Streetwise Professor

June 25, 2016

Brexit: Epater les Eurogarchs

Confounding all elite prognostication (more on this aspect below), British voters repudiated their self-anointed better-thans and voted to leave the EU.

Market reaction was swift and brutal. The pound sold off dramatically, as did UK stocks. Interestingly, though, Continental stock markets fell substantially more. Bank stocks took the brunt. Volatility indices spiked. Oil was down modestly.

These reactions were not due, in my view, to the direct effect of a British exit from the EU, via conventional channels (e.g., increased costs of trade resulting in inefficiencies and a decline in productivity due to failure to exploit comparative advantage, resulting in a decline in incomes). Instead, they reflect a substantial increase in risk, and in particular geopolitical risk. The unexpected result increases substantially the odds of a falling apart of the EU–or at the very least, of it losing quite a few of its parts. That’s why German, French, and Dutch markets sold off more than the UK.

I was in Denmark last month, speaking to shipowners. Several said that if the UK were to leave the EU, Denmark is likely to go as well: since Denmark is not on the Euro, it is easier for it to leave than Eurozone nations, and the Danes have had their fill of European immigration policy, among other things.

But there is now talk of core countries–including France–leaving. What’s more, the Brexit vote demonstrates the depth and intensity of populist, nationalist sentiment, something the elites had convinced themselves was a marginal force that could be contained by insulting it as racist and isolationist. That was tried in the UK, and failed spectacularly. Now everyone should be on notice that the smug, supercilious, and superior are sitting on a caldera.

It is this fear that the British departure creates a bad precedent that is leading some European leaders to advocate a punitive approach to negotiations with Britain. As a one-off, this makes no sense: a battle of trade barriers and regulations and red tape would harm continentals too. But if the Euros view this as a repeated game, punishment of the British to deter others from getting any notions in their heads about following their lead has some appeal.

But this is a finite game: there are only so many countries in Europe. The Euro threats make sense as a rational strategy only if there is some appreciably probability that the leadership is viewed as crazy, and will punish even when that is self-harming. Come to think of it . . .

As for the immediate effects, Brexit has the biggest potential to cause disruptions and inefficiencies in the financial sector, because of London’s dominance. Clearing is one example. How will LCH fit into the fragmented regulatory landscape? Recall the tortuous negotiations between the US and EU over recognizing each other’s CCPs. Will that have to be repeated between the UK and the EU, and under the clouds of recrimination and punishment strategies? As another example, MiFID II is scheduled to go into effect before Britain leaves. Will it be implemented, then changed? Post-exit British firms will no longer be subject to the regulatory and judicial bodies in charge of enforcing these regulations: how will they fill that breach?

Regardless of the specifics, there will inevitably be greater regulatory and legal fragmentation, and this will increase complexity and cost. But it also creates opportunities. The UK can now engage in regulatory competition with the EU (and the US), which is a different thing altogether from trying to influence regulatory policy from inside the tent (which Cameron attempted with a notable lack of success). This is constrained to some degree by supranational regulation (e.g., Basel), but London prospered quite well as a financial center post-War, pre-EU by offering regulatory advantages over the US and European countries. (Remember Eurodollars!) (One specific thought: would the UK proceed with something as inane and costly as the MiFID commodity position limits? Or applying CRD IV capital requirements on commodity traders? Since these initiatives were driven by the continentals, I seriously doubt it.)

This is all very complicated, and will be played out in the context of a larger game between Britain and the EU (and between the EU and individual EU countries). Hence the outcome is wholly unpredictable. But having Britain as an independent player will change dramatically the regulatory game. The greater competition is likely to result in less regulation, and crucially less stupid regulation. Further, even to the extent that one jurisdiction insists on stupid regulations (with the EU being the odds-on favorite here), the existence of competing jurisdictions means that many will be able to escape the stupidity.

As for the broader political lesson here, it is a decisive repudiation of a self-satisfied soi disant elite by the great unwashed. The EU has been neuralgic about democracy since its inception, and Brexit shows you exactly why their fears of it are justified. The people have spoken. The bastards. And the Euros will try mightily to make sure that never ever happens again.

There’s been a lot of commentary along these lines. Gerard Baker’s piece in the WSJ is probably the best I’ve read. This piece also from the WSJ is pretty good too.

This is a global phenomenon: the Trump insurgency in the US is another example. What is most disturbing–and most revealing–about the reaction of the elites to these outbursts of popular opposition to their direction and instruction is their lack of self-examination and humility, and their immediate resort to scorn and insult directed at those who had the temerity to defy them. Immediately after the results were clear, those voting leave were tarred as old/white/stupid/poor/uneducated/racist.

Totally lacking was the question: “If argument and evidence are so clearly on our side, why did we fail so miserably in convincing people of the obvious?” To these self-perceived elites, their superiority is self-evident and any opposition can only be attributed to mental defect or bad faith.

Not only is this superficial and immature–nay, juvenile and narcissistic–it is amazingly self-destructive. You were rejected because it was widely believed–with good reason–that you were aloof, condescending, and lacking in understanding of and empathy for the concerns of millions of people not of your social set. What better way to cement that reputation than by proceeding to piss all over those people? You think that will help them get their minds right, and vote for you next time? Think that, and you truly are delusional.

And mark well: this elite condescension is not heard just in the Midlands, but it comes through loud and clear in France, Germany, the Netherlands, and other countries in Europe. Consequently, this reaction actually increases the odds of an EU crisis. Those who refuse to respond constructively and thoughtfully to adverse feedback are likely to see things get worse, rather than better.

This condescension also helps explain the surprise at the Brexit outcome. So convinced of their virtue and intelligence, the Remain side could not comprehend that large numbers of people could take the opposite side. Secure in their bubble, talking only to one another, they had no idea of what was going on outside it. The Pauline Kael effect, with a British accent.

Further, the concerted effort in the establishment media to malign the Leavers succeeded in silencing many of them–but not in changing their minds. (Most disturbingly, the Remain side took strange comfort in the murder of Jo Cox.) They were bludgeoned into stubborn silence, which lulled the establishment into believing that the opposition was marginal and marginalized: this helps explain the pre-vote 90 percent betting odds on Remain, with the betting being dominated by those inside the bubble. But the silent bided their time and exacted their revenge.

Payback, as they say, is a bitch. But are the elites learning from this lesson? The first indications are negative.

The EU epitomizes what Thomas Sowell referred to as the Vision of the Anointed. This review summarizes the book of that title well, and although Sowell focuses on the US, what he said applies in spades to the EU, and Europhiles:

In The Vision of the Anointed, the distinguished economist and social theorist Thomas Sowell makes an important contribution to classical-liberal and conservative thought by scrutinizing the ways in which a self-consciously elite, or “anointed,” group uses ideas to maintain its power in American political life. Sowell regards American political discourse as dominated by people who are sure that they know what is good for society and who think that the good must be attained by expanded government action. This modern-liberal elite exerts its influence through institutions that live by words: the universities and public schools, the media, the liberal clergy, the bar and bench. Its dominance results from its command of the information that words convey and the attitudes that words inspire.

People who live by words should live also by arguments, butas Sowell richly documentsthe modern-liberal elite is not so good at arguing as it is at finding substitutes for argument. Sowell analyzes the major substitutes. Suppose that you doubt the necessity or usefulness of some great new government program. You may first be presented with a quantity of decontextualized “facts” and abused statistics, all indicating the existence of a “crisis” that only government can resolve. If you are not converted by this show of evidence, an attempt will probably be made to shift the viewpoint: outsiders may doubt that there is a crisis of, say, homelessness, but “spokesmen for the homeless” purportedly have no doubts.

. . . .

If even these methods fail to win you over, attention will be redirected from the political issue to your own failure of imagination or morality. It will be insinuated that people like you are simplistic or perversely opposed to change, lacking in compassion and allied with the “forces of greed.” (As Sowell observes, it is always the payers rather than the spenders of taxes who are considered vulnerable to the charge of greed.) [Emphasis added.]

The Anointed are a self-identified elite. They think that elite is a synonym for “meritorious,” “intelligent,” “wise,” or “morally superior.” But “elite” refers first and foremost to a place in a hierarchy, and the merit, intelligence, wisdom, and morality of those at the top of a hierarchy depends on the system. Hayek noted over 70 years ago that in a statist, crypto-socialist system the worst get to the top, i.e., the elite is a collection of the worst. The Eurogarchy shows just how right Hayek was.

For all the paeans sung to it, the EU has become far more than a means of reducing barriers to the flow of goods, capital, and people: that could have been accomplished with something as simple as the commerce clause to the US Constitution. Instead, the Anointed have constructed a vast hyper-state that controls and regulates every aspect of commercial activity, and much beyond. Cost raising and incentive sapping explicit restrictions on trade and investment across historical borders have been replaced by border-spanning onerous and minute regulations that raise costs and dull incentives: innovation has been especially hard hit. Moribund growth in the post-crisis EU should raise questions, but the Eurogarchs plunge ahead with their vast regulatory schemes.

I would approve of a supra-national organization that reduced the impediments to individuals consummating mutually beneficial bargains and exchanges. But that is not what the EU is. It is a dirigiste organization predicated on the belief that a technocratic elite knows better, and can direct and guide far more effectively than the invisible hand. Although its demise could lead to something worse, there are definitely better alternatives. Hence, the discomfort of the EU worshippers is music to my ears.

European leaders–Merkel most notably–are fond of saying “More Europe,” meaning more centralization and more suppression of local control. If they want Europe to survive as a political entity, they need to reverse their mantra to “Less Europe.” They need to reverse the creation of a hyper-state. They need to be more respectful of local, national sentiments and differences. Brexit shows that if they fail to do so, they are running the serious risk of having no “Europe” at all.

Are they heeding the lesson? Early signs suggest no. So be it. They are reaping what they sowed, and if they decide to sow more, so shall they reap.

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June 15, 2016

Where’s the CFTC’s Head AT?: Fools Rush in Where Angels Fear to Tread

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis,HFT,Regulation — The Professor @ 1:07 pm

The CFTC is currently considering Regulation AT (for Automated Trading). It is the Commission’s attempt to get a handle on HFT and algorithmic trading.

By far the most controversial aspect of the proposed regulation is the CFTC’s demand that algo traders provide the Commission with their source code. Given the sensitivity of this information, algo/HFT firms are understandably freaking out over this demand.

Those concerns are certainly legitimate. But what I want to ask is: what’s the point? What can the Commission actually accomplish?

The Commission argues that by reviewing source code, it can identify possible coding errors that could lead to “disruptive events” like the 2013 Knight Capital fiasco. Color me skeptical, for at least two reasons.

First, I seriously doubt that the CFTC can attract people with the coding skill necessary to track down errors in trading algorithms, or can devote the time necessary. Reviewing the code of others is a difficult task, usually harder than writing the code in the first place; the code involved here is very complex and changes frequently; and the CFTC is unlikely to be able devote the resources necessary for a truly effective review. Further, who has the stronger incentive? A firm that can be destroyed by a coding error, or some GS-something? (The prospect of numerous individuals perusing code creates the potential for a misappropriation of intellectual property which is what really has the industry exercised.) Not to mention that if you really have the chops to code trading algos, you’ll work for a prop shop or Citadel or Goldman or whomever and make much more than a government salary.

Second, and more substantively, reviewing individual trading algorithms in isolation is of limited value in determining their potentially disruptive effects. These individual algorithms are part of a complex system, in the technical/scientific meaning of the term. These individual pieces interact with one another, and create feedback mechanisms. Algo A takes inputs from market data that is produced in part by Algos B, C, D, E, etc. Based on these inputs, Algo A takes actions (e.g., enters or cancels orders), and Algos B, C, D, E, etc., react. Algo A reacts to those reactions, and on and on.

These feedbacks can be non-linear. Furthermore, the dimensionality of this problem is immense. Basically, an algo says if the state of the market is X, do Y. Evaluating algos in toto, the state of the market can include the current and past order books of every product, as well as the past order books (both explicitly as a condition in some algorithms, or implicitly through the empirical analysis that the developers use to find profitable trading rules based on historical market information), as well as market news. This state changes continuously.

Given this dimensionality and feedback-driven complexity, evaluating trading algorithms in isolation is a fools errand. Stability depends on how the algorithms interact. You cannot determine the stability of an emergent order, or its vulnerability to disruption, by looking at the individual components.

And since humans are still part of the trading ecosystem, how software interacts with meatware matters too. Fat finger problems are one example, but just normal human reactions to market developments can be destabilizing. This is true when all of the actors are human: it’s also true when some are human and some are algorithmic.

Look at the Flash Crash. Even in retrospect it has proven impossible to establish definitively the chain of events that precipitated it and caused it to unfold the way that it did. How is it possible to evaluate prospectively the stability of a system under a vastly larger set of possible states than those that existed on the day of the Flash Crash?

These considerations mean that  the CFTC–or any regulator–has little ability to improve system stability even if given access to the complete details of important parts of that system. But it’s potentially worse than that. Ill-advised changes to pieces of the system can make it less stable.

This is because in complex systems, attempts to improve the safety of individual components of the system can actually increase the probability of system failure.

In sum, markets are complex systems/emergent orders. The effects of changes to parts of these systems are highly unpredictable. Furthermore, it is difficult, and arguably impossible, to predict how changes to individual pieces of the system will affect the behavior of the system as a whole under all possible contingencies, especially given the vastness of the set of contingencies.

Based on this reality, we should be very chary about letting any regulator attempt to micromanage pieces of this complex system. Indeed, any regulator should be reluctant to undertake this task. But regulators frequently overestimate their competence, and financial regulators have proven time and again that they really don’t understand that they are dealing with a complex system/emergent order that does not respond to their interventions in the way that they intend. But fools rush in where angels fear to tread, and if the Commission persists in its efforts to become the Commissar of Code, it will be playing the fool–and it will not just be algo traders that pay the price.

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June 11, 2016

Washington Republicans: Subjectively Pro-Capitalism, Objectively Anti-Capitalism

Filed under: Economics,Financial crisis,Politics,Regulation — The Professor @ 8:11 pm

@libertylynx suggested to me that the GOP is primarily responsible for the current unpopularity of capitalism in the US. I agree that this is largely the case. Here’s my first stab at an explanation.

At root it is due to a yawning gap between rhetoric and action. The GOP poses as the party of small government and free markets, but it is not, really. The disconnect was somewhat present during the Reagan administration, but it became progressively (pun alert!) more pronounced starting with Bush I, and particularly during the George W. Bush administration.

Bush II in particular was a big spender. Some of it was war-driven, but he was also profligate domestically. Perhaps most importantly, given the salience of housing to the 2008-2009 financial crisis which inflicted the most grievous blow to belief in the efficacy and efficiency of markets since the Great Depression, was that the Bush administration perpetuated the bias towards investment in housing exemplified by Fannie and Freddie. A truly market-oriented administration would have terminated Fannie and Freddie with extreme prejudice, but it grew apace during the Bush II administration. When combined with an expansive Fed and a flawed banking regulatory framework, the groundwork for a disaster was in place.

In many respects, this is similar to what happened during and after the Great Depression. That event was widely viewed as a failure of capitalism and the market system, when it was actually the result of a combination of bad Fed policy and a dysfunctional banking system that was the result of a political bargain that resulted in the proliferation of small unit banks that could not withstand a broad shock: see Friedman and Schwartz for an analysis of the former, and Calomiris and Haber for an examination of the latter.  The banking system that collapsed in the 1930s was a political artifact, and would have not developed the way that it did in the absence of a regulatory framework that was tailored to benefit very specific political constituencies.

The strong bias towards housing investment in the United States in the 1990s-2000s was also the result of a political bargain: alas, the same is true today, even despite the crisis. This political bargain was based on a coalition of politically connected firms (Fannie, Freddie, major banks, and construction) and populists. This bargain created incentives that led market participants to invest excessively in housing. When this came a cropper, the blame attached to those market participants who responded to incentives, rather than the political agents and political process that created those incentives.

In DC, Republicans talked a pro-market, small-government game, but did not govern that way. Republicans in Congress liked living a comfortable life in DC. They did not have a stomach for fighting the battle that a true pro-market, small government policy would have caused. They liked the sinecures of power too much to risk them, knowing in particular that pursuing such policies would unleash a storm of media criticism and make them unpopular with the bureaucrats and lobbyists who infest the place. So they made a few symbolic gestures, and spouted pro-free market, small government rhetoric, but really did nothing. The continued existence, let alone the growth, of Fannie and Freddie is testament to that.

When the storm hit in 2008, this came back to haunt them. More importantly, it came back to haunt the cause of free markets and smaller government. Since those giving lip service to those ideals were in charge when the storm hit, it was easy to blame the ideals, even though those spouting the rhetoric had done virtually nothing to advance them. Indeed, they had perpetuated, and in fact exacerbated, the market distortion that was the ultimate cause of the crisis. This presented a perfect opportunity for those in politics (the Democratic Party) and the media (an appendage of the Democratic Party) to attack the ideals that they despised.  It would have been better had the Republicans not pretended to be pro-market, as at least that would have limited some of the damage to popular beliefs and opinions about markets.

There are at least a couple of reasons for the Republican reluctance actually to fight the statist DC consensus, despite their rhetorical embrace of that fight.

One is the scars left by the struggles over the government shutdown in 1995-1996, and the impeachment battle that followed. Both fights were a distraction, and what’s worse, the Republicans handled both badly. They took a horrible beating in the media and elections–rightly so, in retrospect–and it got their minds right. The 1994 insurgents were supplanted by time servers and apparatchiks. Hasterts and Boehners and McConnells, and other assorted boneless wonders you’ve never even heard of. They were masters at the Kabuki performance of pretending to be pro-market and pro-smaller government, but really doing nothing to stem the tide.

The second reason is more fundamental, but in a way can explain the first. Politicians respond to incentives too. A good model for them is a pigeon in a Skinner Box. They soon learn to push the lever that results in the magical appearance of a food pellet, and not to push the lever that doesn’t.

Organized constituencies provide the food pellets in DC. There is no organized constituency for freer markets or substantially smaller government. There are constituencies for particular businesses and industries, and for government largesse. The benefits of free markets and smaller government are large, but diffuse. As Olson and Stigler and Becker and others showed long ago, diffuse and unorganized beneficiaries have little incentive or ability to influence policy. In contrast, particular businesses and industries do. Thus, careerist politicians intent on re-election and a comfortable life have little incentive to pursue market-oriented policies, but instead pursue policies that favor particular constituencies, including business constituencies.

Which means that even though many Republicans talk/talked about being pro-market, they are/were at most really pro-business. And there is a difference. A huge difference, as Adam Smith pointed out centuries ago, and Friedman repeated often decades ago. But that difference is not well-understood, which means that failures that occur when Republicans are in power tend to get blamed on the market system, or capitalism.

The S&L crisis of almost 30 years ago provides a good example. The S&L industry was the creation of law and regulation resulting from a political bargain: again see Calomiris and Haber. Inflation devastated the industry, and in response it called for elimination of restrictions on how S&Ls could invest. This was done in the name of deregulation and freeing markets, but the most important government interventions were left in place. In particular, deposit insurance remained, and government regulators refused to shut down insolvent thrifts. The mixture of freeing up the asset side of the balance sheet when (a) liabilities were insured, and (b) S&Ls had no equity, was toxic in the extreme. With insured liabilities and no equity, S&Ls had a tremendous incentive to add risk, and the deregulation of the asset side of the balance sheet gave them the ability to do so. They took on said risk, it ended badly, and taxpayers were on the hook for $200 billion or so as a result. Real money back then!

Was this a failure of deregulation, and a damning verdict on markets? I would say no: the fraught condition of the S&Ls was the product of previous government regulation and policy, and the perverse incentive to take on risk was inherent in another policy—deposit insurance. An organized political constituency (S&L operators) influenced Congress to loosen some regulations that made the perverse effects of the other regulations and policies even more acute.

In other words: they wanted to deregulate in the worst way, and they did. They did so because the deregulation was designed to benefit particular businesses, not to create a free market in banking. Pace the theory of the second best, elimination of something (restrictions on S&L investment) that would be an imperfection in the absence of other imperfections made things far worse when other imperfections (deposit insurance, forbearing regulators) remained in place.

But the narrative that came out of the S&L debacle was one of market failure, not government failure. Deregulation and markets took the blame, when what had really happened is that politicians responding to incentives (the importuning of an organized constituency) changed the laws in ways that created perverse incentives for business, and ultimately all this perversity begot something wretched indeed. The crisis was played out on Main Street, but its origins lay squarely on Pennsylvania Avenue.

The takeaway from all this is rather depressing. It means there is an inherent political bias against pro-market policies because markets, and the beneficiaries of markets, do not form an organized political force. The difficulty of voters to distinguish pro-business policies from pro-market rhetoric often used to advance them means that economic crises (the Great Depression, the S&L collapse, the 2008 Crisis) that are strongly rooted in government failure are blamed on markets instead, which perversely results in even more government intervention.

So this is why Republicans damage the cause of free markets and small government. They spout pro-market and small government rhetoric, but for reasons of political economy, really do little that actually advances free markets or reduce the size of government. But when some government policy creates incentives that lead to a bad market outcome, their rhetoric boomerangs on markets, not government.

The post-crisis years have been a period of slow growth and economic sclerosis. This is largely attributable to the explosion of regulation that has taken place since 2009. The narrative that helped spark this explosion is that markets failed. Alas, Republicans did much to advance that narrative, albeit inadvertently. But advance it they did, and the malign effects will be felt for decades to come.

In brief, Republican politicians may be subjectively pro-market and pro-capitalism, but objectively they have done grievous harm to markets and capitalism.

 

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April 2, 2016

The Rube Goldberg Approach to Integrating CCPs: A Recipe for Disaster

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 12:38 pm

As noted in earlier posts (and by others commenting on the proposed Eurex-LSE merger) the main potential benefit to exchange customers* is the capital and margin savings from netting efficiencies between Eurex futures and LCH swaps. However, regulators and others have expressed concerns that the downside is the creation of an bigger too big to fail clearing entity. A couple of weeks back Silla Brush and John Detrixhe reported that the merger partners are trying to square that circle by cross-margining, but not merging the CCPs:

LCH.Clearnet and Eurex held 150 billion euros ($169.5 billion) of collateral on behalf of their members as of Dec. 31, according to the merger statement. The London-based clearer is developing a system that allows traders to offset their swap positions at LCH.Clearnet with their futures holdings at Eurex. The project, which works even though the two clearinghouses are separate, should enable customers to reduce the total amount of collateral they must set aside.

“We can cross margin our over-the-counter clearing with their listed derivatives without merging the clearinghouses, and without comingling the risk-management framework,” LSE Group CEO Xavier Rolet said in a Bloomberg Television interview on Wednesday. Rolet will step aside if the companies complete their merger.

The devil will clearly be in the details, and I am skeptical, not to say suspicious. In order for the separate but comingled system to work, Eurex’s CCP must have a claim on collateral held by LCH (and vice versa) so that deficiencies in a defaulter’s margin account on Eurex can be covered by excess at LCH (and vice versa). (As an illustration of the basic concept, Lehman had five different collateral pools at CME Clearing–interest rate, equity, FX, commodities, energy. There were deficiencies in two of these, but CME used collateral from the other three to cover them. As a result there was no hit to the default fund.)

How this will work legally is by no means evident, especially inasmuch as this will be a deal across jurisdictions (which could become even more fraught if Brexit occurs). Further, what happens in the event that one of the separate CCPs itself becomes insolvent? I can imagine a situation (unlikely, but possible)  in which CCP A is insolvent due to multiple defaults, but the margin account at A for one of the defaulters has excess funds while its margin account at CCP is deficient. Would it really be possible for B to access the defaulter’s collateral at bankrupt CCP A? Maybe, but I am certain that this question would be answered only after a nasty, and likely protracted, legal battle.

The fact that the CCPs are going to be legally separate entities suggests their default funds will be as well, and that they will be separately capitalized, meaning that the equity of one CCP will not be part of the default waterfall of the other. This increases the odds that one of the CCPs will exhaust its resources and become insolvent. That is, the probability that one of the separate CCPs will become insolvent exceeds the probability that a truly merged one would become so. Since even the separate CCPs would be huge and systemically important, it is not obvious that this is a superior outcome.

I am also mystified by what Rolet meant by “without comingling the risk management framework.” “Risk management framework” involves several pieces. One is the evaluation of market and credit risk, and the determination of the margin on the portfolio. Does Rolet mean that each CCP will make an independent determination of the margin it will charge for the positions held on it, but do so in a way that takes into account the offsetting risks at the position held at the other CCP? Wouldn’t that at least require sharing position information across CCPs? And couldn’t it result in arbitrary and perhaps incoherent determinations of margins if the CCPs use different models? (As a simple example, will the CCPs use different correlation assumptions?) Wouldn’t this have an effect on where firms place their trades? Couldn’t that lead to a perverse competition between the two CCPs?+ It seems much more sensible to have a unified risk model across the CCPs since they are assigning a single margin to a portfolio that includes positions on both CCPs.

Another part of the “risk management framework” is the management of defaulted positions. Separate management of the risk of components of a defaulted portfolio is highly inefficient. Indeed, part of the justification of portfolio margining is that the combined position is less risky, and that some components effectively hedge other components. Managing the risks of the components separately in the event of a default sacrifices these self-hedging features, and increases the amount of trading necessary to manage the risk of the defaulted position. Since this trading may be necessary during periods of low liquidity, economizing on the amount of trading is very beneficial.

In other words, co-mingling risk management is a very good idea if you are going to cross margin.

It seems that Eurex and LSE are attempting to come up with a clever way to work around regulators’ TBTF neuroses. But it is not clear how this workaround will perform in practice. Moreover, it seems to sacrifice many of the benefits of a merged CCP, while creating ambiguities and legal risks. It also will inevitably be more complex than simply merging the two CCPs. Such complexity creates systemic risks.

One way to put this is that if the two CCPs are legally separate entities, under separate managements, relations between them (including the arrangements necessary for cross margining and default management) will be governed by contract. Contracts are inevitably incomplete. There will be unanticipated contingencies, and/or contingencies that are anticipated but not addressed in the contract. When these contingencies occur in practice, there is a potential for conflict, disagreement, and rent seeking.

In the case of CCPs, the relevant contingencies not specified in the contract will most likely occur during a default, and likely during stressed market conditions. This is exactly the wrong time to have a dispute, and failure to come to a speedy resolution of how to deal with the contingency could be systemically catastrophic.

One advantage of ownership/integration is that it mitigates contractual incompleteness problems. Managers/owners have the authority to respond unilaterally to contingencies. As Williamson pointed out long ago, efficient “selective intervention” is problematic, but in the CCP context, the benefits of managerial fiat and selective intervention seem to far outweigh the costs.

I have argued that the need to coordinate during crises was one justification for the integration of trade execution and clearing. The argument applies with even greater force for the integration of CCPs that cooperate in some ways (e.g., through portfolio margining).

In sum, coordination of LCH and Eurex clearing through contract, rather than through merger into a single entity is a highly dubious way of addressing regulators’ concerns about CCPs being TBTF. The separate entities are already TBTF. The probability that one defaults if they are separate is bigger than the probability that the merged entity defaults, and the chaos conditional on default, or the measures necessary to prevent default, probably wouldn’t be that much greater for the merged entity: this means that reducing the probability of default is desirable, rather than reducing the size of the entity conditional on default. Furthermore, the contract between the two entities will inevitably be incomplete, and the gaps will be discovered, and extremely difficult to fill in-, during a crisis. This is exactly when a coordination failure would be most damaging, and when it would be most likely to occur.

Thus, in my view full integration dominates some Rube Goldberg-esque attempt to bolt LCH and Eurex clearing together by contract. The TBTF bridge was crossed long ago, for both CCPs. The complexity and potential for coordination failure between separate but not really organizations joined by contract would create more systemic risks than increasing size would. A coordination failure between two TBTF entities is not a happy thought.

Therefore, if regulators believe that the incremental systemic risk resulting from a full merger of LCH and Eurex clearing outweighs the benefits of the combination, they should torpedo the merger rather than allowing LSE and Eurex to construct some baroque contractual workaround.

*I say customers specifically, because it is not clear that the total benefits (including all affect parties) from cross margining, netting, etc., are positive. This is due to the distributive effects of these measures. They tend to ensure that derivatives counterparties get paid a higher fraction of their claims in the event of a default, but this is because they shift some of the losses to others with claims on the defaulter.

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March 9, 2016

Clearing Angst: Here Be Dragons Too

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 3:21 pm

We are now well into the Brave New World of clearing and collateral mandates. The US clearing mandate is in place, and the Europeans are on the verge of implementing it. We are also on the cusp of the mandate to collateralize non-cleared swaps.

After years of congratulating themselves on how the Brave New World was going to be so much better than the Bad Old World, the smart set is now coming to grips-grudgingly, slowly-with the dawning realization that not all the financial demons have been slain: here be dragons too. From time to time I’ve written about regulators recognizing this reality. There have been several more examples recently indicating that this has become the new conventional wisdom. For instance, Bloomberg recently editorialized on CCPs becoming the New Too Big to Fail: meet the new systemic risk, not that different from the old systemic risk. The BoE is commencing a review of CCPs, focusing not just on financial risks but operational ones as well. Researchers as Citi are warning that CCPs need more skin in the game. Regulators are warning that CCPs have become a single point of aim for hackers as they have become more central to the financial system. Researchers at three central banks go Down Under back into the not-too-distant past to show how CCPs can get into trouble–and how they can wreak havoc when they try to save themselves. An economist at the Chicago Fed warns that CCPs create new risks as they address old ones. Even the BIS (which had been an unabashed clearing cheerleader) sounds warnings.

I could go on. Suffice it to say that it is now becoming widely recognized that central clearing mandates (and the mandated collateralization of non-cleared derivatives) is not the silver bullet that will slay systemic risk, as someone pointed out more than seven years ago.

This is a good thing, on the whole, but there is a danger. This danger inheres in the framing of the issue as “CCPs are too big to fail, and therefore need to be made fail-safe.”  Yes, the failure of a major CCP is a frightening prospect: as the article linked above about the crisis at the New Zealand Futures and Options Exchange demonstrates, the collapse of even a non-major CCP is not a cheery prospect either.

But the measures employed to prevent failure pose their own dangers. The “loser pays” model is designed to reduce credit risk in derivatives transactions by requiring the posting of initial margins and the payment of variation margins, so that the CCP’s credit exposure is reduced. But balance sheets can be adjusted, and credit exposure through derivatives can be-and will be, to a large extent-replaced by credit exposure elsewhere, meaning that collateralization primarily redistributes credit risk, rather than reduces it.

Furthermore, the nature of the credit can change, and in bad ways. The need to meet large margin calls in the face of large price movements  causes spikes in the demand for credit that are correlated with market disruptions: this liquidity risk is a wrong way risk of the worst sort, because it tends to occur at times when the supply of liquidity is constrained, and it therefore can contribute to liquidity crises/liquidity hoarding and can cause a vicious spiral. In addition, as the article on the NZFOE demonstrates other measures that are intended to save the clearinghouse (partial tearups, in that instance) redistribute default losses in unpredictable ways, and it is by no means clear that those who bear these losses are less systemically important than, or more able to withstand them than, those who would bear them in an uncleared world.

The article on the NZFOE episode points out another salient fact: dealing with a CCP crisis has huge distributive effects. This makes any CCP action the subject of intense politicking and rent seeking by the affected parties, and this inevitably draws in the regulators and the central bankers. This, in turn, will inevitably draw in the politicians. Thus, political considerations, as much or more than economic ones, will drive the response. With supersized CCPs, the political fallout from any measures adopted to save CCPs (including extending credit to permit losers to make margin calls) will be acute and long lived.

Thus, contrary to the way they were hawked in the aftermath of the crisis, CCPs and collateralization mandates are not fire-and-forget measures that reduce burdens on regulators generally, and central banks in particular. They create new burdens, as regulators and central banks will inevitably be forced to resort to extraordinary measures, and in particular extraordinary measures to supply liquidity, to respond to systemic stresses created by the clearing system.

In his academic post-mortem of the clearing during the 1987 Crash, Ben Bernanke forthrightly declared that it was appropriate for the Fed to socialize clearinghouse risks on Black Monday and the following Tuesday. In Bernanke’s view, socializing the risk prevented a more serious crisis.

When you compare the sizes of the CCPs at issue then (CME Clearing, BOTCC, and OCC) to the behemoths of a post-mandate world, you should be sobered. The amount of risk that must be socialized to protect the handful of huge CCPs that currently exist dwarfs the amount that Greenspan (implicitly) took onto the Fed balance sheet in October, 1987.

Put differently, CCPs have become single points of socialization. Anyone who thinks differently, is fooling themselves.

Addendum: The last sentence of the Bernanke article is rather remarkable: “Since it now appears that the Fed is firmly committed to respond when the financial system is threatened, it may be that changes in the clearing and settlement system can be safely restricted to improvements to the technology of clearing and settlement.” The argument in a nutshell is that the Fed’s performance of its role as “insurer of last resort” (Bernanke’s phrase to describe socializing CCP risk) during the Crash of 1987 showed that central banks could readily handle the systemic financial risks associated with clearing. Therefore, managing the financial risks of clearing can easily be delegated to central banks, and CCPs and market users should focus on addressing operational risks.

There is an Alfred E. Newman-esque feel to these remarks, and they betray remarkable hubris about the powers of central banks. I wonder if he thinks the same today. More importantly, I wonder if his successors at the Fed, and their peers around the world, share these views. Given the experience of the past decade, and the massive expansion of derivatives clearing world, I sure as hell hope not.

 

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March 7, 2016

Clear the Way: LSE (and LCH!) on the Block

The biggest news from the exchange world in a long time is the proposed merger between LSE and Eurex. Both entities operate stock exchanges, but that’s a commoditized business these days, and it’s not the real driver of the merger. Instead, LSE’s LCH.Clearnet, and in particular LCH’s SwapClear, are the prizes. LSE and Eurex also both have valuable index businesses, but its hard to see how their value is enhanced through a combination: synergies, if they exist, are modest.

There are potentially large synergies on the clearing side. In particular, the ability to portfolio margin across interest rate products (notably various German government securities futures traded and cleared on Eurex, and Euro-denominated swaps cleared through LCH) would provide cost savings for customers that the merged entities could capture through higher fees. (Which is one reason why some market users are less than thrilled at the merger.)

A potential competitor to buy LSE, ICE, could also exploit these synergies. Indeed, its Euro- and Sterling-denominated short term interest rate futures contracts are arguably a better offset against Euro- and Sterling-denominated swaps than are Bunds or BOBLs.

The CME’s experience suggests that these synergies are not necessarily decisive competitively. The CME clears USD government security and STIRs, as well as USD interest rate swaps, and therefore has the greatest clearing synergies in the largest segment of the world interest rate complex. But LCH has a substantial lead in USD swap clearing.

It is likely that ICE will make a bid for LSE. If it wins, it will have a very strong clearing offering spanning exchange traded contracts, CDS, and IRS. Even if it loses, it can make Eurex pay up, thereby hobbling it as a competitor going forward: even at the current price, the LSE acquisition will strain Eurex’s balance sheet.

CME might also make a bid. Success would give it a veritable monopoly in USD interest rate clearing.

And that’s CME’s biggest obstacle. I doubt European anti-trust authorities would accept the creation of a clearing monopoly, especially since the monopolist would be American. (Just ask Google, Microsoft, etc., about that.) US antitrust authorities are likely to raise objections as well.

From a traditional antitrust perspective, an ICE acquisition would not present many challenges. But don’t put it past the Europeans to engage in protectionism via antitrust, and gin up objections to an ICE purchase.

Interestingly, the prospect of the merger between two huge clearinghouses is making people nervous about the systemic risk implications. CCPs are the new Too Big to Fail, and all that.

Welcome to the party, people. But it’s a little late to start worrying. As I pointed out going back to the 1990s, there are strong economies of scale and scope in clearing, meaning that consolidation is nearly inevitable. With swaps clearing mandates, the scale of clearing has been increased so much, and new scope economies have been created, that the consolidated entities will inevitably be huge, and systemically important.

If I had to handicap, I would put decent odds on the eventual success of a Eurex-LSE combination, but I think ICE has a decent opportunity of prevailing as well.

The most interesting thing about this is what it says about the new dynamics of exchange combinations. In the 2000s, yes, clearing was part of the story, but synergies in execution were important too. Now it’s all about clearing, and OTC clearing in particular. Which means that systemic risk concerns, which were largely overlooked in the pre-crisis exchange mergers, will move front and center.

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December 25, 2015

Four Corners Offense: The Social History of Commodity Corners

I’ve been spending something of a busman’s holiday, reading this and that about commodity market corners in days long past. I started out looking into some of the big cotton corners at the beginning of the last century, namely the Brown-Hayne corner of 1903 and the Patten corner of 1910. These are the subject of a new book, The Cotton Kings: Capitalism and Corruption in Turn-of-the-Century New York and New Orleans. The book is entertaining history, but could use some more economics. It is journalistic in style, rather than analytical.

Reading about Patten’s cotton corner led me to read about his wheat corner of 1909, his corn corner of 1908, and his oats corner of 1902. Mr. Patten was a busy man.

And a reviled one. He was known as “The Wheat King,” whom the The Literary Review accused of  “The Crime of Making Bread Dear.” He was the model for the villain in the very influential D. W. Griffith short film, “A Corner in Wheat.”

This early short was one of the first films, if not the first, to address a serious social subject. Its theme would be very familiar today: the two Americas, rich and poorSergei Eisenstein admired Griffith, and employed his “parallel editing” technique (which he referred to as Griffith’s “montage of collision”): some film historians consider Griffith’s technique more subtle and less heavy-handed than Eisenstein’s.

(Unbeknownst to me when I was growing up in Evanston, Illinois, Patten was a longtime resident of the city, and its former mayor. He built a mansion there, and funded the Patten Gymnasium, where I swam in the summers.)

Patten was a nationally known figure. The Justice Department indicted him under the Sherman Act for his cotton corner, and the case attracted front page attention in national newspapers, including the New York Times, when it went to the Supreme Court. (Patten was fined $4000, or less than .1 percent of what he allegedly made in his corner. Not much deterrence effect there, eh?)

Patten was not alone in being a figure of national renown–and infamy. Commodity speculators were the banksters of their day. The Matt Taibbi of the 1880s, Henry Demarest Lloyd, wrote about cornerers at the Chicago Board of Trade in a famous essay. Frank Norris wrote a famous roman à clef, The Pit, based on the Leiter wheat corner of 1898.

In sum, in the last third of the 19th century and the first quarter of the 20th, commodity markets generally, and commodity market corners in particular, were the subject of intense interest. In some respects, it is not surprising that commodity corners were the subject of close journalistic coverage, serious fiction, social critical literature, and film during this era. Agricultural commodities were much more central to Americans as both consumers and producers. In 1900, 41 percent of the American workforce was employed in agriculture: now it is under 2 percent, and agriculture represents less than .7 of GDP. Half of American consumption spending went to food and textiles in 1900: a century later, that figure was down to 20 percent. Relatively speaking, the commodity derivatives markets (the Chicago Board of Trade, the Minneapolis Chamber of Commerce, Kansas City Board of Trade, the New York and New Orleans cotton exchanges, etc.) were more important and more developed that the capital markets, including the New York Stock Exchange, than is the case today: by the 1990s, when I was researching commodity exchanges and doing work with some, the commodity traders lamented that the explosion of financial futures had led the managements of exchanges to lose touch with the realities of commodities.

That said, one can see many echoes of the distant debates about and social criticism of commodity trading and corners in current controversies over financial markets. Just as outrage over the alleged excesses of the 2000s gave birth to the spate of post-Crisis financial regulation, fury over the Leiters and Pattens and Browns led to the first major regulations of financial markets in the United States: the Cotton Futures Act of 1914, and the Grain Futures Act of 1922 (which morphed into the Commodity Exchange Act, which is still with us, and which was amended by Frankendodd). Both Acts followed major government studies, the Commissioner of Corporations’ Report on Cotton Exchanges, and the Federal Trade Commission’s Report on the Grain Trade. Both of these are very well done, and provide very detailed descriptions of both the cash and futures markets. They are priceless resources. In some respects, because of them, we know more about the operation of commodity markets in the first decades of the 20th century than we do of their operation in the first decades of the 21st.

Maybe someday I’ll write a book about all of this, one that integrates the economics, history, and political economy. It’s of great personal interest, but not highly valued in the economics or finance professions today. I was amused when I came upon the link to an AER article about the Cotton Futures Act: it is beyond imagining that something similar would appear there today. But as I hope the foregoing shows, plus ça change, plus c’est la même chose. Issues of the relationship between financial markets and the real economy, the political economy of financial markets, and the influence of financial titans on political and judicial institutions, are still with us. In 1909, a film like A Corner in Wheat grappled with the social impact of finance in a very provocative and arguably simplistic way: in 2009-2015 movies like Too Big to Fail, Margin Call, and The Big Short do the same.

Don’t hold your breath, but maybe someday you’ll read about this in depth in print, rather than superficially in pixels.

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December 1, 2015

The Red Queen’s Race: Financial Regulation Edition

Filed under: Clearing,Derivatives,Economics,Financial crisis,Regulation — The Professor @ 8:44 pm

Well over four years ago, I raised concerns about clearing mandates leading to the rise of “collateral transformation” whereby those needing high-quality assets to pledge as collateral against derivatives trades would obtain them via repos collateralized by low-quality assets. I argued that these transactions were inherently fragile, and could go pear shaped during period of market stress.

If this were the only problem that post-crisis regulations created, how lucky we would be! Yesterday, the FT ran a nice (meaning scary) piece about other regulation-related driven spurts in securities lending that are collateral transformation on steroids.

One big driver is the Liquidity Coverage Ratio, which requires banks to hold one month’s stress period liquidity needs in liquid assets like government bonds. Rather than sell other less liquid assets to raise the cash to buy Treasuries, Gilts, Bunds, etc., banks are posting their less liquid assets (including equities) as collateral against borrowing of government securities.

Think of how this could work in a crisis. Yes, a bank can sell the borrowed guvvies to raise cash to meet deposit outflows or other cash needs in a crisis. But it borrowed these securities, so it has to buy them back, eventually. Perhaps its liquidity crisis will have passed before the loan matures, but perhaps not. What then, genius? Liquidity crisis deferred, not necessarily prevented.

There are other concerns. The lender of the government bond is likely to haircut the collateral more steeply during crisis periods, meaning that the stressed bank is going to have to come up with more collateral to support its loan precisely when it can least afford to do so. The cyclicality of the collateral mechanism is a concern, and it can create all sorts of vicious cycles that have spillovers throughout the financial system.

Furthermore, the article notes that asset managers like BlackRock are the major securities lenders. They lend out bonds purchased to back government bond ETFs, and take other securities as collateral. That is, the asset manager is engaged in a financial transformation in which there can be a mismatch between the assets underlying the ETF and its liabilities: swapping government bonds for equity (or other assets) creates such a mismatch. What happens if the ETF sponsor is it by a wave of redemptions–especially if the redemptions occur because investors become concerned because the value of the collateral the sponsor has collected has fallen, and may be substantially below the value of the assets lent out (which is what the fund is intended to track)? One possibility is fire sales of the collateral and “fire purchases” of the assets the fund has lent out. A more likely outcome is that this is the kind of event which will cause the fund to demand significantly more collateral from the security borrower, setting off the vicious cycles described above.

Oh joy.

The article states that another reason for the rise in securities lending is that banks get better capital treatment on the borrowed securities than the securities posted as collateral. If this is true, it is totally nuts. The borrowed security is not an asset to the bank: the assets posted as collateral for the loan are. The borrower has the asset in his hot little hands, but has an obligation to give it back: these things offset. At the end of the day, the bank still has the other assets posted as collateral. If capital regs treat the borrowed bond as an asset, and don’t treat the securities posted as collateral as an asset, and reduce risk weighted assets (and hence capital requirements) as a result, the regulations are even dumber than I had thought possible.

That is really saying something.

The third reason for the rise in securities lending is my old favorite, collateral transformation to obtain CCP-eligible collateral. This part of the article made me laugh:

There is a third plus, too, as another facet of post-crisis regulation gains momentum. With so much derivatives trading moving to central counterparty clearing, there is increasing demand for high quality assets to be used as collateral. And for that, government bonds — even borrowed ones — avoid punitive haircuts imposed on some equities.

I laugh because in a collateral transformation trade, there is a potentially punitive haircut on the equities (or whatever) posted in the collateral transformation trade.

Whenever I see things like this I keep coming back to the story about the Indian village that was infested by mice, so it brought in cats which then multiplied and became such pests that they brought in dogs to run off the cats, but then the dogs became such a problem that they brought in elephants to scare away the dogs, and when the elephants started wrecking the place they reintroduced the mice to scare away the elephants.

Things like the LCR and clearing mandates were introduced to solve one set of problems (or perceived problems) inherent in the financial transformations that banks provide. But these regulations have led to the proliferation of other kinds of transformations that are problematic in their own ways. These new transformations create new, potentially fragile, interconnections. They create new counterparty and liquidity risks even as they mitigate some old ones.

Or to invoke another metaphor, this is like the Red Queen, running at breakneck speed to stay in the same place:

“Well, in our country,” said Alice, still panting a little, “you’d generally get to somewhere else—if you run very fast for a long time, as we’ve been doing.”

“A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

Yes. Very much like that indeed. Perhaps we haven’t quite stayed in one place, but the running over the past 5 plus years has not moved us nearly as far as the Frankendodd and EMIR and MiFID II pom-pom squad claim.  Risks have been shifted and transformed, rather than eliminated. In the attempt to banish the devil we knew, we’ve teamed up with some lesser-known demons. Sadly, we are likely to become much better acquainted, sooner or later.

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November 12, 2015

Big Sister on the Warpath Against Commodity Derivatives

Filed under: Commodities,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 3:27 pm

Elizabeth Warren’s panties were in a bunch the other night because of an ad that portrayed her as a “Commie dictator” (her description). (Liz’s panties always seem to be in a bunch, but they were bunchier than usual on Tuesday.) The ad, which blasts Warren’s anti-Constitutional monstrosity, the Consumer Financial Protection Bureau is actually somewhat amusing. Warren’s image appears in the background on a Big Brother-ish–or would that be Big Sister-ish?–banner.

I agree with Warren. She is not a  Commie dictator. She is a wannabe Commie dictator.

Her anti-market efforts are not limited to birthing and defending the CFPB. She is also a virulent critic of derivatives, especially when banks trade them. Pre-commercial, her ire this week was focused on the repeal of the swaps pushout rule, the brainchild (and I use that term very loosely) of fortunately ex-Senator Blanch Lincoln (D-for-dim, Arkansas). Warren fulminated that as a result of the repeal, banks were able to keep $10 trillion notional in particularly risky swaps in their deposit-taking units, rather than spinning them off into separately capitalized subsidiaries that cannot benefit from deposit insurance.

This rule was targeted at swaps that were deemed especially risky, including most notably, commodity swaps. But commodity swaps, and many equity derivatives, are not especially risky. Risk depends on whether the positions are hedged or hedgeable, the creditworthiness of the counterparty, and the credit support (e.g., collateral) in the transactions. And notional principle is certainly not a measure of how much risk is in a derivatives book. Therefore, putting commodity swaps, equity swaps, etc., in a ghetto does not make economic sense. There is no reliable mapping between the underlying of a derivative and the risk it creates.

Furthermore, risk has to be evaluated on a portfolio basis. Segmenting derivatives books can reduce diversification benefits, and crucially, breaks netting sets. Breaking netting sets tends to increase counterparty risk, or require more costly collateral to keep counterparty risk the same. (As I’ve written many times, the systemic effects of netting and collateral are ambiguous because of their main effect is redistributive. But if you are concerned about the counterparty risks that banks face, you should prefer more netting to less.)

Frankendodd is chock-full o’ stupid and dangerous, but the swaps push out was in the running for the title of dumbest and most dangerous. It makes no economic sense as a way of achieving the purported purpose of reducing the risks that banks pose to taxpayers. But Warren and other progressives have made it a litmus test for determining which side you are on, that of the angels, or the banksters? This is a false choice.

But expect Big Sister Liz to remain on the warpath against derivatives. Which is exactly why the 1984-esque portrayal of her in that commercial is spot on.

 

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October 24, 2015

Creeping Recognition that Regulation Has Created a Liquidity Death Star

Reason number one (by far) that I believe that clearing and collateral mandates increase systemic risk is that they transform credit risk into liquidity risk. Large price moves during stressed market situations require those with losing positions to make large variation margin payments in a very tight frame. These payments need to be funded, and funded immediately. Thus, variation margining causes spikes in the demand for liquidity. Furthermore, clearing in particular creates tight coupling because failures-or even delays-in making VM payments can put the clearinghouse into default, or force it to liquidate collateral in an illiquid market. The consequences of that, you should shudder to contemplate.

To be somewhat hyperbolic, clearing mandates create a sort of liquidity death star.

Recognition of how dangerous spikes in liquidity demand precisely when liquidity supply evaporates creates a major systemic risk is sadly insufficiently widespread, particularly among many regulators who still sing paeans to the glories of clearing. But perhaps awareness is spreading, albeit slowly. At least I hope that this Economist article indicates a greater appreciation of the collateral issue, although it fails to draw the connection to central clearing, and how clearing mandates can dramatically exacerbate collateral shortages:

WHEN the financial system teetered on the brink of collapse in 2008, the biggest problem was a lack of liquidity. Banks were unable to refinance themselves in the short-term debt markets. Central banks had to step in on a massive scale to offer support. Calm was eventually restored, but not without enormous economic damage.

But has the underlying problem of liquidity gone away? A research note from Michael Howell of Crossborder Capital argues that, in the modern financial system, central banks are no longer the only, or even the main, providers of liquidity. Instead, the system looks a lot like that of the Victorian era, with banks dependent on the wholesale markets for funding. Back then, the trade bill was the key asset for bank financing; now it is the mysteriously named “repo” market.

. . . .

Bigger haircuts mean that borrowers need more collateral than before in order to fund themselves. “When market volatility jumps, funding capacity drops in tandem and often substantially,” writes Mr Howell. The result, a liquidity squeeze at the worst possible moment, is a template of how the next crisis may occur (although regulators are trying to reduce banks’ reliance on short-term funding).

And again, it is at these times when the need to fund VM payments will kick in, exacerbating the liquidity squeeze. Moreover, clearing also ties up a lot of the assets (e.g., Treasuries, or cash) that firms could normally borrow against to raise cash. Perversely, that collateral can be accessed only if a clearing member defaults on a variation margin payment.

Just what the liquidity supply mechanism will be in the next crisis in the new cleared world is not quite, well, clear. As the Economist article (and the Crossborder Capital note upon which it is based) demonstrate, central banks lend against collateral, and the collateral constraint will already be binding in stress situation. Presumably central banks will have to be much more expansive in their definition of what constitutes “good” collateral (a la Bagehot).

It still astounds me that even though every major financial crisis in history has been at root a liquidity crisis, in their infinite wisdom the betters who presume to govern us thought they were solving systemic risk problems by imposing a mechanism that will sharply increase liquidity demand and restrict liquidity supply during periods of market stress. That should work out really, really swell.

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