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Researchers cite faulty analysis in CFTC study.

Researchers cite faulty analysis in CFTC study

Recently, the Commodity Futures Trade Commission (CFTC) proposed legislation to severely curtail dual trading - the practice of floor brokers trading for both customer and personal accounts - at U.S. futures exchanges. The proposals are largely based on results of a CFTC study of the practice. The Coffee, Sugar and Cocoa Exchange, along with seven other U.S. exchanges, commissioned two independent academic analyses of the CFTC's findings. James J. Bowe, CSCE senior vice president for market development and planning, presents a report on the independent researcher's findings.

The Coffee, Sugar and Cocoa Exchange has been among a chorus of voices expressing opposition to the Commodity Futures Trading Commission's (CFTC) heavily publicized campaign to sharply curtail the long-standing practice of dual trading at U.S. futures exchanges. Now, two separate research groups support our contention that the CFTC study underpinning its proposals - "Economic Analysis of Dual Trading on Commodity Exchanges" - does not contain adequate information to support proposed dual-trading restrictions.

Eight U.S. futures exchanges, including the CSCE, commissioned the independent analyses, prepared by economics and finance experts at Duke University and the University of California at Berkeley. Both groups concluded that the CFTC study not only failed to ask the right questions, it used flawed methods to address the questions it did ask. The researchers said the deficiencies undermine the study's conclusions, as well as its use as a basis for dual-trading curbs.

Duke professors Robert Whaley and Thomas Smith focused major criticism on the CFTC study's statistical methods. Citing measurement errors, inconsistencies and econometric misspecifications, Whaley and Smith found the study's conclusions were "either wrong, misleading or unsupported by empirical results."

Berkeley's Raymond Hartman and Gordon Rausser criticized the study for failing to address several key issues. The pair said the study fails to weigh dual trading's benefits against the costs and does not evaluate dual trading's functional effects on markets. Because it ignores these questions, Hartman and Rausser said the study "cannot provide evidence ... to either support or reject the proposal to ban dual trading."

In conducting their analyses, the research teams each examined and found lacking the appropriateness of the data and methodologies used by the CFTC. The Duke findings included: an insufficient sample size; a "grossly misleading" conclusion on the extent of dual trading; distorted results owing to aggregation of sample data across all markets and contract months; and an unsurprising and irrelevant finding that trading and execution costs are the same for both dual and non-dual traders.

The Berkeley findings were in a similar vein; a failure to determine whether the costs of dual trading outweigh benefits, both socially and economically; no attempt to assess the motivations and behavior of markets and their participants; inability to pose the right questions; and absence of analysis of dual trading's effects on other market functions.

Both teams also examined the CFTC study's econometric models and statistical analysis. Their examination revealed misspecifications and other estimation problems as well as the use of econometric techniques that created biased and inconsistent results.

The CSCE feels these analyses underscore the need for caution and more thorough analysis before proceeding with any legislation banning dual trading. At stake is the loss of futures trading volume and its accompanying depletion of market liquidity that we believe the CFTC's proposal will precipitate. A drain on liquidity translates to hampered market efficiency - a high price to pay for the members of the commercial trade who depend on our markets for their hedging needs.

It's abundantly clear to us that the CFTC's study does not justify jeopardizing that which makes our markets among the most efficient anywhere. Hopefully, the CFTC will recognize the need to heed our call for caution.

Highlights of the Duke University Analysis

- the sample size of 15 days of information used by the CFTC is too small and not representative of the activity in dual trading commodity markets. - the CFTC's conclusion on the extent of dual trading is "grossly misleading." By using a "maximum allowance level," the study inaccurately minimizes both the volume affected and the number of floor participants involved. - the CFTC aggregates the sample data across all markets and contract months, a method that distorts the results and undermines the interpretations. - the finding that trading and execution costs are the same for both dual and non-dual traders is irrelevant and "sheds no light whatsoever on the question of the desirability of dual trader markets."

Highlights of the Berkeley Analysis

- fails to determine whether the benefits of dual trading outweigh the costs on both economic and societal levels. - does not attempt to assess the behavior and motivations of markets and their participants. - failed to ask the right questions and used flawed methods to address the questions it did ask. The deficiencies undermine the study's conclusions as well as its use as a basis for dual trading curbs. - did not analyze the effect of dual trading on other market functions such as brokerage costs and price discovery.
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Title Annotation:Commodity Futures Trade Commission, Economic Analysis of Dual Trading on Commodity Exchanges
Publication:Tea & Coffee Trade Journal
Date:Jul 1, 1990
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