I have been thinking about yesterday’s historic negative pricing in the crude oil futures market. There might be more ramifications from that decision than I initially believed.

Let’s first start with a rant from my buddy Alex Manzara from RJ Obrien. Alex is a long time floor trader who doesn’t mince words about the CME’s decision to allow negative pricing.

Alex’s main point is that the exchange had the ability to forbid negative prices and force liquidation at zero. Instead, they chose to allow the previously unheard abomination of negative prices.

I am not here to judge whether that was the correct decision. I happen to agree with Alex, but that doesn’t help our trading one iota.

However, by allowing negative prices, the CME might have just killed all physical commodity ETFs. Think about it for a second. The USO trust cannot trade at a negative price, yet the assets they own are no longer bound by zero and could potentially be a liability. As an administrator of that trust, this risk is most likely unacceptable. The USO trust is a $3 billion entity. What if oil trades at negative $20 bucks for the contracts that the USO trust holds? The administrator would be on the hook for billions.

The decision to allow negative prices in crude oil might haunt us for years to come. Did the CME just hammer the nail in the coffin of commodity ETFs? The real question is whether they knew what they were doing or not. Was it on purpose? Who knows?

Not sure what I will do with my USO positions. I have so many different USO option lines I feel like I have checked into the Hotel California, but this has definitely added some wrinkles to the equation.

The ultimate negative price tale

All this talk about negative prices reminds me of the days of my youth, when I had my first brush with this phenomenon.

I have wanted to tell this tale for some time, but it didn’t feel quite right blasting out to tens of thousands of readers. Kind of like I was telling a tale out of school.

But now that it’s just us, I feel like it's ok.

It all started more than two decades ago. Back then a bright Canadian financier got the idea of selling stock via installment receipt. The way it worked was that the installment receipt buyer would pay for half (or some other portion) of the stock up front, and then promise to pay the final installment some time in the future. Investors loved the product because the installment receipt paid the same dividend as the common stock, but on a much smaller capital outlay. The current yield was therefore much more attractive. Not only that, but the investor controlled the same amount of stock for a fraction of the price. The capital gains as a return on investment were therefore also magnified.

Now, you and I know there is no such thing as a free lunch, but often investors don’t look past the immediate here and now. Sure, we all know the yield-to-maturity would render that supposed pick-up in current yield moot, but investors took a much simpler approach. They looked at the price of the installment receipt. They looked at the dividend. They did the yield calculation. And they bought. And they bought tons. And tons. And then even more.

When I joined the institutional desk, there were already a half dozen big name Canadian companies who had done large installment receipt transactions. Our brokerage firm would trade these installment receipts against the common stock, making large markets in both issues in an attempt to put up blocks for our institutional clients.

Although I was hired to help cover the program trading clients, I wanted to be a prop trader. So I watched everything and tried to learn. Eventually I was given the job of handing out the paper inventory runs in the morning, which I loved because it gave me an opportunity to monitor everyone’s trading.

As I watched the trading in these installment receipts, I realized the stock guys were overlooking an important aspect to the trade. They were long all sorts of receipts and had sold short the common stock against their position. Due to the fact that the installment receipts expired in one year, they were using the one year BA rate (Bankers Acceptance - kind of like Canadian LIBOR) to calculate fair value. Nothing wrong with that. They would figure that the spread was worth something like $4.18, do a trade at $4.20 (overpaying by $0.02 but earning $0.04 a side commission on both trades) and think they were making $0.06.

The trouble was that they would be long the receipt, short the common stock, and have this large credit in their inventory which they then earned overnight rates on. But they had priced it using the one-year BA rate. At that time we had large positive rates with an upwardly sloping yield curve. So overnight rates might have been 5%, but one year might be 6.5%. Their model would be priced off the 6.5%, but they were only earning 5%. Over the course of the year, their trade would be considerably less profitable because they were not managing their cash position correctly.

Even though I was relatively new to the desk, I decided to pipe up and explain it to my boss. To his credit, he instantly understood the problem. Even more to his credit, instead of chewing out some senior equity trader who didn’t really understand these sorts of pricing peculiarities, he told me to fix it.

Emboldened, I started trading Bankers Acceptance to hedge our interest rate exposure for this book. I quickly gained confidence, and even though I was fresh to the desk, they gave me the task of making spread markets for the equity traders to offset their positions against. Nowadays, this seems simple, but back then, few equity traders understood these sorts of nuances.

I started calling extremely tight markets as, after you account for interest rate, borrow and capital charges, it was an easy problem to solve. I felt like I was walking on sunshine. I had found something I was good at, and there I was, a young guy being given an opportunity on the trading desk.

But that’s not my story. That’s just a little warm-up for the real tale. You see, even though I was the young spread trader who understood the rudimentary trading mechanics of receipt trading, there was another trader in our shop who understood the ever-so-difficult-to-teach skill of being a real pig when a great opportunity presented itself.

Let’s zip back to the installment receipt construction again. Remember how I said the buyer of an installment receipt pays a portion up front, and then promises to pay the rest later? Yup, that wasn’t a poor choice of wording. As crazy as it sounds, the installment receipts were not the right to buy a share of common stock on expiry but instead were the obligation to do so.

Let’s make a theoretical company called DumFrac Well Services. Their stock is trading at $15, so they issue a 2-year installment receipt at $7.50. Clients line up to buy the receipts at $7.50 because the company pays a $1.00 a year dividend. The investment bankers issue a ton of receipts and earn their fees. They are happy. The corporate client is happy because they have issued equity at $15 per share.

However, then a bear market hits. Next thing you know, DumFrac is trading at $8.00. Ooops. The installment receipts trade down in sympathy with the stock, but then traders start to question whether the receipts are the right or the obligation to buy the stock at $7.50. If it’s the right, then the receipt should trade like an option. But if it’s the obligation, then the pricing becomes much more difficult.

After some debate and expensive consultations with securities lawyers, it turns out that the installment receipt does in fact represent the obligation to buy the Dumfrac stock at $7.50.

Next thing you know, clients are pitching the receipt and putting pressure on the stock. Suddenly the stock is trading at $7.25 and the installment receipt is now worth negative $0.25.

Holy shit. How can a security trade at a negative price? Don’t forget this was back in the 1990s, so the computers were completely unable to handle the minus sign.

The exchange moved the installment receipt to the over-the-counter market where trades were done by hand over the phone.

Think about the absurdity of the situation. Clients had bought a security and then when it went bad, they had to pay someone to take the obligation off their hands.

It was a gong-show. Clients were rightfully furious. Many refused to pay. What was the dealer going to do? Sue them for payment?

I got told from the higher ups to stop trading receipts that had gone negative. It was an embarrassment and the last thing they wanted was some young kid making money off this disaster.

But there was a prop trading who sat in the other room. To this day, I still think he’s the smartest guy I have ever met. He was tall, good-looking, shrewd beyond belief and just a rock star. He would ask me what I did on the weekend and I would tell him about waiting in line for some new movie, and then when I asked him what he did, he would casually tell me how he flew his plane to New York city to watch the Tragically Hip play at some small intimate bar. Not only that, but he was just a nice person. We all wanted to be this guy.

Anyways, he sized up the installment receipts situation and instantly realized it was a terribly designed product. The ability of dealers to force clients to pay for the second half of the obligation would be tenuous at best.

So what did he do? He opened an offshore corporate account with limited liability, and starting buying negative priced receipts by the bucketful.

You offer 500k Dumfrac receipts at negative $1.00? Bought from you. Another 750k come at minus $0.85. Done! and do you have any more? This went on for days. He would get the receipt and get paid! He collected millions.

Sure enough, the installment receipt came due and the company demanded payment. What did our prop trader do? Absolutely nothing. He sat back and waited. The company huffed and puffed. They threatened all sorts of legal action. But that didn’t phase our trader one bit. He just waited.

And then do you know what happened? The stock rallied. Eventually it went up through the strike and the company was just relieved to get this liability off the sheets, so they asked if the trader would take up his stock. Which of course he did because the receipt now had intrinsic value. So our rock-star trader ended up buying a receipt for negative value and eventually selling it for positive without ever putting up a dime or taking any risk (if you ignored the legal kind). It was just one of the trades that I saw him make that made him probably the greatest trader I have ever had the privilege of knowing.

I will never forget it as long as I live.

Thanks for reading,
Kevin Muir
the MacroTourist