Claims on claims, not claims on commodities

Poor, abused readers — I am making a recycling bin of your eyes!

The following is modified from a monstrosity I began and abandoned over a month ago, thinking about futures markets. Michael Masters’ allegations regarding “index speculators” and the CFTC’s investigation of price manipulation in the oil market only make sense if the arbitrage between future claims and physical stuff fails to work as advertised. The most clear example arbitrage failures have been with agricultural products, where cash market prices and prices of supposedly equivalent expiring futures contracts have simply not converged. It is to that (now ancient in blog-years) controversy that this suggestion was originally addressed, but I think it applies to the more recent hullabaloo as well. I’m sorry that the links and context are somewhat dated.

For those of you who have been in the financial equivalent of outer space (that is, for those of you with a life), commodity futures markets have been misbehaving recently. I don’t want to get into it, but see here and here and here and here and here and here. The problem is that textbook arbitrage constraints are coming loose, the prices of things are wriggling free from one another in incoherent ways, and smashing up farmers in their confusion. Arbitrage is to finance what gravity is to physics. The movement of the spheres makes no sense, has no meaning, if rational relationships between prices aren’t maintained.

The universe is blessed with diligent quantum smurfs who ensure the constancy of gravity for us. But arbitrage is left in the frail hands of humans, and frequently our institutions are not up to the task. Fortunately, institutions are fixable. The trouble with commodity futures is that, although all the world can see that, say, spot and future corn seem inconsistently priced, relatively few actors — those with ready access to good, wholesale corn and the means and expertise to store and deliver it — can actually make the trade that would force prices and cosmic spheres to realign themselves. There are limits to arbitrage.

So, a suggestion: As an alternative to delivering actual corn to one of various warehouses in Illinois, permit those short a futures contract deliver a note issued by a kind of “corn bank”, entitling the bearer to a quantity of that very same corn on demand from the bank’s warehouses. Futures exchanges would regulate and certify competitive commodity banks, delivery of whose notes would constitute contract fulfilment [1]. At the same time, exchanges would host accessible cash markets in these zero-maturity notes (against which there would be negative accruals to cover storage costs, but lets put this technical detail aside for now).

At first glance, this proposal is a kind of nonsolution: Sure, convergence failures in futures markets would trivially disappear, as financial investors would purchase and hold underpriced spot claims and short overpriced futures (or vice versa) if the futures and spot prices were misaligned. But today’s convergence failures would just reappear in the form of overpriced deliverable notes relative to the cash price of the commodities they represent. Why would that help?

Financial markets are fundamentally information processing devices. Their purpose is to help investors place capital (or risk) where it can do the most good (or least harm). Thus, it matters very much whether the structure of a market reveals or obscures relevant details about an economic problem. This was a fatal flaw of the late securitization boom — there’s nothing wrong with securitization per se, it’s a great idea actually, to get previously obscure investments priced by broad and deep capital markets. But capital markets aren’t magic. If the securities hawked are complicated bundles of mathematical formulas of incompletely described uncertain securities, “market prices”, while they last, may not prove reliable. (OT: See this great post by Going Private about the CDO securitization process).

Trading claims on deliverables rather than direct obligations to deliver would open the arbitrage process to all financial investors, rather than relying on small groups of potentially collusive firms. Mysterious convergence failures would disappear. Rather than going “WTF?” and convening at the CFTC, we’d observe commodity banks eager but unable to sell simple IOUs for commodities at prices well above their cost because they lack storage or shipping capacity. A phenomenon of high finance would unmask itself as an easy to remedy operational problem, with a clear business case attached. Of course, people in commodity industries already understand the bottlenecks they face, and eventually they’ll find the financing to do whatever needs to be done. But clarity matters. A couple of months ago, farmers and grain elevators faced a “liquidity crisis” — their traditional funding sources, banks, were skittish due to the credit crunch, and other capital sources don’t understand their business well enough to jump in with quick money. With a more transparent informational architecture, capital would cure bottlenecks faster. Time is always of the essence, both from a broad economic perspective, and to farmers who are struggling to meet margin calls on volatile futures contracts when all they want to do is lock-in a price for corn.

This scheme would also render market manipulation more visible, by eliminating complexity at the interface between opaque, dispersed cash markets and liquid, transparent futures markets. If futures prices spike somehow, spot note price would rise, which ought to cause banks to compete for cheap access to the physical commodity. If prices seem “too high”, regulators could focus on spot market conditions (are commodity banks competitive? are producers withholding output? are precautionary inventories rising at banks? is there unusual non-bank-intermediated demand, either by current users or speculators?). Arbitrage relationships hold quite well among predictable, liquid paper assets. With a simple market for spot claims, regulators could focus on the present, and let the future take care of itself.

[1] Exchanges would insist upon these notes being non-fractional claims against actual inventory, as the exchange’s clearinghouse would ultimately guarantee the notes. These would be depreciating, negative carry notes (due to storage costs), so investors without use of the commodity would shed notes quickly, keeping inventories minimal, unless they wish to finance storage for precautionary or speculative purposes (which inventories would be transparent and measurable). Banks would compete both on the price (reflecting their quality of access to the dispersed cash market) and storage fees (reflecting operational efficiencies).


6 Responses to “Claims on claims, not claims on commodities”

  1. groucho writes:

    Steve, Sounds like you want to do to commodities what the goldsmith’s did to gold.

    Look where that has taken us.

    ” Oh, what a tangled web we weave

    When first we practice to deceive! ”

    CB’s use “the money illusion” deception to drive the system, expecting any rational information supply and demand outcome from such manipulation is preposterous.

    Gov’t has confused “activity with accomplishment”

  2. Groucho — Sorry for the so-late response. You are right on to note the similarity of “commodity banks” in this proposal to way-back “gold banks”. That similarity is not unintentional — I consider it a virtue of this proposal that wit would create a wide array of money-like claims not denominated in any fiat currency. But, your tone suggests some concern that “commodity banks” would devolve to ever first fraudulent, then potentially legitimized fractionality, as happened with gold. That’s a very legitimate concern. I’ve three responses, none perfect: 1) public regulation could help to prevent this. It could be explicitly fraudulent for commodity-banked notes not to be backed by storage; 2) private regulation, since commodity exchange clearing members would guarantee the all notes deliverable on the exchange, they would have an incentive to frequently audit banks. (Of course, public regulators would have to insist that exchange clearing members and commodity banks be economically distinct, otherwise exchanges might prefer to profit from creeping fractionality rather than guard against it.); 3) Commodity-banks wouldn’t pay interest, they would charge fees. No lending would occur. Investors would have every reason to keep “deposits” in commodity banks minimal, making the likelihood of “runs”, and therefore the ability to get away with fraudulent fractionality, much higher. 4) Fluctuations in investor enthusiasm for different commodities would also make “runs” normal.

    None of these are perfect safeguards, but there is no perfection in this world. Even if some fraudulent fractionality happened, these notes would be more sound than notes that are enforceable claims on nothing. And, unlike notes against a single monetary commodity like, say, gold, such a collection of banks would define a somewhat “elastic” currency. Growing wheat production would lead to a growing supply of “wheat money”. If the scheme were expanded to banks of claims not only on commodities, but also on services (really capacity to be served), and the portfolio of banks grew sufficiently large, the “money supply” and the productive capacity of the economy might grow very naturally in tandem, without any one commodity or service having any special monetary status.

  3. br writes:


    I have been looking at this post for a few days now, and I can’t resist sticking my nose in. I have long, involved, complicated things I might say, but I would try to reduce it all to ten quick points. Some of what I will say may seem unbearably obvious and stupid, some obtuse and impossible, but I am making a try.

    1. I come at all of this with the thoughts a) that money is a kind, a form, a species of information, and b) that the salient property of informational things is non-conservation. By “non-conservation” I mean the opposite of what we were taught in high school physics and chemistry about physical things, that “mass-energy is conserved,” that atoms are conserved, although re-arranged into different molecules, across chemical reactions. So… where does new money, never before seen money, “come from”? It gets created in the midst of a transaction. It kinda comes out of “nowhere” — conventions and conventional behaviors among people and institutions, right — but don’t try to make it subject to the kinds of symmetries that characterize Physics. If prices are cut in half in a market, where does the money go…? It doesn’t really go anywhere. Actually it just unbecomes; no longer exists.

    2. Commodities are some of the most physically physical things transacted for in markets. Oil, coal, copper, etc. Btus are being bought and sold, pounds, tons. Conservation principles, you can’t get something for nothing, there are no perpetual motion machines (except as filings to delight patent examiners), there’s heat, and then there’s waste heat… all that very physical, very engineering as science as organized around basic equations that are basic statements of conservation applies quite closely in almost all of what anybody is going to do with most commodities. (Even the financial “commodities” traded are governed by accounting – which is a set of conservation principles… debits equal credits, etc. Money itself is pure information and not conserved, but accounting imposes conservation upon practices using money.)

    3. Without going into a long shpeel, I would summon your intuition to suggest that commodity market are one of the places in the economy in which the differences in the basic nature of the subject matter of the transaction, the oil, coal, gold, etc. and the informational tokens and representations used in transactions, money and money-like things, stand ready to create anomalous conditions and results. True, so long as the actions in the market are just basic contracts and cash settlements, accountancy will constrain and organize the money to a conservational form that will match well enough the “in gross” physical properties (here-it-goes/ there-it-goes) properties of the stuff transacted for in the markets. Coupled to or become part of a market structure in which money is created and extinguished, made complex in form, one rife with “informational amplifications” (we’ll get to that) it makes a certain sense that apparently anomalous behavior will occur. (As in the real estate and mortgage market — houses and acres are physical things… the real “creativity” goes into playing with the money.)

    4. You say: “Financial markets are fundamentally information processing devices.” I completely agree. That is absolutely right. I would add that they are not entirely unlike other information processing devices employed by society, bureaucracies, computers, etc. And markets are used for similar kinds of things: modeling, systematizing, resource allocation, policy implementation and propagation, feedback control structures…etc.

    5. You immediately go on to say: “Their [markets] purpose is to help investors place capital (or risk) where it can do the most good (or least harm).” Hmmm. I’m struggling. It’s kind of Aristotelian (virtue of a knife is its sharpness… Aristotle was not trying to turn the screw to open the battery compartment of his kid’s Christmas toy….)

    6. I would rather sneak up on the question instead of making any big decaration of “purpose” and just talk about comparatively functional and dysfunctional market behavior, to ask “How are we doing at…. allocating some particular resource…or how are we doing at… representing and charging for some set of costs ….”? Yes markets give investors opportunities — and that’s just fine, but markets do a lot of things, keep some people and interests out, hold others in, act as sinks and sources for subject matter bulk in cycles (act like eocnomic capacitors – store charge), and so on and so on. (These are informational behaviors rather than physical — but somethines physical analogies help to conceptualize.) It is a matter of taste, but one might rather look at the market as a system having “properties” than propose to enshrine a “purpose.”

    7. Like other “information processing devices” then, markets do interestingly well and badly. Digital computers are able to model the complex hydrodymanics of rotating surfaces well enough to come up with amazingly quiet submarine propellers and to simulate fusion bomb construction well enough to avoid much testing. But the same digital computers do not understand even the most mildly amusing dumb joke. Or pun. Or observation about a stopped clock. Long theory about why this should be so, properties of informational structures and systems, theory of “informational amplificaton” theory of informational “depth” / context, managment of context. Etc.

    Limits to arbitrage, absolutely. Failure of aribtrage to rationalize market conditions, definitely. Every “informaiton processing device,” and the components of it considered, has its strengths and weaknessses, abilities and failures.

    8. The argument is that it is that kind of thing that is happening from time to time to certain markets, in particular to features of the commodity markets that you write about. The facts that Michael Masters assembles are basically right, large influx of money into the commodities markets in the last few years, regular use of positions in the markets for new and different purposes, etc. He could have added other facts, even those having to do with the central bank equity position in the currency, or at least the failure of the dollar as a reserve currency. (The argument indeed being that people are tyring, willy nilly, to create a kind of substitute “reserve currency” / store /index of value; are using what is to hand, and don’t completely know how to do it — certainly not elegantly). The commodity markets as an information processing system are now being put to a notably different “purpose” (I’ll call it that – sure) than they were a decade ago. I don’t think anybody really cares, per se, that a commodity future isn’t organizedly merging to the spot price as delivery date approaches (somebody isn’t cleaning some chips from the table … but so what) but it is hard not to see a reason to care that such failures instigate a larger failure in basic resource allocation and pricing functions of the markets.

    9. To which you say, if I understand correctly, let’s create a new form of money, and add that for use specifically to make the market functional in some of the small ways that it now isn’t — hoping that it will solve some of the bigger problems concommitantly. I’m not trying to be flip in calling it “money”; the thing being talked about is representational in nature and negotiable for value. That pretty much meets the requirments for money, whether money as hogsheads of tobacco or bit strings in a transmission “wiring” bank funds.

    10. I note that you then announce some pretty meaty rules regarding this money. You talk about making sure it is claims against *actual* inventory [my emphasis]; you describe it as negative carry (could arguably be a problematic thing to enforce … a secondary marcket can always re-price and re-price-structure an asset.) To summarize, I hear you yelling (yelling is called for — no worries) “And goddamit, this is going to
    be money with which some of these people behave well…” or some such. I’m exaggerating for effect, but my point is that, wihtout talking about the issue as such, I get the sense you are tryng to get system structure from the subject matter in which it deals. That is not impossible. Language gives structure to thought, etc. BUT it is not something that money readily does in a good way. Money is information, pure informaiton, nothing but information. But in itself it is very simple, low quality information. It doesn’t explain much, doesn’t of itself organize much; it is merely scalar. Compared to strand of DNA, money is inarticulate. If one needs principles, or rules to be followed, or systems to guide systems, best go straight to making them. The creation of the money can be an aid, no one should be against it. But not more than an aid. All of the arcitecture is in the rules.

  4. br — Wow, that’s meaty. Here are a few quick responses. (My numbers don’t match yours, BTW…)

    1) Yes, money is just information, and needn’t be conserved per se. But it is only useful if it is kept limited in relation to things that are bounded. One useful analogy for money is units of measure. It is ridiculous to talk about the nation’s centimeter supply. We don’t need NIST managing it. But then, it is imperative that we attach centimeters to things in a certain relation to the things themselves. If, in a fit of exuberance, we started attaching more centimeters to people so they would be taller, we might briefly be happier, but we would make errors… bluejeans made and sized not long ago, purchased precisely according to our current measure, would fail to fit. If the unit of measure is constantly shifting, but we make arrangements over time in terms of those units, we will have problems. So it is with money. “Traction” is the metaphor I like. Values in money should track the “real” value of goods, services, and claims on future goods and services.

    2) Of course, it is easy to define a sound centimeter, but not so easy to define a sound unit-of-value measure. It’s incoherent, actually. Subjectively, a single person’s values change frequently. That’s pretty much an unavoidable risk — if I buy chocolate ice cream because I value it, and then my tastes suddenly change, I’m screwed. Any measure if value I had previously ascribed is obsolete. We can’t get a perfect measure of value. But we can try to limit the layers of uncertainty we mix together into our valuation estimates. Commodities can at least be fixed in definition, although of course both their private use and pubic exchange values are constantly shifting. I don’t think commodities, especially any single commodity, are sufficient as “money”. I don’t think there’s any “good” money. We really need a mix of things to serve the purposes of money. But claims on commodities have certain advantages (and disadvantages). They are good ways of hedging consumption needs, bad ways of maximizing future consumption, useful but imperfect as measures of value.

    3) I agree there’s something pushy about my imposition of a purpose to markets, when markets serve all kinds of uses. But though knives may have many virtues, a knife designer must make choices about which to value when designing the blade. Markets have many “designers”, each trying to push them to be more useful in whatever way she uses them. We have to make judgements, though. “Special interests”, as it were, try to structure markets to meet private ends that might not be socially beneficial, e.g. investment banks trying to sustain lucrative OTC derivative markets. I think we need to have public, normative framework for distinguishing among market virtues and vices. I judge the “smart” allocation of capital and risk to be the principal virtues we desire from capital markets (and think we should try to unbundle some of the other conflicting purposes to markets are bent). But of course, that’s a choice, others can and do take issue. I don’t like the “properties” not “purpose” view you offer, because it suggests that markets are facts of nature, rather than constructed and alterable systems. Markets do have properties. But we have to, however arbitrarily, make judgements about those properties — good property, bad property — and work (cautiously and incrementally to be sure) to improve.

    4) Commodity claims would be put to monetary use, but I wouldn’t want to put all the burden of moneyhood on them. Stocks can be used as currency, and not infrequently are in a variety of ways. There’s no need to announce a new currency regime. The introduction of nonfractional, spot claims on commodities might solve certain problems, with respect to the functioning of futures markets, with respect to hedging risks against consumption plans. We wouldn’t need to remeasure all things in terms of corn or declare pork bellies legal tender. People could use such claims as measures of value or to mediate exchange transactions as they see fit. Perhaps its best to think of money as a practice rather than a thing, or even information. We do certain things — store stuff, trade stuff, make and take promises. We use the idea of money to help us make sense of what we do. But really we should be focused on improving our ability to do the deeds. Getting too bogged down in how we’d attribute our traditional notions of moneyhood to our expanding portfolio of practices might not be worth it. We’ll make sense of ourselves by and by. But we do need to ensure that the practices are sound.

    5) Again, re “meaty rules”, I think we’re thinking to big. I don’t think it’s beyond our institutional capacity to have regulated storage facilities that do not make unauthorized use of customer property. Nothing is perfect, but on the scale of social challenges, getting this approximately right doesn’t seem to hard, as long as the rules, as you say, are clear. To serve their futures markets function, and to serve their hedging function, they have to be nonfractional, and we can insist that they should be. Negative carry follows. If some commodity bank wants to offer positive carry, they’d better have one of those perpetual motion machine patents on file, because here come the auditors. Of course, we would have to be careful about institution design. We want the claims to accurately price commodity storage costs. We’d want these to be simple, standalone entities, that don’t for example use commodity storage as a loss-leader against “relationships”, thereby offering zero or positive carry. Fortunately, the futures market helps us here. Futures arbitrage rates would be set against the lowest cost-of-carry commodity bank, pushing hedgers to make great use of any bank that hid a subsidy in their carry cost. Banks and the exchanges that regulate and guarantee them would have every incentive not to take losses on storage to avoid exploitation. Since any use stored commodities by banks would be fraudulent and criminal, there’d be little way to offset those losses without taking large risks. Any human enterprise can go wacky, but in the scheme of things, “commodity banks” don’t strike me as the hardest institution to get reasonably right.

    BTW, futures price nonconvergence strikes me as a big deal. I could care less about the money left on the table, but if futures prices don’t converge, I can’t use futures to hedge my future consumption. If we want futures at all, we do want this fixed, I think.


  5. br writes:


    Thank you very much for your thoughtful and long note in answer to mine.

    Clearly the two of us would be capable of putting forth an worthwhile, if extended, symposium.

    I find myself agreeing with eighty-five percent of what you say, (I’m not sure that all of it lies in direct contradiction to what I thought I was saying originally.) Maybe it is the “Blah” part at the end that we would contend over.

    Let me try to be as short and sweet as I can in a quick review, and then one or two questions that I think might be helpful.

    Your #1 I take to be a statement that the representational (I’m going to call them properties — because I don’t have another word) the representational properties of information matter. I couldn’t agree more. That is what information, including especially money information is all about. The failure of the money to represent what it needs to …. essentially negotiable value — is a big deal. We would agree.

    I think we also agree that there is “better” and “worse” in this, your #2 and the matter of “tastes” notwithstanding.

    You say “I don’t think there’s any “good” money.” I agree that there is not in any *absolute* sense, but I am quite persuaded that there is good, and better and worse, money in every practical sense. I am further persuaded that Gresham’s “Law” (more or less “bad money drives out good”) is a very significant principle. As a concrete example, we recently saw (Bloomberg piece I can’t quite put my finger on as I write – I’m at the wrong computer – but about 3 wks ago) even that the US Fed, having accepted crummy collateral in the bank “asset” swaps was being force fed another slug of it.

    I agree that markets are a form of collective design – your #3, and I hugely agree that all forms of “not knowing what we’re doing” are entirely more risky than forms which evidence what is going on. Public framework for distinguishing among market virtues and vices. I’m totally there. But those are what I would be calling “properties” of the market ( again, just because I don’t have a better word handy).

    I’m not arguing that markets are “facts of nature.” Quite the contrary. I’m arguing that markets are “constructed,” made, created, built like houses are built, written like books are written, they are structures and systems that are invented and installed. I’m probably somewhere toward the extreme in this view, thinking, as I do, that classical economics as a sort of “physics” is silliness. Notions that supply or demand, or their pre-ordained intersection, exist in the abstract aren’t right. For various social reasons we try to make it seem as if that is so from time to time — but there is nothing fundamental to it. And, for me, a lot of this comes from realizing the truth of non-conservation…. informational things can come into being by being made into place; they don’t get “taken away” from some other bundle of mass-energy.

    I do somewhat disagree with your #4. I definitely do not want to get “bogged down.” Biiig Blah. BUT I think a lot of our troubles, including our recent troubles, come from not understanding (collectively) what finance is and is not, from supposing it is “magic” in ways that it isn’t, from various kinds of false categorizations (there’s the price of eggs, and that is all that inflation is about, and there’s the price of houses, and that is a totally separate thing we’ll call asset value increase, and that has nothing to do with the stability of the currency because that depends upon inflation, and I’ve just checked the price of eggs and…) Somehow, people whose eyes glaze over when phrases like “futures arbitrage” are spoken need to be able to see enough of a picture…

    “Meaty” rules was just a phrase I came up with — maybe not a particularly helpful one. I’ll withdraw it, but I might note that in the middle of your #5 it is “…because here come the auditors” Let’s let it go at that and head for a question or two.

    Question number A would be whether you suspect that, somewhere toward the center here, let’s just call them “relationships,” outside the market are having a somewhat de-marketizing effect on the market? No corruption, collusion, monopolization… nothing criminal. Essentially another form of “derivative.”

    The second question would be whether you wold guess that there can be a kind of “disclosure tipping point” at which enough information about who is doing what and to whom is readily available that a market, even one that was for a time a “semi-public” market again becomes a sufficiently public market?

    Third would have to do with the technique for organizing the “disclosure” (description, information flow); and whether transactions in an entity-vehicle are best suited, qualified?

    Thanks again so much for your long response. Sorry to have gone on long again.

  6. br — it’ll be a bit before i can respond. maybe drop me a line by mail so you don’t have to check back here…