Streetwise Professor

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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October 10, 2015

Igor Gensler Helps the Wicked Witch of the West Wing Create Son of Frankendodd

Hillary Clinton has announced her program to reform Wall Street. Again.

The actual author of the plan is said to be my old buddy, GiGi: Gary Gensler.

Gensler, if you will recall, was the Igor to Dr. Frankendodd, the loyal assistant who did the hard work to bring the monster to life. Now he is teaming with the Wicked Witch of the West Wing to create Son of Frankendodd.

There are a few reasonable things in the proposal. A risk charge on bigger, more complex institutions makes sense, although the details are devilish.

But for the most part, it is ill-conceived, as one would expect from Gensler.

For instance, it proposes regulating haircuts on repo loans. As I said frequently in the 2009-2010 period, attempting to impose these sorts of requirements on heterogeneous transactions is a form of price control that will lead some risks to be underpriced and some risks to be overpriced. This will create distorted incentives that are likely to increase risks and misallocations, rather than reduce them.

A tax on HFT has received the most attention:

The growth of high-frequency trading (HFT) has unnecessarily burdened our markets and enabled unfair and abusive trading strategies that often capitalize on a “two-tiered” market structure with obsolete rules. That’s why Clinton would impose a tax targeted specifically at harmful HFT. In particular, the tax would hit HFT strategies involving excessive levels of order cancellations, which make our markets less stable and less fair.

This is completely wrongheaded. HFT has not “burdened” our markets. It has been a form of creative destruction that has made traditional intermediaries obsolete, and in so doing has dramatically reduced trading costs. Yes, a baroque market structure in equities has created opportunities for rent seeking by HFT firms, but that was created by regulations, RegNMS in particular. So why not fix the rules (which in Hillary and Gensler acknowledge are problematic) rather than kneecap those who are responding to the incentives the rules create?

Furthermore, the particular remedy proposed here is completely idiotic. “Excessive levels of order cancellations.” Just who is capable of determining what is “excessive”? Furthermore, the ability to cancel orders rapidly is exactly what allows HFT to supply liquidity cheaply, because it limits their vulnerability to adverse selection. High rates of order cancellation are a feature, not a bug, in market making.

It is particularly ironic that Hillary pitches this as a matter of protecting “everyday investors.” FFS, “everyday investors” trading in small quantities are the ones who have gained most from the HFT-caused narrowing of bid-ask spreads.

Hillary also targets dark pools, another target of popular ignorance. Dark pools reduce trading costs for institutional investors, many of whom are investing the money of “everyday” people.

The proposal also gives Gensler an opportunity to ride one of his hobby horses, the Swaps Pushout Rule. This is another inane idea that is completely at odds with its purported purpose. It breaks netting sets and if anything makes the financial system more complex, and certainly makes financial institutions more complex. It also discriminates against commodities and increases the costs of managing commodity price risk.

The most bizarre part of the proposal would require financial institutions to demonstrate to regulators that they can be managed effectively.

Require firms that are too large and too risky to be managed effectively to reorganize, downsize, or break apart. The complexity and scope of many of the largest financial institutions can create risks for our economy by increasing both the likelihood that firms will fail and the economic damage that such failures can cause.[xiv] That’s why, as President, Clinton would pursue legislation that enhances regulators’ authorities under Dodd-Frank to ensure that no financial institution is too large and too risky to manage. Large financial firms would need to demonstrate to regulators that they can be managed effectively, with appropriate accountability across all of their activities. If firms can’t be managed effectively, regulators would have the explicit statutory authorization to require that they reorganize, downsize, or break apart. And Clinton would appoint regulators who would use both these new authorities and the substantial authorities they already have to hold firms accountable.

Just how would you demonstrate this? What would be the criteria? Why should we believe that regulators have the knowledge or expertise to make these judgments?

I have a Modest Proposal of my own. How about a rule that requires legislators and regulators to demonstrate that they have the competence to manage entire sectors of the economy, and in particular, have the competence to understand, let alone manage, an extraordinarily complex emergent order like the financial system? If some firms are too complex to manage, isn’t an ecosystem consisting of many such firms interacting in highly non-linear ways exponentially more complex to control, especially through the cumbersome process of legislation and regulation? Shouldn’t regulators demonstrate they are up to the task?

But of course Gensler and his ilk believe that they are somehow superior to those who manage financial firms. They are oblivious to the Knowledge Problem, and can see the speck in every banker’s eye, but don’t notice the log in their own.

People like Gensler and Hillary, who are so hubristic to presume that they can design and regulate the complex financial system, are by far the biggest systemic risk. Frankendodd was bad enough, but Son of Frankendodd looks to be an even worse horror show, and is almost guaranteed to be so if Gensler is the one in charge, as he clearly aims to be.

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October 3, 2015

People. Get. A. Grip: Glencore Is Not the Next Lehman

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,History,Regulation — The Professor @ 6:53 pm

There is a lot of hysterical chatter out there about Glencore being the next Lehman, and its failure being the next Lehman Moment that plunges the financial system into chaos. Please. Get. A. Grip.

Comparing the firms shows there’s no comparison.

Let’s first talk size, since this is often framed as an issue of “too big to fail.” In November, 2007, Lehman’s total assets were $691 billion. As of August, Glencore’s were $148 billion. Lehman was about 4.5 times bigger. Moreover, Glencore’s assets include a lot of short term assets (inventories and the like) that are relatively liquid. Looking at Glencore as a $100 billion firm is more realistic. Lehman was much bigger.

Then let’s talk leverage. Lehman had 3 percent equity, 97 percent debt. Glencore about one third-two thirds. Stripping out the short term debt and short term assets, it’s about 50-50.

Then let’s talk off-balance sheet. Lehman was a derivatives dealer with huge OTC derivatives exposures both long and short. Glencore’s derivatives book is much smaller, more directional, and much in listed derivatives.

Lehman had derivatives liabilities of about $30 billion after netting and collateral were taken into account, and $66 billion if not (which matters if netting is not honored in bankruptcy). Glencore has $2 billion and $20 billion, respectively.

Lets talk about funding. Lehman was funding long term assets with short term debt (e.g., overnight repos, corporate paper). It had a fragile capital structure. Glencore’s short term debt is funding short term assets, and its longer term assets are funded by longer term debt. A much less fragile capital structure.  Lower leverage and less fragile capital means that Glencore is much less susceptible to a run that can ruin a company that is actually solvent. That also means less likelihood that creditors are going to take a big loss due to a run (as was the case with Lehman).

As a major dealer, Lehman was also more interconnected with every major systemically important financial institution. That made contagion more likely.

But I don’t think these firm-specific characteristics are the most important factors. Market conditions today are significantly different, and that makes a huge difference.

It wasn’t the case that Lehman failed out of a clear blue sky and this brought down the entire financial system through a counterparty or informational channel. Lehman was one of a series of casualties of a financial crisis that had been underway for more than a year. The crisis began in earnest in August, 2007. Every market indicator was flashing red for the next 12 months. The OIS-Libor spread blew out. The TED spread blew out. Financial institution CDS spreads widened dramatically. Asset backed security prices were plummeting. Auction rate securities were failing. SPVs holding structured products were having difficulty issuing corporate paper to fund them. Bear Sterns failed. Fannie and Freddie were put into receivership. Everyone knew AIG was coughing up blood.

Lehman’s failure was the culmination of this process: it was more a symptom of the failure of the financial system, than a major cause. It is still an open question why its failure catalyzed an intensified panic and near collapse of the world system. One explanation is that people inferred that the failure of the Fed to bail it out meant that it wouldn’t be bailing out anyone else, and this set off the panic as people ran on firms that they had thought were working with a net, the existence of which they now doubted. Another explanation is that there was information contagion: people inferred that other institutions with similar portfolios to Lehman’s might be in worse shape than previously believed and hence ran on them (e.g., Goldman, Morgan Stanley, Citi) when Lehman went down. The counterparty contagion channel has not received widespread support.

In contrast, Glencore’s problems are occurring at a time of relative quiescence in the financial markets. Yes commodity markets are down hard, and equities have had spasms of volatility lately, but the warning signs of liquidity problems or massive credit problems in the banking sector are notably absent. TED and OIS-Libor spreads have ticked up mildly in recent months, but are still at low levels. A lot of energy debt is distressed, but that does not appear to have impaired financial institutions’ balance sheets the same way that the distress in the mortgage market did in 2007-2008.

Furthermore, there is not even a remote possibility of an implicit bailout put for Glencore, whereas it was plausible for Lehman (and hence the failure of the put to materialize plausibly caused such havoc). There are few signs of information contagion. Other mining firms stocks have fallen, but that reflects fundamentals: Glencore has fallen more because it is more leveraged.

Put differently, the financial system was more fragile then, and Lehman was clearly more systemically important, because of its interconnections and the information it conveyed about the health of other financial institutions and government/central bank policy towards them. The system is more able to handle a big failure now, and a smaller Glencore is not nearly as salient as Lehman was.

In sum, Glencore vs. Lehman: Smaller. Less leveraged. Less fragile balance sheet. Less interconnected. And crucially, running into difficulties largely by itself, due to its own idiosyncratic issues, in a time of relative health in the financial system, as opposed to being representative of an entire financial system that was acutely distressed.

With so many profound differences, it’s hard to imagine Glencore’s failure would lead to the same consequences as Lehman. It wouldn’t be fun for its creditors, but they would survive, and the damage would largely be contained to them.

So if you need something to keep you up at night, unless you are a Glencore creditor or shareholder, you’ll need to find something else. It ain’t gonna be Lehman, Part Deux. But I guess financial journos need something to write about.

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September 28, 2015

Regulation Confronts Reality In the Commodity Markets. Reality Is Losing.

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Financial crisis,Regulation — The Professor @ 6:36 pm

Following the commodities markets today was like drinking from a fire hose. Many big stories, with “up” and “down” being the operative words. Alcoa split up. Shell announcing that it was giving up on its Arctic plans after its controversial test well failed to find commercially viable reserves. Oil price down around 3 percent, etc.

But the biggest news items were Glencore’s continuing downward spiral, and ESMA’s release of its technical recommendations for application of MiFID to non-financial firms, including commodity firms.

Glencore’s stock was down hard at the open, and at one point was down 31 percent. It’s CDS are now trading up-front (always a bad sign), and the spread widened from an already big 550 bp to 757 bp. At conventional recovery rates, this gives a (risk neutralized) probability of default of better than 50 percent. The Biggest Loser was Glencore’s CEO, Ivan Glasenberg, AKA, Ex-Glencore Billionaire.

The CDS are now trading wider than when Glencore had it s last near-death experience at the height of the financial crisis. Arguably the firm’s situation is worse now. It cannot attribute its woes to stressed financial market conditions generally, in which pretty much everyone saw spreads blow out to one degree or another. This is unique to it and the mining sector. It is a verdict on the firm/sector.

Moreover, in 2008 the firm was private, and Glasenberg and the other owners were able to stanch the bleeding by injecting additional capital into the firm. The ominous thing for Ivan et al now is that they tried that again a couple of weeks ago (along with announcing other measures to reduce debt and conserve cash) and it only bought a temporary respite before the blood started gushing again.

Moreover-and this is crucial-Glencore 2015 is a very different creature than Glencore 2008. It was more of a pure trader then: it is a mining firm with a big trading arm now. This means that its exposure to flat prices (of coal and copper in particular) is much bigger now. In fact, most commodity firms saw little drop off in profits in 2008-2009, and several saw profits increase. The fundamentals facing trading firms in 2008-2009 were not nearly as bad as the fundamentals facing mining firms today. That’s because their flat price exposures weren’t large, and margins and volumes (which drive trading profits) are not as sensitive to macro conditions as flat prices. Given the lack of any prospects for a rebound in flat prices, Glencore’s prospects for a recovery are muted.

Some tout Glasenberg et al’s trading acumen. But it is one thing to be able to sniff out arbs/relative mispricings and structure clever trades to exploit them. (Or to hold one’s nose while doing deals with dodgy regimes around the world.) It is something altogether different to predict where prices are going to go. Glencore made a bet on China, and now that bet is not looking good. At all.

In a nutshell, this is pretty much out of Glencore’s hands. It is along for the ride.

The irony here is that Glasenberg sold the Xstrata merger and the new business model as a way of using the less cyclical profitability of the trading venture as a way of dampening the cyclicality of the mining operation. As it is developing, an extremely adverse cyclical downturn in the mining operation is impairing the viability of the trading operation. How the trading operation can flourish within a financially distressed corporation is an open question. Maybe the company will have to pull an Alcoa, and separate the trading from the mining operations, to keep the latter from dragging down the former.

A key takeaway here relates to the other story I mentioned: ESMA’s release of its recommendations regarding the application of MiFID to non-financials. The objective is to mitigate systemic risk. I was always skeptical that commodity traders posed any such risk (and have been making that argument for 3+ years), and so far the Glencore meltdown is supporting that skepticism. There has been no evidence of spillovers/contagion from Glencore to financial institutions, or to the broader market, a la Lehman.

But ESMA has proposed Technical Standards that would impose the full panoply of CRD-IV capital requirements on commodity traders (and other non-financial firms) that cannot avail themselves of an exemption (on which I will say more momentarily).

  1. If firms cannot make use of an exemption under MiFID II, capital requirements under the new banking regulatory framework will apply to them. This new framework consists of Regulation EU No 575/2013 (CRR) and Directive 2013/36/EU (CRD IV), repealing Directives 2006/48/EC and 2006/49/EC. While CRD IV is addressed to CAs and includes, inter alia, qualitative provisions on the Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP), the new CRR imposes quantitative requirements and disclosure obligations pursuant to Basel III recommendations on credit institutions and investment firms, including own funds definition, minimum own funds requirements and liquidity requirements. However, under Article 498(1) of CRR, some commodity dealers falling within the scope of MiFID are transitionally exempt from the CRR’s provisions on own funds requirements until 31 December 2017 at the latest, if their main business consists exclusively of providing investment services or activities relating to commodity derivatives.
  2. Moreover, firms falling within the scope of MiFID II will be considered to be financial counterparties rather than non-financial counterparties under Article 2(8) of EMIR. Therefore, they will not be able to benefit from the clearing thresholds or the hedging exemption available to the latter under Article 10 of EMIR. An additional consequence of being classified as a financial counterparty will be that the trading obligation (i.e. the obligation to trade derivatives which are subject to the clearing obligation and sufficiently liquid on trading venues only, cf. Article 28 of MiFIR) would apply in full without being subject to a threshold.

So, even if you aren’t a bank, you will be treated like a bank, unless you can get the exemption. Apropos what I said the other day about impoverished carpenters, hammers, nails, etc.

To get an exemption, a firm’s non-hedging derivatives business must fall below a particular threshold amount, e.g., 3 percent of the oil market, 4 percent of the metals market. ESMA recommends that hedges be determined using EMIR criteria. The big problem with this is that only months ago ESMA itself recognized that the EMIR framework is unworkable:

  1. It appears that the complex mechanism introduced by EMIR for the NFC+ [Non-Financial Company Plus] classification has so far led to significant difficulties in the identification, monitoring and, as a consequence, possible supervision of these entities by their competent authorities.
  2. As a result, in the context of the revision of EMIR, ESMA would see some merit in the simplification of the current framework for the determination of NFC+.
  3. One route that the Commission may wish to explore is to move from the current two-step process (Hedging/Non Hedging and clearing threshold) to a one-step process, where counterparties would qualify as NFC+ when their outstanding positions exceeds certain thresholds per asset class, irrespective of the qualification of the trades as hedging or non-hedging. This idea is further developed in Section 4.2 which addresses the way in which NFCs qualify their transactions as hedging and non-hedging.

In other words, ESMA judged that it is impossible for regulators to distinguish firms’ hedging derivatives from its speculative ones. Given these difficulties, just a few months ago ESMA recommended jettisoning the entire mechanism that it now proposes to use to determine whether commodity firms are exempt from MiFID, and the associated capital and clearing requirements.

Makes perfect sense. In some universe.*

At the very least the ESMA plan will impose a huge compliance burden on firms who will have to justify their categorizations of derivatives positions as hedges or no. Given the complexities of risk management (e.g., managing risk on a portfolio basis means that saying what trade is a hedge is difficult, if not impossible, the rapid and frequent adjustments of positions inherent in most trading operations, etc.) this will be a nightmare.

So the good news is: You can get an exemption from capital and clearing requirments! Yay!

The bad news is: The entity proposing the exemption says that the process for getting the exemption is unworkable, and you’ll have not just a compliance headache, but a compliance migraine.

So at the very same time that the financial travails of a big commodity firm cast serious doubt on the systemic riskiness of these firms, European regulators advance regulations intended to fix this (non-existent) problem, and are doing so in a way that they themselves have cast serious doubt on.

Put differently: regulation is confronting reality in the commodity markets at this very moment, and reality is coming off second best.

* It also hardly inspires confidence that ESMA fails basic arithmetic. Note that the threshold in oil is 3 percent, then consider this from its Briefing on Non-Financial Topics: “If a firm’s speculative trading activity is less than 50% of its total trading, it may be MiFID II exempt providing its market share is less than 20% of each threshold in the market share test e.g. 0.8% for metals, 0.3% for oil etc.” Um, last time I checked .2 x 3%=0.6%, not 0.3%.

 

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