Craig Pirrong

The organization of financial exchange markets: Theory and evidence

This article presents theory and evidence regarding the organization of financial exchange markets. It derives conditions under which (1) a member-owned exchange has a monpoly over the trade of a particular financial contract and its close substitutes, and (2) exchange members earn economic rents.

A THEORY OF FINANCIAL EXCHANGE ORGANIZATION

Although there has been extensive research on the economic functions of financial exchanges and the properties of prices determined on exchanges, there has been little research on their organization and governance. The heterogeneity of the suppliers of financial services who are members of financial exchanges explains salient features of exchange organization. When suppliers of financial services are heterogeneous, one expects to observe exchanges organized as not‐for‐profit firms, especially if an exchange can enforce collusive agreements. Moreover, heterogeneity can lead to conflicts between members over rents, which necessitates the creation of formal governance mechanisms. Finally, if exchanges exercise market power or are protected from competitive entry (as is plausible), exchanges may adopt inefficient rules; the efficiency of exchange rules depends on the degree of member heterogeneity, the distributive consequences of these rules, and the ability of exchange governance structures to enforce wealth‐enhancing bargains among members with disparate interests.

Manipulation of Cash-Settled Futures Contracts

Replacement of delivery settlement of futures contracts with cash settlement is frequently proposed to reduce the frequency of market manipulation. This article shows that it is always possible to design a delivery-settled futures contract that is less susceptible to cornering by a large long than any given cash-settled contract. Such a contract is more susceptible to manipulation by large shorts, however. Therefore, cash settlement does not uniformly dominate delivery settlement as a means of reducing the frequency of market power manipulations in derivatives markets. The efficient choice of settlement mechanism depends on whether supply and demand conditions favor short or long manipulations. Copyright 2001 by University of Chicago Press.

Clearing and Collateral Mandates: A New Liquidity Trap?

All too often, legislative solutions to some financial crisis have serious consequences that are both unwanted and unintended. The author of this article foresees several possible negative consequences arising from Title VII of the Dodd‐Frank Act, which mandates that eligible derivatives be cleared through central counterparties (CCPs) that require initial and variation margin. The new legislation also requires that the remaining non‐cleared derivatives that are traded by some market participants be more heavily collateralized. The Acts authors have argued that derivatives pose uniquely dangerous systemic risks because of the leverage and counterparty risk associated with them. Increased collateralization, their thinking goes, would reduce derivatives‐related leverage and the systemic risk to the financial system associated with such leverage. The author argues that these hopes are unduly optimistic because they fail to recognize how market participants can substitute other forms of leverage, such as bank lines of credit or collateral transformation trades, for the leverage derivatives provided previously. The author also believes that the larger collateral mandates and frequent marking‐to‐market will make the financial system more vulnerable since margin requirements tend to be “pro‐cyclical.” And more rigid collateralization mechanisms can restrict the supply of funding liquidity, and lead to spikes in funding liquidity demand that can reduce the liquidity of traded instruments and generate destabilizing feedback loops. The fragmentation of CCPs across jurisdictions and products will lead to greater demand for CCP‐eligible collateral to maintain the same level of hedging transactions. This demand will likely be met by using riskier assets as collateral and encourage the shadow banking system to create new assets that can be posted as collateral (for example, via collateral transformation services). In sum, although the Dodd‐Frank rules are intended to reduce systemic risk, their expected impact on liquidity makes it a very open question as to whether they will achieve this goal. Although they may reduce some risks, they will simply shift others while possibly creating new ones.

Squeeze Play: The Dynamics of the ManipulationEnd Game

This article considers one of the most significant regulatory concerns facing derivatives markets: the case of market manipulation by means of a corner, or “squeeze.” There are many famous examples of squeezes dating back to the very origins of derivatives trading and extending to the present day. These manipulations distort prices by moving them away from the supply- and demand-driven equilibrium, which limits the effectiveness of the market as a venue for price discovery and effective hedging. Unfortunately, the dynamics of trading as a contract nears expiration have not been modeled extensively. As a result, the existing literature cannot capture many of the interesting actions and interactions observed during actual squeezes. This article fills that void by examining the effects of asymmetrical information on the trading strategies of large longs and shorts as a contract approaches expiration. It provides insight into the mechanism of real-world corners and squeezes and the associated price movements around expiration that are not driven by supply and demand.

The Risk of Skewness and Kurtosis in Oil Market and the Cross-Section of Stock Returns

We show that exposure to the risk of kurtosis in oil market drives the cross-section of stock returns from 1996 to 2014. The average monthly difference between the return of portfolio of stocks with low exposure and high exposure to the risk of kurtosis is -0.37%, showing that higher exposure to oil’s kurtosis risk will be penalized by lower average returns. We are able to confirm the significance of kurtosis risk within the statistical framework of Carhart 4-factor model. In contrast to the skewness risk, which is only a significant player in some of the sub-periods, kurtosis risk is keeping its significance through all sub-periods, as well as after taking market moments into account and within different maturities. The significance of the risk of skewness gets more evident moving from shorter to longer maturities. The risk of volatility, which has been shown to be a significant-priced risk in the cross-section of stock returns in literature, loses its significance after controlling for the third and fourth moments.

Liquefying a Market: The Transition of LNG to a Traded Commodity

The Liquefied Natural Gas (LNG) industry has grown significantly since it began a half-century ago, and it will continue to diversify both its sources of supply and the contractual arrangements between suppliers and users. Economic theory says that contracting modes adapt to facilitate gains in efficiency, and that this process of adaptation responds to changes in technological, market, and regulatory factors. When an industry relies heavily on highly specialized assets with limited alternative uses, as is true of LNG, the use of longterm contracts (or vertical integration) will generally be more efficient than short-term dealings. But once conditions begin to encourage vigorous competition among buyers and sellers, it becomes increasingly economical to rely on shorter-term (and spot) markets for exchange. The history of the LNG industry supports these theoretical predictions, and illustrates the transition from one contracting mode to another. For most of its history, the specialization and scale of LNG assets dictated the predominant use of long-term contracting. In recent years, however, market and regulatory changes have raised the demand for short-term and spot contracting, which in turn has provided the impetus for a virtuous cycle of market liquidity. As buyers and sellers have become increasingly able to obtain or dispose of LNG in an active market, they have needed less protection against the opportunism of trading partners that long-term contracts have provided in the past. Given this self-reinforcing process, it is likely that the LNG market will soon look nothing like it did as recently as a decade ago. Buyers and sellers will rely on shorter-term contracts, and the longerterm contracts that do exist will be linked to spot LNG prices rather than crude oil. Consumers and producers will also benefit from more flexible pricing that more accurately reflects rapidly changing fundamentals of supply and demand.