2011 © Mark H. Melin all rights reserved.

Risk Disclosure: This article is intended for educational and informational purposes. Past performance is not always indicative of future results. There is risk of loss when investing in futures and options. Managed futures investing can involve volatility and may not be appropriate for all investors. The opinions expressed are solely those of the author, they are not appropriate for all investors and may not have considered all risk factors.

Those nifty charts that consist of colored boxes, each representing an investment class, are worth examining now and then. They show the comparative performance of asset classes over the years at one glance, tempering the temptation to stick with the flavor-of-the-day. Countries, regions, industries, strategies all go up and all come down, given time.

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With so much political controversy swirling around the New York Mercantile Exchange in recent days, it is somewhat surprising that no politician has yet made an issue out of the continuing consolidation in the market for commodities exchanges: in particular, about the impending acquisition of NYMEX by the CME Group.

After all, the charge that energy speculators are to blame for much of the recent price run-up in gasoline and/or crude oil has become part of the common coin of political debate in the U.S., sometimes indeed promoted under such monikers as, “trader realism.”

NYMEX is necessarily at the center of that controversy, and CME will find itself in the same position when, as is now expected, the two complete their nuptials.

So: why hasn’t anyone on the national scene made an issue out of the merger?

In part, it may just be the the issue has too many moving parts. When the CME and CBOT merged last year, some discussion of the general trend of consolidation of derivatives exchanges did take place. That discussion involved the vertical integration of exchanges and clearinghouses, the “barriers to entry” this may create, the fungibility of products, the relationship between equity exchanges and their derivatives counterparts, and much else.

Even when a matter is of great public interest, once discussion passes a certain threshold of complexity it gets re-allocated in the public mind to a small circle of deskbound wonks.

Or it might be a general recognition that globalization has come to the point where everything has to happen on a very large scale, and that the consolidation of exchanges is an inevitability.

“Consolidation among exchange operators continues to be a viable growth strategy. The transaction will result in a more competitive exchange, offers NYMEX Holdings shareholders a financially fair consideration and is expected to be accretive to earnings for the surviving shareholders of CME Group,” is how Glass Lewis put the key point, in recommending that both sets of shareholders vote in favor of the deal at their upcoming meetings.

Still, I have the uneasy feeling that exchange consolidation could easily be portrayed, by a politician looking for a point to make, as a way of easing the least productive or rational or consumer-friendly forms of speculation out there. [I'm not making such a point, mind you, only commenting on what some hypothetical demagogue might be able to put together in this line].

My unsolicited (but inexpensive) counsel to any deal makers out there is, then, as follows: make these deals while the makin’ is good. The climate could change.

An organization that calls itself “Stop Oil Speculation Now” put out a press release Friday, with the now-customary laundry list of demands. The bottom line is that it wants Congress to limit the number of contracts that individuals or groups can trade speculatively in the energy futures markets.

The organization never uses the initials of its adopted name. At any rate, I haven’t yet come across a reference to SOSN. That is understandable. How does one pronounce SOSN? “Soused-in”?

But let’s get back to basics. The overall price of the goods and services produced by an economy (ignoring the small portion traded in barter) must equal the amount of money in circulation multiplied by the velocity at which the money is circulating. There isn’t a lot of room for velocity increase, so for the most part the overall level of prices is determined by the money supply, which in these days of fiat money is determined by central bankers. Inflation, in other words, isn’t a cost-push problem. It’s a monetary problem.

Were the monetary problem resolved (no easy matter, surely, but SOSN isn’t proposing anything that would help there) then price increases in any one industry would result in price decreases elsewhere. The overall height of a see-saw doesn’t rise just because one side of it rises. There is no “cost-push” elevation of the whole see-saw!

SOSN’s membership consists of businesses, and trade organizations for businesses, that use a lot of hydrocarbons. The Air Transport Association takes a leading role.

What is going on here, I suspect, is properly described as “legislative arbitrage.” If you knew what Congress was going to do tomorrow, you could make a good guess which industries’ assets would increase in value as a result, and which would decrease. So you’d take a long position on the former and a short on the latter. Likewise: if you believe that the ATA will prevail in limiting speculation, and you believe that this in turn will reduce the price of hydrocarbons, you might well want to buy equity in U.S. airlines.

My own view is that speculation (which is not to be confused with manipulation) is part of the solution, not any part of the problem. If speculation and the markets in which it occurs result in increased prices for hydrocarbons – well, that is a signal to which one should pay heed before buying equity in U.S. airlines. After all, when whales became scarce due to the success of the Captain Ahabs of the nineteenth century, lamp fuel became expensive. That, in turn, created the market incentives for Daniel Plainview and his real-life counterparts from Pennsylvania to Saudi Arabia. The markets may be trying to tell us that it is again time for such a shift.

The simple fact is that the oil for which Ahab was searching existed in only a finite quantity, and that the same is true of Plainview’s sort of oil.

I’m eager to join an organization that would call itself Stop Legislation Arbitrage Presently. That would have an acronym one could pronounce.

Saying nasty things about commodity markets is good for politicians; it looks like they’re doing something for households hit by high food and energy prices. In the past couple of months investigations, hearings and press conferences by various government players and regulators have been prominent in the news.

 Is there any non-political upside to these dog-and-pony shows? Certainly some industry people think so.

“We’re all for it if the investigations shine a light on a darker corner of the market,” says Christopher Keenan of Welton Investment Corp, a global macro and managed futures manager. “Free and fair markets benefit everyone. Uncertainty and lack of confidence isn’t good for either the buyer or the seller.”

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With the news this morning that Bayou’s Samuel Israel has turned himself in to police in Southwick, Mass., the long and often bizarre saga of his legal battle, sentencing, faked suicide and RV flight seems to be at an end. His capture certainly is good news from a law-and-order perspective, as he did cheat Bayou Group investors out of some $400 million. But as observers to this strange tale, we can’t help but be a tad disappointed at what appears a rather anticlimactic ending.

Mr. Israel no doubt had his reasons for surrendering, just as he probably had some reason, albeit twisted, for running a pyramid-style scheme on investors in the Bayou fund group. But someone with the determination to flee the law, orchestrate a false suicide, and go on the run with a fully equipped recreational vehicle would seem as though he already had nothing to lose. Why turn himself in now?
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Last week, at the annual meeting of a Canadian silicon-processing company, the chief executive said that the company has already sued someone for spreading dangerous rumors. Or maybe he said that it was going to sue someone.

It is, sadly, less than clear what Heinz Schimmelbusch was saying during the shareholders’ meeting for Timminco Ltd., in Toronto, Thursday afternoon. These were his words: “There are a few short sellers here, running up and down the streets here, making idiotic, bizarre … statements on the company … The matter is, by the way, before courts. If somebody oversteps a certain line, if he’s over the line, it’s straight going to the courts.”
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