Streetwise Professor

April 3, 2015

BATS in the OCC’s Belfry?, or The Perils of Natural Monopoly Regulation, CCP Edition

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 11:13 am

The Options Clearing Corporation (“OCC”) and the exchanges that own it (Chicago Board Options Exchange, Incorporated, International Securities Exchange, LLC, NASDAQ OMX PHLX LLC, NYSE MKT LLC, and NYSE Arca) are embroiled in a dispute with virtually everyone else in the options business regarding its new capital plan. Pursuant to its designation as a “Systemically Important Financial Market Utility” (“SIFMU”) under Frankendodd, OCC was required to boost capital from $25 million to nearly $250 million. Part of this will be obtained through retained earnings, with an additional $150 million via a capital injection from the four owner-exchanges. In addition, CBOE et al promise to inject up to $117 million in the event of “unexpected losses”, which would be most likely to occur during a financial crisis.

In return, the owner-exchanges receive in essence preferred stock, which pays a dividend in perpetuity. The exact amount of the dividend is not known publicly, but those objecting to the plan (including BATS and KCG) claim that it could be as much as 16-19 pct, at least in the first few years of the plan’s operation.

Non-owner exchanges like BATS and market users like KCG are furious, claiming that the the capital plan allows OCC’s owners to “monetize” the rents accruing to its status as the monopoly clearer for options transactions in the US. They believe that OCC will pay for the dividend by charging super competitive fees that will impair competition among exchanges (advantaging the owner exchanges over the non-owners) and will burden market users.

This is a difficult issue, the nature of OCC. Here are some thoughts:

1. OCC is a regulated monopoly, and arguably a natural monopoly.This creates the traditional conflict between the owners of the utility and its customers, which include other exchanges that aren’t owners (like BATS) and clearing firms and market users (like KCG). This is in many ways very similar to a dispute between a traditional electric utility and its ratepayers heard before a state utility commission, with the exception that this is before the SEC.

2. Like a traditional are case involving a regulated utility, the dispute here is over what is a fair rate of return on capital. BATS and KCG are objecting to the rate of return the 4 exchange owners of OCC are being promised for their capital contribution, and the process by which the SEC approved this rate of return.

3. It is particularly challenging to determine a “fair” rate of return on this capital because of the unique risks that the OCC exchanges are assuming. This capital is at risk of taking a big hit, and the owner-exchanges are potentially obligated to make additional capital contributions, during periods of financial crisis (the “dire circumstances”) referred to in BATS’s letter to the SEC. This tends to make this capital very expensive, and it should therefore earn a relatively high rate of return (high dividend). Capital that has bad returns when the market is doing poorly overall-“high beta”, if you will-is expensive capital. The type of capital being provided is fraught with wrong-way risk: it is likely to take a hit precisely when the capital suppliers are least able to afford it. Determining how much of a risk premium is warranted is a challenge, because of the exceptional nature of the risk. In essence, the exchanges are assuming tail risk, i.e., the risk of exceptional events, and it is inherently difficult to evaluate and price these risks.

4. The other exchanges and firms like KCG benefit from the risk bearing capital supplied by the owner exchanges. Otherwise, they would have to bear the risk. But of course they would like to underpay for this benefit, just as the owner exchanges might want to overcharge for it.

5. In other words, this situation is tailor made for disputes. Monopoly rate setting to determine fair rates and a fair rate of return on capital with very unusual and hard to evaluate risks.

6. The fears about the effects of pricing on inter-exchange competition in execution service are misdirected. Yes, it is possible that the owner exchanges will capture monopoly rents accruing to the OCC’s dominant position, but traditional “one monopoly rent” analysis implies that they don’t have an incentive to use OCC pricing power to advantage their competitive position in execution services. Indeed, the opposite is true.

This also highlights some organization, ownership and governance issues that I addressed in my research on exchanges that culminated in my 2000 JLE piece. Exchanges (and clearinghouses) have market power, and serve disparate and heterogeneous interests. They can use pricing to redistribute rents (which accrue in part due to market power) from one group of intermediaries to another. Not-for-profit status and mutual ownership (having the exchange or CCP operate as a non-profit “utility” serving disparate intermediary-owners is a way of reducing rent seeking and mitigating the use of pricing to redistribute rents.

But non-profit, mutual organization comes at a cost. It requires highly participative, committee-heavy governance that slows decision making and often creates gridlock that makes it difficult for the exchanges/CCPs to respond to technology, regulatory, or market shocks. (Look at the CBT in the 1990s and early-2000s if you want an example.) If everybody has a voice and a vote, it is very difficult to get things done.

In sum, “financial market utility” pricing and governance is inherently messy and controversial.  It has all of the problems associated with public utility regulation, and then some. The problems are particularly daunting when it comes to capitalizing, allocating and pricing the systemic and wrong way risks that CCPs bear. Given these complexities, I won’t venture an opinion here, except to say that (a) I can see both sides of the argument here, and (b) this ain’t going away anytime soon.

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March 30, 2015

An Elegant Answer to the Wrong Question (or an Incomplete One)

Filed under: Clearing,Derivatives,Economics,Financial crisis,Regulation — The Professor @ 1:14 pm

Rodney Garrett and Peter Zimmerman of the NY Fed have produced a paper studying the effect of clearing on derivatives counterparty risk exposures. It is basically an extension of the Duffle-Zhu paper from a few years ago. It studies more realistic networks and a more diverse set of scenarios than D-Z. It demonstrates that with a variety of network structures, clearing actually reduces netting efficiency and increases counterpart risk exposures. This is especially true with “scale free” or “core-periphery” networks, which are more realistic representations of actual derivatives markets than the all-to-all structure in D-Z. They show that when the system relies on relatively few crucial nodes, as is the case in most dealer structures, clearing reduces netting efficiency. This, as Garrett and Zimmerman note, could explain why clearing has not been adopted voluntarily. It also raises doubts about the advisability of clearing mandates, inasmuch as the alleged benefit of clearing is a reduction in counterparty credit exposures.

A few comments. The results, taken on their own terms, make sense. In particular, networks connecting dealers and customers via derivatives transactions, are endogenous. And although network structures are not necessarily efficient due to network externalities and path dependence, there are forces that lead to minimizing credit exposures. thus, although it would be Panglossian to assert that existing structures minimize these exposures, it should not be surprising that interventions that lead to dramatic alterations to networks increase counterparty risk exposures as existing networks are configured at least in part to reduce these exposures.

More importantly, though, there is the issue of whether counterparty risk exposure in derivatives transactions is the proper metric to evaluate the effect of clearing mandates. As I have noted for  years (as has Mark Roe), when participants in derivatives transactions have other liabilities, changes in netting efficiency in derivatives primarily redistribute wealth to or from one group of creditors (derivatives counteparties) from or to other creditors (e.g., unsecured lenders, commercial paper purchasers, deposit insurers). Netting and offset essentially privilege the creditors that can use them, at the expense of others who cannot. So telling me policy A reduces counterparty risk exposures by netting provides me very little information about the systemic effects of the policy. To understand the systemic effects, you need to understand the distributive effects across the full set of creditors impacted by the change in derivatives netting efficiency induced by the policy–and that would be every creditor of derivatives market participants. This paper, like all others in the area, does not do that.

Put another way. Papers in this literature say little about systemic risk because they only analyze a piece of the system. The derivatives-centric approach is of little value in assessing systemic risk. To analyze systemic risk, you need to analyze the system, not a piece of it.

What’s more, shuffling around credit risk is probably not the most important effect of clearing mandates, even though it receives the vast bulk of the attention. As I’ve written repeatedly in the past, including here, clearing reduces credit risk by increasing liquidity risk, most notably, through variation margining which results in the need to obtain cash in a hurry to meet margin calls, which can be large when there are large market shocks. The expansion of clearing to OTC markets which dwarf listed derivatives potentially leads to orders-of-magnitude increases in liquidity needs.

It is these liquidity demands which create huge potential systemic risks. Financial crises are usually liquidity crises: mechanisms such as clearing increase demands for liquidity in stressed market conditions, and do so in a way that increases the rigidity and tightness of the coupling in the financial system. This is extremely dangerous. Tight coupling in particular is associated with system failure in a variety of real world systems including both financial and non-financial systems.

Indeed, all of the attempts to make CCPs invulnerable all tend to exacerbate these problems. This raises the possibility that CCPs could be bastions surviving in the midst of a completely rubbled financial system.

In sum, papers like the Garrett-Zimmerman work are very elegant and technically sophisticated, and help answer a question: Does clearing reduce derivatives counterparty risk exposures? But all the elegance and technical sophistication is likely for naught given that the question is the wrong question, or a very incomplete one.

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March 23, 2015

The Systemic Risk, or Not, of Commodity Trading Firms

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics,Russia — The Professor @ 2:03 pm

My latest white paper, “Not too big to fail: Systemic Risk, Regulation, and the Economics of Commodity Trading Firms” was released today. A video of me discussing it can be found here (as can my earlier white papers on commodity traders and LNG trading).

The conclusion in a nutshell: commodity trading firms do not pose systemic risks, and therefore it is inappropriate to subject them to bank-like prudential regulations, including capital requirements. Commodity trading firms are not systemically risky because (a) they aren’t really that big, (b) they are not that highly leveraged, (c) their leverage is not fragile, (d) the financial distress of a big trader is unlikely to result in contagious runs on others, or fire sale problems, and (e) their financial performance is not highly pro cyclical. Another way to see it is that banks are fragile because they engage in maturity and liquidity transformations, whereas commodity trading firms don’t: they engage in different transformations altogether.

Commodity traders are in line to be subject to Capital Requirement Directive IV starting in 2017. If the rules turn out to be binding, they will cause firms to de-lever by shrinking, or issue more equity (which may force them to forego private ownership, which aligns the interests of owners and managers). These will be costs, not offset by any systemic benefit. All pain, no gain.

It is my understanding that banks obviously think differently, and are calling for “consistent” regulations across banks, commodity traders, and other intermediaries. Since these firms differ on many dimensions, imposing the same regulations on all makes little sense. Put differently, apropos Emerson, a foolish consistency is the hobgoblin of little minds. Or bankers who want to handicap competitors.

The white paper has received some good coverage, including the Financial Times, Reuters, and Bloomberg. I will be writing more about it when I return to the states later in the week.

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January 31, 2015

A Devastating Critique of the Worst of Frankendodd: The SEF Mandate

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 9:05 pm

On the day of its passage, I proclaimed the Swaps Execution Facility (SEF) Mandate to be the Worst of Frankendodd. Somewhat later, I called the Made Available for Trade (MAT) process to be the Worst of the Worst. Nothing that has happened since has led me to change my mind. To the contrary.

Many considerations led me to these conclusions. Most notably, the SEF mandate, especially as implemented by the CFTC, substituted government judgment for user choice in how to execute swaps transactions. In particular, the mandate imposed a one-size-fits-all execution model on a very diverse marketplace. In the swaps market, heterogeneous participants with varying objectives want to engage in heterogeneous transactions, and over time a variety of execution methods evolved to accommodate this diversity. The mandate ran roughshod over this evolved ecosystem.

Congress, and especially the CFTC, took the futures market with centralized exchanges as its model. They liked the futures markets’ pre-trade and post-trade price transparency. (Remember Gentler and his damn apples?) They liked counterparty opacity (i.e., anonymity). They liked centralized execution and a central limit order book. They liked continuous markets.

But swaps markets evolved precisely because those features did not serve the needs of market participants. The sizes of most swap transactions, and the desire of participants to transact in such size relatively infrequently, are not handled efficiently in a continuous market. Moreover, the counterparty transparency available to the parties of bilateral trades each to evaluate the trading motives of the other, thereby limiting exposure to opportunistic informed trading: this enhances market liquidity. Limited post-trade transparency makes it cheaper for dealers who took on an exposure in a trade with a customer to hedge that risk. The inter dealer broker model also facilitates the efficient transfer of risk among dealer banks.

But those arguments were unavailing. Congress and the CFTC were deeply suspicious of the bank-dominated swaps markets. They viewed this structure as uncompetitive (despite the fact that there were more firms engaged in that market than in most major sectors of the economy), and the relationship between dealers and end users as one of greatly unequal power, with the former exploiting the latter. The protests of end users over the mandate did not move them in the slightest.

I predicted several consequences of the mandate. Fragmentation along geographical/jurisdictional lines was the most notable: I predicted that non-US entities that could avoid the strictures of Frankendodd would do so.  I also predicted a decline in swaps trading activity, due to the higher costs of an ill-adapted trading system.

These things have come to pass. What’s more, it’s hard to discern any offsetting benefits whatsoever. Indeed, when compliance costs and the costs of investing in and operating SEF infrastructure are considered, the deadweight losses almost certainly run into the many billions annually.

If you want detailed chapter and verse describing just how misguided the mandate is, you now have it. Thursday CFTC Commissioner Christopher Giancarlo released a white paper that exposes the flaws in the mandate as implemented by the CFTC, and recommends reforms. It is essential reading to anyone involved in, or even interested in, the swap markets.

Commissioner Giancarlo may be talking his ex-book as an executive of IDB GFI, but in this case that means he knows what he’s talking about. He carefully demonstrates the economic purposes and advantages of pre-Dodd Frank swaps market structure and trading protocols, and shows how the CFTC’s implementation of the mandate undermined these.

The most important part of the white paper is its demonstration of the fact that the CFTC made the worst even worse than it needed to be. Whereas Congress envisioned that a variety of different execution methods and platform would meet its purposes, CFTC effectively ruled out all but two: a central limit order book (CLOB) and request for quote (RFQ). It even imposed unduly restrictive requirements for RFQ trading. As the commissioner proves, the statute didn’t require this: CFTC chose it. Actually, it would be more accurate to say that Gensler chose it. Giancarlo does not name names, for obvious reasons, but I operate under no such constraints, so there it is.

Commissioner Giancarlo also goes into great deal laying out the perverse consequences of the mandate, including in addition to the fragmentation of liquidity and the inflation of costs the creation of counterproductive tensions in relations between American and foreign regulators. Perhaps the most important part of the paper is the discussion of fragility and systemic risk. By creating a more baroque, complex, rigid, illiquid, and fragmented marketplace, the CFTC’s SEF regulations actually increase the likelihood and severity of a market disruption that could have systemic consequences. This is exactly contrary to the stated purpose of Dodd-Frank.

Seemingly no detail goes unaddressed. Take, for instance, the discussion of the provision that voids swaps that fail to clear ab initio, i.e., a swap that fails to clear for any reason-even a trivial clerical error that is readily fixed-treated as if it never existed. In addition to raising transactions costs, this provision increases risks and fragility. For instance, a dealer that uses one swap to hedge another loses the hedge if one of the swaps is rejected from clearing. If this happens during unsettled market conditions, the dealer may need to re-establish the hedge at a less favorable price. Since there are no free lunches, the costs associated with these risks will inevitably be passed on to end users.

The white paper suggests many reforms, most of which comport with my original critique. Most importantly, it recommends that the CFTC permit a much broader set of execution methods beyond CLOB and RFQ, and that the CFTC let the market evolve naturally rather than dictate market structure or products. Further, it recommends that market participants be allowed to determine by contract and consent acceptable practices relating to, inter alia, confirmations, the treatment of swaps rejected from clearing, and compression. More generally, it advocates a true principles-based approach, rather than the approach adopted by the CFTC, i.e., a highly prescriptive approach masquerading as a principled based one.

One hopes that these very sound ideas get a fair hearing, and actually result in meaningful improvements to the SEF regulations but I am skeptical. The Frankendodd SEF monster has long since escaped the confines of the castle on 21st Street. Moreover, in the poisoned and reductionist political environment in DC, Dodd Frank is treated by many (Elizabeth Warren and the editorial board of the NYT in particular) as something carved on stone tablets that Barney brought down from Mount Sinai, rather than Capitol Hill. The Warren-NYT crowd considers any change tantamount to worshipping the Golden Calf of Wall Street.

But to reform the deformed and inform the uninformed you have to start somewhere, and the Giancarlo white paper is an excellent start. One hopes that it provides the foundation for reasoned reform of the most misbegotten part of Dodd Frank. I challenge the die hard defenders of every jot and tittle of this law to meet Giancarlo’s thorough and thoughtful contribution with one of their own. But I’m not holding my breath.

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January 13, 2015

It’s Deja Vu All Over Again, or the Putin Hamster Wheel, Crisis Edition

Filed under: Commodities,Economics,Energy,Financial crisis,Politics,Russia — The Professor @ 8:12 pm

I was glancing over some posts from the 2008-2009 crisis period, and was struck at the similarities between what happened in Russia then and what is happening now. The imploding ruble. Capital flight. Discussions of whether capital controls were necessary to stem the rout. The heavily stressed banking system. The government’s desperate attempts to support the the banking system and big firms. The attempts of Rosneft and Gazprom to use the crisis as an excuse to feed at the government trough. Putin’s crazed and frequently paranoid ramblings, and a broader national paranoia.

Russia scraped by last time, in part because oil prices rebounded starting in mid-2009, and because the world economy (notably China) also fought its way out of the crisis. The stimulus-driven Chinese rebound was especially important, because it supported commodity prices, which was vital for a commodity producer like Russia.

Will it scrape by this time? Well, there is a lot of ruin in a country, as Adam Smith informed us, so it’s always risky to predict a collapse. And Russia has rebounded from even worse situations (think 1998).

That said, things aren’t nearly so favorable for Russia this time around. First, there is the self-inflicted wound: the invasion of Ukraine and the sanctions that followed. This is harming the banking and extractive sectors in particular. The fundamentals are bad enough for these sectors: sanctions exacerbate the problems. Second, Russia can’t look to a return to rapid Chinese demand growth to save it this time. China’s slowdown (which is have broad based effects, including on Tesla which has seen Chinese sales on which it was counting decline substantially) is at the root of the current commodity downturn, and since it is likely that this growth slowdown will persist Russia can’t look for succor from that quarter. Third, as bad as Russia’s institutional environment and governance were in 2009, they are even worse now. The ossification of Putinism (and Putin himself!) and his deep fear of overthrow are leading to regress, rather than progress in the development of the rule of law, secure property rights, and civil society, and the reduction of corruption, cronyism and rent seeking. The horrible institutions and governance will be a drag on growth. Fourth, the fiscal situation is weaker. Reserves are relatively smaller now, and Putin’s electoral promises to raise social payments and his commitment to increase dramatically armaments expenditures represent a significant departure from the fiscal probity of the Kudrin years.

Russia emerged tenuously from the last crisis, and never regained the pre-crisis rate of growth. Its post-2009 growth performance was lackluster, given the fundamental environment and Russia’s stage of development. In my view, the conditions for a recovery are even less favorable this time. Some-and arguably the lion’s share-of the reasons for that are self-inflicted, or more accurately, inflicted by one Vladimir Vladimirovich Putin, whom the Russian populace has chosen to inflict on itself. Consequently, though Russia will hit bottom and rebound, I think it is likely that this rebound will be even weaker than the last one. The national equivalent of a dead cat bounce.

Not that the current situation is not without its moments of levity. Today, for instance, oligarch Mikhail Prokhorov announced he is putting the Brooklyn Nets up for sale. Prokhorov’s wealth has been running in reverse for the past several years, and in the current circumstances, the Nets are arguably his most salable asset. His Russian holdings, not so much.

In a way this is sad, because although Prokhorov is a jerk like most NBA owners, he is also somewhat amusing. In contrast, other owners are just jerks.

But back to the main show. When looking at Russia today, Yogi Berra comes to mind. It’s deja vu all over again. Only worse.

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December 11, 2014

The Height of Absurdity: The Operation of the Government Hinges on Blanche Lincoln’s Brainchild

Filed under: Commodities,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 9:20 pm

There’s a whole lotta stupid in Frankendodd. A whole lot. The SEF Mandate is at the top of the list, but the “Swaps Pushout” isn’t far behind.

The Pushout was the brainchild of ex-Arkansas Senator Blanche Lincoln. (NB: I understand the risks of using “brain” in the same sentence as “Blanche Lincoln”.) Blanche, she of the historic 21 point annihilation in the 2010 midterms.

In brief, the Pushout required federally insured banks to move-“push out”-some swaps dealing activities to separate subsidiaries that do not have access to federal deposit insurance. This does not apply to all swaps, mind you. Not even to the bulk of them (interest rate swaps, many CDS). But just to commodity derivatives (other than gold), equity derivatives, and un-cleared CDS.

I took particular interest in this because-again-it slammed commodity derivatives. It was one of several provisions (position limits being another prominent example) that explicitly targeted commodities. Apparently the belief is that commodity derivatives are uniquely risky and subject to abuse, which is just untrue.

Consider a dealer making a market in a commodity index swap. That swap is easily hedged in the futures markets. Ditto with a NYMEX lookalike gas or oil swap. Yes, maybe an unhedged commodity swap is riskier than your typical unhedged IRS, but so what? That’s not the way dealers typically trade (they typically run matched books, or nearly matched books), and capital requirements and other regulations mean that riskier positions incur additional costs that mitigate the incentive to take on excessive risks.

So commodity derivatives (or equity derivatives) don’t create exceptional risks that justify exceptional treatment. What’s more, creating stand-alone affiliates to handle this business entails additional costs. More people. Duplication of infrastructure. Additional capital. There are also scope economies (deriving in particular from capital efficiencies that arise from greater netting opportunities that arise from holding multiple, relatively uncorrelated, positions in a single book). Sacrificing those scope economies will lead to fewer commodity swaps dealers, which in turn makes hedging costlier and the market for these swaps less competitive.

In other words, like many parts of Frankendodd, the Pushout was all pain, no gain. And the pain, mind you, will be suffered not so much by the dealer banks, but by the firms in the real economy that use commodity derivatives to hedge their price risks.

That said, it never seemed to be that big a deal, given the relatively small scale of commodity derivatives and equity derivatives in comparison to IRS and other trades that banks were allowed to keep on the books of insured entities. Small beer compared to the rest of the havoc wreaked by the rampaging Frankendodd Monster.

But this obscure provision could be the one that brings on yet another government shutdown. The most hardcore lefties in the Senate (e.g., Elizabeth Warren) and the House (e.g., Maxine Waters) have drawn a line in the sand over the part of the “Cromnibus Bill” that would repeal the Pushout. If passed, “Cromnibus” would fund the government (except DHS) for the next year, thereby avoiding another shutdown.

But claiming that eliminating the Pushout would be an unconscionable capitulation to Wall Street, the lefties are going to the barricades, and threatening to bring DC to a grinding halt rather than let the Pushout bite the dust. This is not about substance, but symbolism. It is also about a defeated party carrying out a rearguard action on ground where its most rabid partisans can rally.

You cannot make up this stuff. Blanche Lincoln’s populist hobby horse, a desperate effort by a doomed politician, could be the pretext for yet another unproductive partisan confrontation that has virtually nothing to do with the more serious issues associated with funding the government for the next year. (If the Pushout hadn’t passed, would Lincoln have lost by 25 points or 15, rather than 21?) (I note that Gary Gensler worked very closely with Lincoln on Frankendodd: “During drafting sessions, Gensler sometimes sat at the table reserved for staff, advising its Democratic chairwoman, Blanche Lincoln of Arkansas.”)

Cromnibus raises very serious issues. The Swaps Pushout isn’t one of them. But rather than joining the debate on the real issues, or conceding their thumping at the polls, demagogic progs are screaming Swaps Pushout or Fight.

What a travesty.

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December 10, 2014

Regulators, Finally Getting a Clue

Filed under: Economics,Financial crisis,Politics,Regulation — The Professor @ 8:07 pm

Global regulators are concerned, and apparently mystified, by the evaporation of liquidity in bond and stock markets:

Global financial regulators worry that banks are scaling back costly market making functions and that this could leave investors stranded, as well as squeezing funds to drive economic recovery, a senior official said on Tuesday.

. . . .

David Wright, secretary general of the International Organization of Securities Commissions (IOSCO), which groups market regulators like the U.S. Securities and Exchange Commission and Germany’s Bafin, said it was an issue that was being looked at.

“We have seen a ‘Houdini’ disappearance of market makers in general,” Wright added. “First of all we have got to establish the facts, look at the markets … and see if this is a big problem … It’s a new frontier-type issue. I think it’s partly caused by some regulation, but we need to know.”

Partly caused by regulation? What was your first clue, Mr. Wright?

Between the impending Volcker Rule and more stringent capital rules and limitations on off-exchange dealing in stocks, regulators have piled restriction on restriction on market making activities. And they are shocked that liquidity is drying up?

Reminds me of a guy standing with a gasoline can and a blowtorch, and wondering just how his house caught on fire.

The article focuses on Europe, but it’s an issue in the US too. And Canada:

The Bank of Canada warned that investors in the nation’s corporate bond market may be underestimating the difficulty of selling the securities in a market downturn, putting them at risk of greater losses.

Rising holdings of corporate bonds in mutual and exchange-traded funds could exacerbate price swings if the funds are forced to sell in a rout, the central bank said in its semi-annual Financial System Review. Some market participants also “believe” dealers are reducing market-making activity, or acting as the middleman between trades, which may make it harder to unwind large positions, the bank said.

“A potential deterioration of liquidity in Canadian corporate bond markets may not be fully priced in,” according to the report. “Market trends suggest that more sizable price swings might be observed in the future than previously, should investors seek to simultaneously unwind large positions.”

In the aftermath of the post-crisis regulatory bacchanalia, the regulators are finally coming to recognize the unintended consequences of their actions. They are starting to see-sometimes rather dimly, pace Mr. Wright-that regulations intended to make the system less risky are creating new risks.

I’ve used the analogy of the Sorcerer’s Apprentice before. It’s as relevant now, as it ever was.


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December 6, 2014

Hit the Road, State Street

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 11:51 pm

Following the lead of Bank of New York, State Street announced that it is exiting the swaps clearing business:

State Street (STT) Corp. is closing down its swaps business after clients said new regulations steered them away for using the products.

The bank will shutter its U.S. business for clearing swaps early next year and will shelve plans to start a similar operation in Europe, Anne McNally, a spokeswoman for the Boston-based company, said in an e-mail statement today.

State Street will instead focus on trading other types of derivatives, particularly more traditional exchange-traded futures, that have not been subject to broad new regulations imposed since the 2008 financial crisis.

“Due to market and regulatory factors, our clients have largely evolved their investment strategies towards the use of futures and away from” over-the-counter derivatives, McNally said in the statement.

From even before Frankendodd was passed, I predicted that the swap clearing firm business would be highly concentrated and dominated by the major dealers who had dominated the OTC market. Indeed, I argued that the regulatory overhead created by Frankendodd would actually tend to increase scale economies and make the clearing services business more concentrated and connected.

But Gensler, with the vocal support of BNY, State Street, and Ken Griffen of Citadel-and also MF Global-argued that there was a clearing cabal of dealer firms that was was creating unnecessary barriers to entry into clearing. BNY and State Street claimed that the dealers were forcing ICE Clear to require members to have excessively large amounts of capital, an this prevented them from becoming clearing members. Tear down those walls, and doughty entrants like BNY and State Street and Newedge and others would make the clearing business far more competitive.

This view was channeled in a NY Times story written by Louise Story almost exactly four years ago: I criticized Story’s story pretty harshly. Reflecting this view, the CFTC rules substantially eased the capital requirements and other requirements to become clearing members. Gensler, BNY, STT, etc., thought that this would lead to a much less concentrated, much more competitive clearing business.

But this was to misunderstand the economics of clearing, clearing firm scale and scope economies, and how the complicated regulatory structure CFTC put in place exacerbated these scale economies. Even futures clearing (which is substantially simpler than swaps clearing) has become much more concentrated over the years. Only the truly huge can survive.

BNY and State Street tried, and failed. They couldn’t overcome their inadequate scale even though they could offer complementary collateral management and custodial services. They were just too small.

State Street announced that it was going to focus on futures clearing, but even here it faces problems. It just lost its biggest customer (Pimco). Moreover, there are scope economies between futures clearing and swap clearing. State Street will be at a disadvantage relative to say Goldman, which can offer customers who trade both swaps and futures one stop shopping for clearing services at lower cost because of these scope economies.

So much for clearing mandates making the financial markets less concentrated and less interconnected: instead we (predictably and predicted) have a derivatives marketplace dominated by a small number of CCPs each dominated by a small number of large bank clearing members who are members of all major CCPs, which makes entire world clearing space concentrated and highly interconnected. That anybody thought the post-crisis regulations would reduce concentration and interconnections in swaps markets is illuminating. It demonstrates that those primarily responsible for implementing Frankendodd didn’t really understand the economics of what they were attempting to regulate, and as a result, they didn’t really know what they were doing.  They thought they were striking a blow against too big to fail and a collusive dealer oligopoly. They were wrong, and State Street’s abandonment of its swaps clearing effort is just further proof of how wrong they were.

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October 19, 2014

It *Was* Too Quiet Out There

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis — The Professor @ 5:28 pm

Four weeks ago I gave the keynote talk at Energy Risk Asia in Singapore. My talk was a look back at commodity market developments in the past year, followed by a look forward.

The theme of the look back was “A Perfect Calm.” I noted that volatility levels across all markets, not just commodities, were at very low levels. Equity vols, as measured by the VIX, had been in the 10 percent range in August and had only ticked up to around 12 percent by late-September. Commodity volatilities were even more remarkable. Historically, the low level of commodity volatilities (the 5th percentile) have been around the median of equity vols and well above currency and bond vols. During the first half of the year, however, commodity vols were below the 5th percentile of equity vols, and below the 95th percentile of currency and bond vols. Pretty amazing.

I argued that this reflected a happy combination of supply and demand factors. In energy and ags in particular, abundant supplies put a drag on volatility. But volatility from the demand side was low too. The low VIX levels are a good proxy for macro uncertainty, or the lack thereof. Put both of those together, and you get a perfect calm.

But perfect calms are the exception, rather than the rule. The last slide in my talk looked forward, and cribbed a movie cliche: It was titled “It’s Quiet Out There. Too Quiet.” I noted that periods of very low volatility frequently bear the seeds of their destruction. When risk measures are low, firms and traders lever up and increase position sizes. A bit of economic turbulence increases volatilities, which leads to breaches in risk limits, which forces deleveraging and reductions in positions. This tends to lead to reduced liquidity, exaggerated price moves, yet higher volatility, leading to more deleveraging and repositioning, and on it goes. That is, there can be a positive feedback loop. Transitions from low to high volatility can be very abrupt.

It looks like that’s what has happened in the weeks since my return. Equity markets are down substantially. Commodities, notably energy, have slumped: Brent is down to around $88. Volatilities have spiked. The VIX reached over 31 percent last week, and the crude oil VIX went from about 15 percent at the end of August to over 37 percent last week.

The spark appears to have been mounting evidence of a slowdown in Europe and China. Ebola might have been a contributing factor in the last week or two, but in my view the economic weakness is the main driver.

I admit to being like the title character in My Cousin Vinnie. He had difficulty sleeping in the Alabama country quiet, but slept like a lamb in a raucous county jail. Times like these are more interesting, anyways.

So it turns out it was too quiet out there.

And remember. Today is the 27th anniversary of the ’87 Crash (one of the formative experiences of my professional life). Octobers are often . . . interesting (the most dangerous word in the English language). So the markets bear watching closely. If you aren’t interested in them, they may well be interested in you.

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October 13, 2014

You Might Have Read This Somewhere Before. Like Here.

The FT has a long article by John Dizard raising alarms about the systemic risks posed by CCPs. The solution, in other words, might be the problem.

Where have I read that before?

The article focuses on a couple of regulatory reports that have also raised the alarm:

No, I am referring to reports filed by the wiring and plumbing inspectors of the CCPs. For example, the International Organization for Securities Commissions (a name that could only be made duller by inserting the word “Canada”) issued a report this month on the “Securities Markets Risk Outlook 2014-2015”. I am not going to attempt to achieve the poetic effect of the volume read as a whole, so I will skip ahead to page 85 to the section on margin calls.

Talking (again) about the last crisis, the authors recount: “When the crisis materialised in 2008, deleveraging occurred, leading to a pro-cyclical margin spiral (see figure 99). Margin requirements also have the potential to cause pro-cyclical effects in the cleared markets.” The next page shows figure 99, an intriguing cartoon of a margin spiral, with haircuts leading to more haircuts leading to “liquidate position”, “further downward pressure” and “loss on open positions”. In short, do not read it to the children before bedtime.

This margin issue is exactly what I’ve been on about for six years now. Good that regulators are finally waking up to it, though it’s a little late in the day, isn’t it?

I chuckle at the children before bedtime line. I often say that I should give my presentations on the systemic risk of CCPs while sitting by a campfire holding a flashlight under my chin.

I don’t chuckle at the fact that other regulators seem rather oblivious to the dangers inherent in what they’ve created:

While supervisory institutions such as the Financial Stability Oversight Council are trying to fit boring old life insurers into their “systemic” regulatory frameworks, they seem to be ignoring the degree to which the much-expanded clearing houses are a threat, not a solution. Much attention has been paid, publicly, to how banks that become insolvent in the future will have their shareholders and creditors bailed in to the losses, their managements dismissed and their corporate forms put into liquidation. But what about the clearing houses? What happens to them when one or more of their participants fail?

I call myself the Clearing Cassandra precisely because I have been prophesying so for years, but the FSOC and others have largely ignored such concerns.

Dizard starts out his piece quoting Dallas Fed President Richard Fisher comparing macroprudential regulation to the Maginot Line. Dizard notes that others have made similar Maginot Line comparisons post-crisis, and says that this is unfair to the Maginot Line because it was never breached: the Germans went around it.

I am one person who has made this comparison specifically in the context of CCPs, most recently at Camp Alphaville in July. But my point was exactly that the creation of impregnable CCPs would result in the diversion of stresses to other parts of the financial system, just like the Maginot line diverted the Germans into the Ardennes, where French defenses were far more brittle. In particular, CCPs are intended to eliminate credit risk, but they do so by creating tremendous demands for liquidity, especially during crisis times. Since liquidity risk is, in my view, far more dangerous than credit risk, this is not obviously a good trade off. The main question becomes: During the next crisis, where will be the financial Sedan?

I take some grim satisfaction that arguments that I have made for years are becoming conventional wisdom, or at least widespread among those who haven’t imbibed the Clearing Kool Aid. Would that have happened before legislators and regulators around the world embarked on the vastest re-engineering of world financial markets ever attempted, and did so with their eyes wide shut.

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