The economics of manipulation

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economics of manipulation
Market participants must absolutely adhere to strict regulations, or investors and corporations will lose faith in the market, writes Zain Naeem. Photo: Rafael Matsunaga

Demand and supply are the basic fundamental pillars of any economy. Having a ‘good’ and having people supply that ‘good’ allow for the smooth functioning of markets. Well informed buyers and sellers use their knowledge in order to get the best price possible, while sellers are able to sell at the prevailing market price.

The mechanism is supposed to work flawlessly, and frictionless operations are guaranteed by all the participants in the market. If any of the stakeholders are taken advantage of, not only is it detectable but it is also punishable. That’s how the theoretical market is supposed to work.

Newsflash; We do not live in a theoretically rational and perfect world.

There will always be people who will be looking to evade the law and abuse the system in their favor to make an extra buck at the cost of others, and are willing to shortchange another providing there is enough incentive and opportunity. As long as there are huge rewards to be reaped, this will always be a concern.

Sunday saw another indictment against Goldman Sachs where the New York Times alleged that the company was using its Detroit warehouse in order to decrease the physical supply of its aluminum stock which caused the price to spike. It is thought that the use of its aluminum stockpiles goes back to 2010 when Goldman Sachs bought the warehousing company Metro International Trade Services.

Using that company, Goldman was taking evermore inventory into its storage, releasing it with ever-increasing reluctance in recent times. In 2011, Coca Cola filed a complaint with London Metals Exchange in regards to this issue.

Conceivably, this could allow Goldman Sachs to control most of the inventoried aluminum — and then use other market tools to take advantage of the situation.

Let’s assume that a storage company is storing oil and selling it to firms when they need it. This makes the storage company not just a storage company, but an intermediary in the market, making earnings from their services. Now suppose the company starts limiting either the outflow of the oil or inflow to its firms. The decrease in supply in the overall market raises prices or a glut can send the price plummeting.

Just before the company starts implementing this manipulation, the company takes a huge position in the market that can benefit from either the increase or decrease in price that will be seen in the future. To illustrate, If I know that the price will increase by USD 10. for example, I buy 1000 contracts for the future. When the market is hit by the price increase, I have made USD 10,000.

It’s not wrong to make money. That’s what firms are for. The violation is to create the situation that causes the company to make that money.

The profit, is risk free and easy, and it makes investors lose faith in the transparency and operations of the markets. The manipulation that has been alleged against Goldman goes a step further, as they also acted as the gatekeeper to the supply. They also charged extra fees to buyers like Coke and Alcoa in order to insure smooth supply in the future.

The last allegation against Goldman is that once the markets saw that the price of aluminum rising, there was a higher demand for the metal that was humbly provided by Goldman to the markets. The liquidity provided by the bank allowed the investors to get involved in the market on a larger scale. Other investors and funds were willing to buy the options and the asset itself, which was being created and funded by the bank in the end.

There is a proper beginning, middle, and end to this, and allegedly, Goldman has been involved each step of the way.

It would be suspect that a company is involved in both asset and derivative market of a product which it can clearly manipulate and use to its own advantage. This was possible due to Fed’s ruling in 2003 where it allowed financial institutions to run storage facilities as they had to complement their financial products with actual assets. Hearings are expected on the hill Wednesday in order to determine the next step in this problem and a decision will be reached. This is another bruise against a banking industry which keeps proving that it will do all it can to take advantage of the market.

As a result of this, if strict and stringent regulations are put in place, it might not be a bad thing.

There is a growing sentiment that some sort of regulation should be put forward like the Glass-Steagall Act under the new Dodd-Frankesque Act that was just passed. The Senate has another chance to take a strict action against the financial industry right now and make an example of the alleged perpetrators.

© Zain Naeem

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