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the latest source of comment and analysis from the Institute for Security & Resilience Studies at UCL.


Rage Against the Dying of the Light

By Mandeep K Bhandal, on 18 July 2012

ISRS Senior Research Fellow, Chris Cook, argues that the Brent/BFOE crude oil price is the subject of routine manipulation by market participants.

A generation of markets is dying and the era of the Middleman is coming to an end.  The ‘Bezzle’ – as J K Galbraith described financial misbehaviour in a boom, revealed by a bust – is now coming to light.

We now see a wave of popular rage against the freshly revealed manipulation by banks of LIBOR, the London Interbank Offered Rate benchmark for interest rates which is the cornerstone of the money market.

This manipulation in the financial world is being augmented by a groundswell of protest against manipulation taking place in the real world.  Here, the allegation is that the Brent/BFOE (Brent, Forties, Oseberg, Ekofisk) crude oil benchmark price, against which global crude oil prices are set, is the subject of routine manipulation by market participants, particularly investment banks and traders of physical oil.

In both cases, the popular outcry is based upon misconceptions as to what has actually been going on. The good news in the oil market at least is that the manipulation which is being revealed is nowhere near as serious in its effects on the general public as is believed. The bad news is that the true manipulation, as yet still concealed, is far more serious than anyone has yet conceived.

They shoot horses, don’t they?

The current LIBOR pogroms are the regulatory equivalent of flogging a dead horse. The Interbank money market in wholesale lending had a heart attack in 2007 and essentially died in October 2008 with the collapse of Lehman Brothers. The money market is now on life support directly to central banks and to all intents and purposes there is no independent Interbank Market in money and there never will be again.

LIBOR is dead, and the markets are moving on.

The Brent/BFOE crude oil market benchmark, on the other hand, has been in failing health for a long time as the North Sea oil production upon which it is based has been in secular decline. Despite the best efforts of Platts – the Price Reporting Agency who are getting most of the flak – the market is at the point where if it were a horse it would be put down.

Market Manipulation

A regulator friend of mine used to joke that since excessive market manipulation is a US felony, the implication is that there is such a thing as ‘acceptable’ market manipulation. My response was that trading might be defined as ‘acceptable market manipulation’.

While producers desire a stable high price, and consumers desire a stable low price, for a trading intermediary who aims for transaction profit, price stability is Death, and the only bad news is no news at all.

I am not familiar enough with the endemic LIBOR manipulation to say much about the victims and their losses. But I can say that from its inception in the mid-1980s crude oil trading and the associated fun and games in the Brent/BFOE complex of contracts have taken place entirely among consenting adults. The outcome of the routine short term ‘micro’ manipulation by oil market participants has been pretty much a zero sum game between trading intermediaries.

Some of these middlemen are traders of physical oil like Vitol and some of them are the ‘Wall Street Refiner’ traders in investment banks such as Goldman Sachs. There have been no direct effects from these continuing trader games on the man in the street, but there are indirect effects such as the higher cost of energy investment arising out of unnecessarily high market price volatility.

Whenever producers or consumers can gain market power, through some kind of leverage, to either support or suppress prices in the medium and long term, then they will. The history of markets is full of examples of such ‘macro’ market manipulation and while LIBOR is among them, that is only now of historic interest, now that the market is dead.  In crude oil, on the other hand, we are approaching the end of the greatest macro market manipulation in the history of commodity markets, by comparison to which Yasuo Hamanaka’s $2bn manipulation of the copper markets through Sumitomo is a car boot sale.

Cui Bono

Ask yourself who benefits from high oil prices? It’s the producers, stupid. From 2005 onwards a market bubble in crude oil has been deliberately created. This has been achieved opaquely through use of the Prepay funding used by Enron to sell commodities at a discount for cash now, and deliver them later.

Creditors and investors who were unaware of Enron’s ‘off-balance sheet’ liabilities were misled as to the true financial position and were thereby defrauded. Most oil market participants have been similarly misled as to the true position in the oil market through the use of prepays by producers, funded by passive investors.

In simple terms, risk averse investors have lent dollars to producers, and producers have lent oil to investors.  None of the resulting changes of ownership of oil in the physical market were visible to other market participants, and the price has become a completely distorted and financialised bubble as a result.

The bubble first collapsed during the second half of 2008 from $147 to $35 per barrel and it was then re-inflated in 2009 through the use of prepays, facilitated by US investment banks to the benefit of producers.  Oil prices have since been kept pegged as far as possible between levels which: (a) do not endanger US presidential re-election; and (b) enable producer populations to be financially anaesthetised.

A key element in the evolution of this macro manipulation has been that banks as financial intermediaries are no longer capitalised to take risks in the way that they could and did prior to the collapse of the banking system. The outcome has been that market risk – i.e. the risk that the oil price will fall – is no longer held by the banks but has been transferred to passive and risk averse investors.

The motive of passive investors is not the speculative desire of active investors to make a transaction profit, but its very opposite: the desire to avoid loss. So they invest in oil funds in order to offload the risk that the dollar will depreciate in value relative to oil. Unfortunately, they are blithely unaware that they have a massive market risk if the oil price falls in a market ‘bust’, as it did in 2008; has recently been doing; and will continue to do at least until the end of the year. This is a regulatory accident waiting to happen.


The direct ‘Peer to Peer’ connections between producers and consumers which were first demonstrated by the music file-sharing phenomenon Napster have also been evident in the financial markets for some time through Peer to Peer lending businesses such as Zopa, and the new phenomenon of ‘crowd-sourcing’ of investment and donations.

But it is not widely understood that in financial services, the transition of middlemen to a role as service providers managing risk, business platform and direct P2P relationships is actually in the interests of the middlemen themselves. The reason is that when credit or market risk is with end users, then the only capital needed by service providers is the limited amount necessary to cover operating costs.

This is precisely why, since 2008, investment banks starved of capital have been originating and selling the new generations of funds responsible for the bubbles, where the market risk is with the investors, and not the banks. Unfortunately they have also been able to prey upon end users through their privileged ‘asymmetric’ access to markets and market data and through trading such as ‘High Frequency Trading’ (HFT).

Intermediaries are also responsible for short term micro manipulation, but they are not directly guilty of the macro manipulation of markets which has inflated the medium and long term market price because they simply do not have the capital to invest in this way anymore, even if regulators allowed it.

The End Game

Once the current bubbles collapse, which is only a matter of time, I believe that we will see markets evolve to the next ‘adjacent possible’, which will be the widespread – and necessarily transparent – use of direct Peer to Peer relationships through a new generation of market instruments, of which Enron’s Prepay was the first.

This return to what is in fact an ancient form of financing and funding will complete a cycle which began some 300 years ago when modern money and capital markets began with the foundation of the first Central Banks and the wave of Joint Stock Companies which financed and funded the Industrial Revolution.

A stock answer

By Dan Fox, on 9 January 2012

ISRS Senior Research Fellow, Chris Cook, argues for qualitative easing through stock issuance.

For several hundred years, the Exchequer financed and funded English sovereigns by issuing IOUs, in the form of wooden tally sticks (pictures) split into two parts.  Individual creditors were given the Stock as a receipt and as a credit token which was returnable to the Exchequer in payment of taxes: the Exchequer retained the counter-stock or foil to be matched against returned Stock.

13th-century Exchequer "stocks".

By the time the (privately incorporated) Bank of England came along to privatise the money supply in the late 17th century there were at least £17m worth of tallies in issue at a time when the total cost of the operation of the Kingdom was perhaps £2m to £3m per annum.-

From 1660 onwards, the UK began to issue interest-bearing Stock wholesale which met a demand for long term risk free annuity investments.  This Stock paid interest periodically to the holder and became very popular with long term investors, representing the lowest risk and most solid income stream available.  Meanwhile the physical tally stick accounting system gradually fell into disuse as the accounting system became a more secure double-entry book-keeping system.

Several classes of Stock were issued and in 1752 these were consolidated into what became known as Consolidated Stock or Consols.  Further issues were made and in 1888 these were all brought together by (Chancellor) Goschen’s Conversion as the 2.5% Consols which remain in existence to this day.

A Return to Stock

Under professional management of credit managers/service providers, and the accountable supervision of the Bank of England as monetary authority, local Treasury branches could issue, in virtual form, undated Stock which would be redeemable in payment against taxes.

Stock would be issued at a discount – eg a Unit of £1.00 of Stock sold for 90p – and the rate of return depends on the period over which the Stock is returned to the Treasury in payment of taxes.  The very word return alludes to this long forgotten practice of returning Stock to the issuer.

Stock revolutionises long term investment by transforming the risk.  There is no longer a risk that debt and interest will not be paid.  The stockholder may redeem Units against taxation, or may sell Units to other taxpayers/investors.  Even if pure investors will not buy Stock, taxpayers will always buy Stock when the price is below £1.00.

The rate of return depends literally upon the date of return of the Stock to the Treasury or the date of sale: the former depends on the rate and basis of taxation, while the latter depends on liquidity – the ability to sell stock.

Liquidity is transformed: instead of a market in debt fragmented by different rates of interest; repayment dates; and trading platforms, there will be a single wholesale market in Stock, probably through periodic auctions on the Treasury web-site.  The retail market in Stock takes place throughout the nation: Units of Stock in bearer form – Treasury Notes – may simply circulate alongside Bank of England notes as they still do in the US.

Stock also revolutionises Government funding, since massively reduced funding costs enable the issuance of new Stock to create new productive assets – which was precisely the reason why the wiser sovereigns issued Stock in the first place.

Qualitative Easing

The outcome of such 21st Century Stock issuance would be to transform the quality rather than the quantity of UK public credit – a debt/equity swap on a national scale.

Such Qualitative Easing will give a short/medium term breathing space for the transition of the UK economy to a sustainable long term fiscal basis.

But that is another story.




“We can stack odds in our favour on risky events”

By Dan Fox, on 9 January 2012

ISRS Director of Programmes, Dr Jamie MacIntosh, and Paul Ormerod of Volterra Consulting, had a joint letter published in the Financial Times last week. They wrote to detail the FuturICT project, in response to an article of 30 December, by Gillian Tett, highlighting the threats still posed by phenomenon such as May 2010’s “Flash Crash”, and calling for a “wind tunnel” to test financial innovations such as High Frequency Trading.

The letter is available on the FT”s website (free registration may be necessary). A fuller exposition of the ideas is below.



As Gillian Tett points out (30th Dec, Flash Crash threatens to return with a vengeance), a “wind tunnel” for evaluating financial innovations would be “pretty sensible”. Whilst the US Office of Financial Research (OFR) is “floundering”, the EU need not wait. In addition to the UK Government’s Large-Scale Complex Information Technology Systems project, a consortium of world-class researchers from across Europe is among six finalists for a €1-billion research grant from the European Commission’s Future and Emerging Technologies programme. The FuturICT project has already assembled the research network necessary to build the financial innovation “wind tunnel”. It offers a capacity to explore the healthiness of innovations for the world economy – not just the financial sector or one state.

A key lesson from the first phase of the financial crisis is that regulators were far too slow to absorb crucial advances in scientific knowledge. As early 2000, two major findings had been established beyond doubt. Firstly, the distributions of asset price changes did not adhere to a normal distribution. They had fat tails. Extreme price movements were rare, but many orders of magnitude more likely than if price changes really were normally distributed. Secondly, the risk diversification claimed for many portfolios was a delusion.

Despite these findings, established in scores if not hundreds of scientific papers, regulators remained wedded to the classical Value at Risk and capital asset pricing models. In ideal times, these may be adequate approximations of reality. In reality, made evident during challenging times, they give dangerously misleading information.

Regulators once again are at risk of failing to keep pace with technological and scientific advances. The on-going crises have not stopped financial innovation. Just like the innovations in Credit Default Swaps (CDS) that did so much to fuel the economic crises from 2007 onwards, the High Frequency Trading  innovations at the heart of May 2010’s “Flash Crash” may be healthy or unhealthy. It is too hard to tell using conventional approaches.

FuturICT is a pan-European project that integrates natural sciences, technology and social sciences. It does so by harnessing complexity science. This not only enables multiple disciplines to integrate but also does so where it matters most to us today: improving our understanding of risk and uncertainty in networks.

This is as much about preventing unhealthy regulation as unhealthy innovation that defies regulation. To achieve such an outcome, the FuturICT financial innovation “wind tunnel” will learn the lessons of financial sector circularity, which was masked as risk diversification. Instead, the measure of healthy innovation will be grounded in what it does for the real economy.

FuturICT is not another sounding box for despair among doom-mongers. Nonetheless, it is realistic about human behaviour. The basic toolkit of the consortium is not the isolated rational agent of economic theory, but networks. An appreciation of the connected nature of the world economy, and especially of the financial sector, was sadly lacking in the regulatory and policy worlds in the period leading up to the crash. To understand the world today, we simply must understand networks.  What the structure of connections is, how it is evolving, and who influences whom.

Advanced modelling is also able to anticipate the formation of hubs, through which activities become either harmful or healthy “superspreaders”. Where “too-big-to-fail” and “too-connected-to-fail” may be obvious, other hubs in networks are not so. Learning the lessons of the last war can be counter-productive. So, for example, in well-regulated mature financial centres innovative use of High Frequency Trading (HFT) may be healthy enough (it may even offer a way to smooth Repo Markets) but HFT can spawn trading platforms anywhere. Detecting when or if these became unhealthy superspreader could be vital to the world economy.

We should, of course, be cautious about predicting events in our complex world. But there is no reason why we cannot stack the odds more in favour of winning the race to learn rather than being overtaken by events. Access to data, evolutionary modelling and participation in use of both models and data are all accelerating the potential for healthy innovation. The race to learn is not only realistic but an imperative. Finance has its innovative part to play. Finance, jobs and competitiveness can be brought into strong accord, based on the one real competitive advantage a developed economy has: knowledge workers.

The Irish Patient

By Dan Fox, on 10 June 2011

By Chris Cook, ISRS Senior Research Fellow.

ISRS’s first foray into my chosen field of ‘Resilient Markets’ was a jointly presented seminar which took place on 6th June before an eclectic audience,  including a former US central banker and a distinguished retired financier, but extending far beyond financial practitioners.

My co-host, Arthur Doohan, is a successful and radically innovative Irish banker. My background is of 25 years experience of market regulation and development, including six years as a director of a global energy exchange.

Our presentations, and the ensuing discussion, concerned two different approaches to resolution of unsustainable debt funding.  The current position in the aftermath of property bubbles in affected countries, such as the US, UK, Ireland,and Spain in particular, is analogous to the aftermath of a bad accident.

The English Patient has had his visible wounds patched up and these are now healed. But he continues – undiagnosed – to bleed internally, resulting in the need for regular transfusions of credit (Quantitative Easing – QE) by the Bank of England.  But at least – thanks to his QE – he’s walking about, albeit weakly and with dizzy spells.

The Irish Patient, on the other hand, was treated by doctors who stitched him up and then applied leeches, and is in a very bad way indeed.

Before even beginning to recover, the undiagnosed internal haemorrhaging of both patients must be stopped by Resolution of the debt:  only then can the patients’ recovery begin through a transition to a sustainable financial system.

Arthur and I take different, but complementary, approaches to treating the patients.

Quantitative Resolution  – Debt Offset

Arthur’s presentation covered his innovative proposal to galvanise the Resolution of Ireland’s disastrous and unsustainable legacy of property debt in the aftermath of what was perhaps the most egregious of all the national property bubbles.

In simple terms, he proposes to refinance and thereby resolve existing unsustainable debt.  He proposes new issues of debt at (say) 50% of the face value of the original, now unsustainable, loans which are secured against properties now worth 50% of their peak value.

The outcome is that the distressed borrower would have a dramatically reduced mortgage loan at a new (lower) rate, while the investors in the new loans exchanged for the old would own matching deposits on the other side of the bank’s balance sheet at the prevailing (lower) deposit rate.

Since the bank’s original distressed loan is currently priced in the market at 50% of its original value, this proposal recognises that unpleasant reality and builds Resolution upon it.

So Arthur’s debt offset mechanism offers a simple and elegant way in which Resolution of an unsustainable debt burden may be made by reducing the quantity of obligations.

Qualitative Resolution – Unitisation

My approach is based not upon debt created and issued by banks and secured against property, but upon the simple but radical concept of the issue by property owners of undated credits – ‘Units’ – redeemable in payment for affordable and index-linked property rentals.  Anyone who understands Air Miles, or Storecard points such as Tesco Clubcard points, will understand a Unit redeemable in payment for value.

Unitisation is, in effect, direct – ‘Peer to Peer’ – investment in property, with a return which derives from the market price of the Unit compared to the redemption value. eg a Unit with a face value of £1.00 issued at 80p offers a return of 25%,  but the rate over time of that return depends upon the date of redemption.

The enabling mechanism for Unitisation is the use of one of an emerging generation of legal ownership frameworks which are not conventionally based upon Company or Trust Law, but upon associative agreements and partnership-based vehicles.

Instead of a loan by a bank to a land-owner, which is ‘asset-backed’ by a mortgage claim, Units comprise a loan by investors direct to the land.  This ‘asset-based’ approach does not amend the quantity of obligations, but instead transforms the quality, so that the obligation to repay debt capital on specific dates disappears, along with compound interest.

This creates an interesting new calculus in respect of risk and reward.

Firstly, in terms of security, the risk for Unit investors in respect of their capital is not a credit risk – since their investment is not repayable on a specific date as debt is – but rather the risk that they cannot find a buyer:  i.e. a liquidity risk.  The risk that the Unit will not be honoured – through insufficient rental or otherwise – remains, however. Here it is the case that a rent set at an affordable level is, by definition, more likely to be paid; is thereby a lower risk; and therefore justifies a more modest rate of return.

Secondly, in terms of liquidity, instead of having numerous classes of debt fragmented by date, rate of interest and issuer; we have one single class of Unit in a rental pool created by multiple Unit issuers, with a  common custodian.  Moreover, if a financial investor is unwilling to buy Units, the price will fall to a level at which property occupiers will enter the market and buy Units for redemption.


There are certainly common elements to the proposals: there is the recognition that affordable payments are more likely to be made; and there is a similar symmetry between a right and an obligation, albeit Arthur’s model still has an intermediary bank between the two.

Where I principally differ from Arthur is in his view that the ‘London Model’ of property rights and investment is fundamentally a sound model. In my view, it is the London Model’s combination of compounding interest on debt, and absolute private property (particularly in land) which has led to periodic booms and busts for hundreds, if not  thousands, of years, and to the current systemic imbalance in wealth and purchasing power which is frustrating all conventional economic remedies.

I believe that through what is essentially an exchange of unsustainable debt for a new form of equity, we may  permanently resolve the existing funding problem, and prepare the way to a transition to a sustainable and resilient economy through a new approach to financing. But that, as they say, is another story, and for another seminar.