Streetwise Professor

March 29, 2014

Margin Sharing: Dealer Legerdermain, or, That’s Capital, Not Collateral.

Concerns about the burdens of posting margins on OTC derivatives, especially posting by clients who tend to have directional positions, have led banks to propose “margin sharing.”  This is actually something of a scam.  I can understand the belief that margin requirements resulting from Frankendodd and Emir are burdensome, and need to be palliated, but margin sharing is being touted in an intellectually dishonest way.

The basic idea is that under DFA and Emir, both parties have to post margin.  Let’s say A and B trade, and both have to post $50mm in initial margins.  The level of margins is chosen so that the “defaulter (or loser) pays”: that is, under almost all circumstances, the losses on a defaulted position will be less than $50mm, and the defaulter’s collateral is sufficient to cover the loss.  Since either party may default, each needs to post the $50mm margin to cover losses in the event it turns out to be the loser.

But the advocates of margin sharing say this is wasteful, because only one party will default.  So the $50mm posted by the firm that doesn’t end up defaulting is superfluous.  Instead, just have the parties post $25mm each, leaving $50mm in total, which according to the advocates of margin sharing, is what is needed to cover the cost of default.  Problem solved!

But notice the sleight of hand here.  Under the loser pays model, all the $50mm comes out of the defaulter’s margin: the defaulter pays,  the non-defaulter receives all that it is owed, and makes no contribution from its own funds.  Under the margin sharing model, the defaulter may pay only a fraction of the loss, and the non-defaulter may use some of its $25mm contribution to make up the difference.   Both defaulter and non-defaulter pay.

This is fundamentally different from the loser pays model.  In essence, the shared margin is a combination of collateral and capital.  Collateral is meant to cover a defaulter’s market losses.  Capital permits the non-defaulter to absorb a counterparty credit loss.  Margin sharing essentially results in the holding of segregated capital dedicated to a particular counterparty.

I am not a fan of defaulter pays.  Or to put it more exactly, I am not a fan of mandated defaulter pays.  But it is better to confront the problems with the defaulter pays model head on, rather than try to circumvent it with financial doubletalk.

Counterparty credit issues are all about the mix between defaulter pays and non-defaulter pays.  Between collateral and capital.  DFA and Emir mandate a corner solution: defaulter pays.  It is highly debatable (but lamentably under-debated) whether this corner solution is best.  But it is better to have an open discussion of this issue, with a detailed comparison of the costs and benefits of the alternatives.  The margin sharing proposal blurs the distinctions, and therefore obfuscates rather than clarifies.

Call a spade a spade. Argue that there is a better mix of collateral and capital.  Argue that segregated counterparty-specific capital is appropriate.  Or not: the counterparty-specific, segregated nature of the capital in margin sharing seems for all the world to be a backhanded, sneaky way to undermine defaulter pays and move away from the corner solution.  Maybe counterparty-specific, segregated capital isn’t best: but maybe just a requirement based on a  firm’s aggregate counterparty exposures, and which doesn’t silo capital for each counterparty, is better.

Even if the end mix of capital and collateral that would result from collateral sharing  is better than the mandated solution, such ends achieved by sneaky means lead to trouble down the road.  It opens the door for further sneaky, ad hoc, and hence poorly understood, adjustments to the system down the line.  This increases the potential for rent seeking, and for the abuse of regulator discretion, because there is less accountability when policies are changed by stealth.  (Obamacare, anyone?)  Moreover, a series of ad hoc fixes to individual problems tends to lead to an incoherent system that needs reform down the road-and which creates its own systemic risks.  (Again: Obamacare, anyone?)  Furthermore, the information produced in an honest debate is a public good that can improve future policy.

In other words, a rethink on capital vs. collateral is a capital idea.  Let’s have that rethink openly and honestly, rather than pretending that things like margin sharing are consistent with the laws and regulations that mandate margins, when in fact they are fundamentally different.

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March 11, 2014

CCP Insurance for Armageddon Time

Matt Leising has an interesting story in Bloomberg about a consortium of insurance companies that will offer an insurance policy to clearinghouses that will address one of the most troublesome issues CCPs face: what to do when the waterfall runs dry.  That is, who bears any remaining losses after the defaulters’ margins, defaulters’ default fund contributions, CCP capital, and non-defaulters’ default fund contributions (including any top-up obligation) are all exhausted.

Proposals include variation margin haircuts, and initial margin haircuts.  Variation margin haircuts would essentially reduce the amount that those owed money on defaulted contracts would receive, thereby mutualizing default losses among “winners.”  Initial margin haircuts would share the losses among both winners and losers.

Given that the “winners” include many hedgers who would have suffered losses on other positions, I’ve always found variation margin haircutting problematic: it would reduce payoffs precisely in those states of the world in which the marginal utility of those payoffs is particularly high.  But that has been the industry’s preferred approach to this problem, though it has definitely not been universally popular, to say the least.  Distributive battles are never popularity contests.

This is where the insurance concept steps in.  The insurers will cover up to $6 to $10 billion in losses (across multiple CCPs) once all other elements of the default waterfall-including non-defaulters’ default fund contributions and CCP equity-are exhausted.  This will sharply limit, and eliminate in all but the most horrific scenarios, the necessity of mutualizing losses among non-clearing members via variation or initial margin haircutting.

Of course this sounds great in concept.  But one thing not discussed in the article is price.  How expensive will the coverage be?  Will CCPs find it sufficiently affordable to buy, or will they decide to haircut margins in some way instead because that is cheaper?

As I say in Matt’s article, although this proposal addresses one big headache regarding CCPs in extremis, it does not address another major concern: the wrong way risk inherent in CCPs.  Losses are likely to hit the default fund in crisis scenarios, which is precisely when the CCP member firms (banks mainly) are least able to take the hit.

It would have been truly interesting if insurers would have been willing to share losses with CCP members.  That would have mitigated the wrong way risk problem.  But the insurers were evidently not willing to do that.   This is likely because they are concerned about the moral hazard problems.  Members would have less incentive to mitigate risk if some of that risk is offloaded onto insurers who don’t influence CCP risk management and margining the way member firms do.

In sum, the insurers are taking on the risk in the extreme tail.  This of course raises the question of whether they are able to bear such risk, as it is likely to crystalize precisely during Armageddon Time. The consortium attempts to allay those concerns by pointing out that they have no derivatives positions (translation: We are not AIG!!!)  But there is still reason to ponder whether these companies will be solvent during the wrenching conditions that will exist when potentially multiple CCPs blow through their entire waterfalls.

Right now this is just a proposal and only the bare outlines have been disclosed.  It will be fascinating to see whether the concept actually sells, or whether CCPs will figure it is cheaper to offload the risk in the extreme tail on their customers rather than on insurance companies in exchange for a premium.

I’m also curious: will Buffett participate.  He’s the tail risk provider of last resort, and his (hypocritical) anti-derivatives rhetoric aside, this seems like it’s right down his alley.

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March 4, 2014

Derivatives Priorities in Bankrutpcy: A Hobson’s Choice?

And now for something completely different . . . finance.  (More Russia/Ukraine later.)

The Bank of England wants to put a stay on derivatives contracts entered into by an insolvent bank, thereby negating some of the priorities in bankruptcy accorded to derivatives counterparties:

he U.K. central bank wants lenders and the International Swaps and Derivatives Association Inc., an industry group, to agree to temporarily halt claims on banks that become insolvent and need intervention, Andrew Gracie, executive director of the BOE’s special resolution unit, said in an interview.

“The entry of a bank into resolution should not in itself be an event of default which allows counterparties to start accelerating contracts and triggering cross-defaults,” Gracie said. “You would get what you saw in Lehmans — huge amounts of uncertainty and an uncontrolled cascade of closeouts and cross defaults in the market.”

The priority status of derivatives trades is problematic at best: although it increases the fraction of the claims that derivatives counterparties receive from a bankrupt bank, this effect is primarily redistributive.  Other creditors receive less.  On the plus side, in the absence of priorities, counterparties could be locked into contracts entered into as hedges that are of uncertain value and which may not pay off for some time.  This complicates the task of replacing the hedge entered into with the bankrupt bank.   On balance, given the redistributive nature of priorities, and the fact that some of those who lose due to the fact that derivatives are privileged may be systemically important or may run, there is something to be said for this change.

But the redistributive nature of priorities makes me skeptical that this will really have that much effect on whether a bank gets into trouble in the first place.  In particular, since runs and liquidity crises are what really threatens the stability of banks, the change of priorities likely will mainly just affect who has the incentive to run on a troubled institution, without affecting all that much the overall probability of a run.

Under the current set of priorities, derivatives counterparties have an incentive to stick longer with a troubled bank, because in the event it becomes insolvent they have a priority claim.  But this makes other claimants on a failing bank more anxious to run, because they know that if the bank does fail derivatives counterparties will get a lion’s share of the remaining assets.  By reducing the advantages that the derivatives couunterparties have, they are more likely to run and pull value from the failing firm, whereas other claimants are less likely to run than under the current regime.  (Duffie’s book on the failure of an OTC derivatives dealer shows how derivatives counterparties can effectively run.)

In other words, in terms of affecting the vulnerability of a bank to a destabilizing run, the choice of priorities is something of a Hobson’s choice.  It affects mainly who has an incentive to run, rather than the likelihood of a run over all.

The BoE’s initiative seems to be symptomatic of something I’ve criticized quite a bit over the past several years: the tendency to view derivatives in isolation.  Triggering of cross-defaults and accelerating contracts is a problem because they can hasten the collapse of a shaky bank.  So fix that, and banks become more stable, right? But maybe not because it changes the behavior and decisions of others who can also bring down a financial institution. This is why I am skeptical that these sorts of changes will affect the stability of banks much one way or the other.  They might affect where a fire breaks out, but not the likelihood of a fire overall.

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January 28, 2014

Were the Biggest Banks Playing Brer Rabbit on the Clearing Mandate, and Was Gensler Brer Fox?

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 10:25 pm

One interesting part of the Cœuré speech was his warning that the clearing business was coming to be dominated by a few large banks, that are members of multiple CCPs:

Moreover, it appears that for many banks, indirect access is their preferred way to get access to clearing services so as to comply with the clearing obligation. Client clearing seems thus to be dominated by a few large global intermediaries. A factor contributing to this concentration may be higher compliance burdens, where only the very largest of firms are capable of taking on cross-border activity. This concentration creates a higher degree of dependency on this small group of firms.

There are also concerns about client access to this limited number of firms offering client clearing services. For example, there is some evidence of clearing firms “cherry picking” clients, while other end-users are commercially unattractive customers and hence unable to access centrally cleared markets.

These are all developments that I believe the international regulatory community may wish to carefully monitor and act on as and when needed.

And wouldn’t you know.  He supports a longstanding SWP theme: That Frankendodd and EMIR and Basel create a huge regulatory burden that is essentially a fixed cost.  This increase in fixed costs raises scale economies, and this inevitably leads to an increase in concentration-and arguably a reduction in competition, in the provision of clearing services.

It now seems rather quaint that there was a debate over whether CCPs should be required to lower the minimum capital threshold for membership to $50 million.  That’s not the barrier to entry/participation.  It’s the regulatory overhead.

It’s actually an old story.  I remember a Maloney and McCormick paper from the 80s-hell, maybe even the late 70s-about the effects of the regulation of particulates in textile factories (if I recall).  The cost of complying with the regulation was essentially fixed, and the law essentially favored big firms and they profited from it.  It raised the costs of their smaller rivals, led to their exit, and resulted in higher prices and the big firms profited.  Similarly, I recall that  several papers by the late Peter Pashigian (a member of my PhD committee) found that environmental regulations favored large firms.

The Cœuré speech suggests this may be happening here: note the part about client access to a “limited number of clearing firms.”

And it’s not just pipsqueaks that are exiting the clearing business.  The largest custodian bank-BNY Mellon-is closing up shop:

More banks are expected to follow BNY Mellon’s lead and pull out of client clearing, as flows have concentrated among half a dozen major players following the roll-out of mandatory clearing in the US last year.

The decision of the world’s largest custodian bank to shutter its US clearing unit was the first real indication of how much institutions are struggling with spiralling costs and complexity associated with clearing clients’ swaps trades – a business once viewed as the cash cow of the new regulatory regime.

You might recall that BNY Mellon was one of the firms that complained loudest about the high capital requirements of becoming a member of ICE Trust and LCH.  Again: it’s not the CCP capital requirements that are the issue.  It’s the other substantial cost of providing client clearing services, and regulatory/compliance costs are a big part of that.

Ah yes, another Gensler argument down in flames.  Remember how he constantly told us-lectured us, actually-that Frankendodd would dramatically increase competition in derivatives?  That it would break the dealer hammerlock on the OTC market?

Remember how I called bull?

Whose call looks better now?  Sometimes I wonder if JP Morgan, Goldman, Barclays, etc., weren’t playing the role of Brer Rabbit, and Gensler was playing Brer Fox. For he done trown dem into dat brer patch, sure ’nuff.

Though it must be said that this was not Gensler’s biggest contribution to reducing competition in derivatives markets in the name of increasing competition.  His insane extraterritoriality decisions have fragmented the OTC derivatives markets, with Europeans reluctant to trade with Americans.  The fragmentation of the markets reduces counterparty choice in both Europe and the US, thereby limiting competition.

This is not just a matter of competition.  There are systemic issues involved as well, and these also make a mockery of the Frankendodd evangelists.  They assured the world that Frankendodd and clearing mandates would reduce reliance on a few large, highly interconnected intermediaries in the derivatives markets. That is proving to be another lie, on the order of “if you like your health plan, you can keep your health plan.”  The old system relied on a baker’s dozen or so large, highly interconnected dealers.  The new system will rely on probably a handful or two large, highly interconnected clearing firms.

The most important elements in the clearing system are a small number of major banks that are clearing members at several global CCPs.  The failure or financial distress of any one of these would wreak havoc in the derivatives markets and the clearing mechanism, just as the failure of a major dealer firm would shake the bilateral OTC markets to the core.

Just think about one issue: portability.  If there are only a small number of huge clearing firms, is it really feasible to port the clients of one of them to the few remaining CMs, especially during times of market stress when these might not have the capital to take on a large number of new clients?

What happens then?

I don’t want to think about it: there’s only so much I can handle.

But Cœuré assures us the regulators are on top of it.  Or at least they are thinking about getting on top of it: “the international regulatory community may wish to carefully monitor and act on as and when needed.”  ”May wish to act as needed.”  Sure. Take your time! What’s the hurry? What’s the worry?

I won’t dwell on the  irony of those who advocated the measures that got us into this situation pulling their chins and telling us this might be a matter of concern, especially since they were deaf to warnings made back when they could have avoided leading us down the path that led us to this oh-so-predictable destination.

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January 26, 2014

Disconnected About Interconnections: Regulators Still Don’t Get the Systemic Risks in Central Clearing

A board member of the ECB, Benoît Cœuré, gave a speech that discussed “the new risks associated with central clearing.” It is evident that Cœuré is a proponent of central clearing, though it is annoying to see him identify multilateral netting as the main benefit (<holds head in hands>).  But it is good to see yet again that central bankers are aware that central clearing does create new risks, and that regulators must be proactive in addressing them.

The problem is that he overlooks the most important risks.  Reading between the lines, like most regulators, Cœuré focuses on the solvency risks of CCPs, and about policy tools that can limit the probability of CCP insolvency and mitigate the adverse impacts of such an insolvency.

But as I’ve written repeatedly in the past, it’s not the insolvency risk per se that should keep people up at night.  Indeed, the measures taken to address the solvency risk can actually exacerbate the real risk a dramatic expansion of central clearing creates for the financial system: liquidity risk.

Liquidity crises are what threaten to bring down financial systems.  For most financial institutions, there is a connection between liquidity risk and solvency: banks become illiquid because (in a world of imperfect information) people believe they might become insolvent.  Maturity mismatches plus imperfect information plus possibility of insolvency combine to create liquidity crises.

CCPs don’t have the maturity mismatches, and they aren’t leveraged.  They cannot experience liquidity crises in the same way banks can.  The direct liquidity risk of CCPs is related to their ability to turn collateral into cash in the event of a member default.

But as I’ve said over and over, clearing affects the needs for liquidity by market participants.  Central clearing can be a source of, or accelerant of, liquidity crises.  Big price moves lead to big margin calls lead to spikes in liquidity demand. These are most likely to occur during periods of financial stress, and can greatly exacerbate that stress.  Moreover, failure of a CCP is most likely to occur due to the inability of traders to fund margin calls due to the shortage of liquidity.   This old article by Andrew Brimmer discusses two episodes I’ve analyzed on several occasions-the Hunts in silver and Black Monday-and shows how it is liquidity/credit/funding of margin calls for CCPs that can create stresses in the financial system.

This is where the systemic risk of clearing arises.  But the subject is totally absent from Cœuré’s speech.  Which is worrisome.

There is also the fallacy of composition problem.  The measures that Cœuré advocates to make CCPs stronger do NOT necessarily make the system stronger.  Strengthening CCPs can actually exacerbate the liquidity problems that clearing causes during a crisis.  The CCP may survive, due to these measures, but the stresses communicated to the rest of the system (and the stress has to go somewhere) can cause other institutions to fail.

This is what scares the bejeezus out of me.  Regulators don’t seem to get the fallacy of composition, and aren’t focused on the liquidity implications of greatly expanded central clearing.

These fears are heightened by reading this DTCC report about collateral and collateral management.

It contains this heading that should make every central banker and financial regulator soil his armor:

Margin Call activity to increase By up to 1000%

Then there’s this:

Operational Capabilities and Settlement Exceptions Management: The potential ten-fold increase in margin call volumes, and the resulting complexity due to market changes, could overwhelm the current operational processes and system infra-structures within banks, buy-side firms and their administrators. As a result, firms will need to invest in technology and also reengineer the settlement, exceptions management and dispute resolution processes in place today. According to a 2011 De- loitte paper, investments in operations required to build and sustain advanced collateral capabilities is estimated at upwards of $50 million annually for top-tier banks.

Be afraid.  Be very, very, very afraid.

The dramatic increase in the scope of clearing substantially increases the operational complexity of the system.  More importantly, it increases the system’s operational rigidity, because cash has to flow quickly, and according to a very precise schedule.  From client to FCM to CCP to FCM to client.  Any failures in that chain can bring down the entire system.

I say again.  Systemic risk in financial systems is largely due to the fact that these systems are tightly coupled.  Clearing increases tight coupling.  This almost certainly increases systemic risk.

More players have to move more money in more jurisdictions as a result of clearing mandates.  As the DTCC report makes plain, this is a new responsibility for many of these players, and they do not have the capability or experience or systems.  Greater operational complexity involving more parties, many of whom are relatively inexperienced, creates grave risks in a tightly coupled financial system.

The irony of all this is that the evangelists of clearing, including notably Timmy! and GiGi in the US, argued that central clearing would reduce the interconnectedness of the financial markets.  Wrong. Wrong. Wrong. Wrong.

It reconfigures the interconnections.  The entire collateral management system the DTCC document describes is a dense web of interconnections.  And to reiterate: under central clearing (and the mandate to margin and mark-to-market uncleared derivatives) these connections (couplings) are tighter than in the old system.  Both old and new systems are highly interconnected.  The connections in the new system are tighter, and are more vulnerable to failure as a result.

I’ll tell you what makes me have to go change my armor: the regulators seem oblivious to this.  To the extent they are focused on collateral, they are focused on initial margin. No! It is variation margin calls during periods of large market movements that will threaten the stability of the system. Now there will be more such calls–1000 pct more, according to DTCC–and more participants are involved, meaning that there are more links and nodes.  The tightly coupled nature of the system means that the breakdown of a few links can bring down the entire thing.

In other words, there seems to be a disconnect on interconnections, most specifically on how clearing has not reduced interconnections but reshaped them, and how the new system’s interconnections are much more rigid, tightly coupled, and time-sensitive.

Not to pick on Cœuré: his speech is just one example of that disconnect.  The thing is that most speeches by regulators and central bankers exhibit the same disconnect.  Target fixation on making CCPs invulnerable does not address the main systemic risk that an expansion of clearing creates.  That systemic risk involves the financial/funding and operational risks of meeting large margin calls in a stressed environment on a precise time schedule.

It’s about liquidity, liquidity, liquidity.  Clearing transforms credit/solvency risk into liquidity risk.  The operational aspects of clearing-the need to move cash and collateral around in large amounts on a tight time schedule-affects the demand for liquidity, and also create points of failure that can cause the liquidity mechanism to seize up, threatening the entire system.

This is what should be the focus, but I’m seeing precious little evidence that it is.  Someday we’ll pay the price.

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January 13, 2014

What is the World Coming To, When SWP Shares Headlines With the Dodd of Frankendodd?

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 7:08 pm

Risk Magazine’s annual review issue includes a set of short contributions on the progress that has been made on the G-20 OTC derivative reforms.  (If you run into paywall problems: there are ways.  There are ways.)  The contribution by yours truly is under the category Academics (plural) even though I am the only academic in the piece.  I guess I count for double, or something.
But that’s not the best part.  The best part is the headline:

Progress and peril: Davie, Dodd, Maijoor, Pirrong and more on the G-20 reforms.

Sharing top billing with Chris Dodd!  What is the world coming to?  I guess it could be better (or worse): it could have been Barney.  Or Gary.  Or Bart.

To spare you having to scroll through all of the contributions by politicians, lawyers and people who actually work in these markets, here’s my two cents:

When the Dodd-Frank Act was passed, I thought the Sef mandate was its worst part. It has nothing to do with the act’s ostensible purpose – reducing systemic risk – and imposes a one-size-fits-all model for trading swaps that will likely decrease the efficiency of the market. The made-available-for-trade provision of the Sef rule merits the title ‘worst of the worst’. This says if a Sef applies to the CFTC to trade a particular type of swap, and it approves the application, all trading of that type of swap must occur on a Sef. This turns the ordinary competitive process on its head. In most markets, a firm introduces new products, and if it is desirable to consumers, it sells. If the product is flawed, it doesn’t. Under this rule, a firm that introduces a flawed execution method imposes this bad choice on all consumers.

The CFTC could prevent such a perverse outcome by not approving an application. However, the agency’s animus to the traditional dealer-centric trading model and its fetish for transparency means the CFTC sets very low standards for approval. It also demonstrates the CFTC’s bizarre interpretation of cost-benefit analysis: it considers only the trivial cost of filing an application, and totally ignores the massive costs that would result if traders are forced to execute in an inefficient way.

Swap market participants and transactions are diverse. There is no execution model to fit all – counterparties themselves are best placed to determine how to execute their trades. Sef mandates already constrain choice, and made-available-for-trade puts the execution decision in the hands of third parties whose interests are not aligned with those actually trading. Given the size of these markets, if the untried Sefs don’t work as hoped – even for a modest subset of traders – the dislocations and inefficiencies will be immense.

The Risk editors chopped my last line, which was: “I fear that the epitaph of the OTC swap market will be: ‘Died of a Theory.’”  (A line lifted from Jefferson Davis’s epitaph on the Confederacy.)  The Theory, of course, is that traditional means of executing OTC derivatives trades are flawed, if not evil, and that Gary Knows Best in imposing a simulacrum of a centralized, order driven market that has worked well for futures on swaps, which are different in many ways.

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December 24, 2013

Neanderthals Have Rights Too!

Filed under: Commodities,Economics,Financial crisis,Politics,Russia — The Professor @ 2:55 pm

Whenever I see a picture of Rusal CEO Oleg Deripaska, I know that Neanderthals still walk the earth.  This particular Neanderthal is in serious financial difficulties these days.  When Rusal IPOd about four years ago, it was priced at HK$10.20/share, and it’s been all downhill since.  The stock is now trading for about 75 percent less, at HK$2.32.  Rusal is levered up to the wazoo, and Deripaska has other pressing obligations, including construction projects at Sochi  made at Putin’s insistence which will almost certainly be huge white elephants.

The main reason for My Favorite Neanderthal’s financial distress is the depressed price of aluminum, which is down by about a third in the past three years.  For a smelter like Rusal, the only saving grace is the high premium of cash aluminum over the prices of metal in LME warehouses.  That premium is inflated by a bottleneck at LME warehouses like Goldman Sachs’s Metro in Detroit.  If that bottleneck is widened, the huge stocks accumulated during the financial crisis will make their way onto the market, crushing premiums and bringing down the price that Rusal (and Alcoa and Chinalco) get for their production.  This would probably be enough to put Rusal and Deripaska over the brink.

Stung by intense criticism, the LME has announced rule changes intended to loosen the bottleneck.  The mooted rule changes are a mortal threat to Deripaska, so he’s suing in London.  This is not surprising, because Deripaska has nothing to lose.

What is somewhat surprising is the specific claim that Rusal/Deripaska are making:

“Rusal has alleged that the consultation conducted by LME was unfair and procedurally flawed, that the LME’s changes to its warehousing policy are irrational and disproportionate, and that Rusal’s human rights have thereby been breached,” Hong Kong Exchange and Clearing, also known as HKEx, said in a news release. [Emphasis added.]

Human rights.  What a riot.  I know that many Russians have sued in European courts claiming that their human rights have been violated by the Russian government.  In 2012, there were over 22000(!) such claims filed in the European Court of Human Rights, which I believe is the largest total for any country.  The Court rejects virtually all these claims, but still enough proceed to make Russia consider invalidating the Court’s decisions.  (Ironically, this story appears today.  Merry Christmas!)

So I guess Rusal is playing turnabout is fair play.  Good luck with that, Oleg. Methinks the LME will prevail, cash aluminum premiums will fall $75/$80 per tonne or so, and Rusal will soon be staring bankruptcy in the face.  And maybe Neanderthals will become extinct after all.  Financially, anyways.

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December 15, 2013

Frankendodd Shifts Risk Around, Rather Than Making It Disappear! Who Knew?

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 5:20 pm

According to one of my industry contacts, this article in the Fiscal Times has “created a lot of unwanted buzz” in DC.  Because our betters find it so very inconvenient when reality intrudes on their fantasies.

The article focuses on the clearing mandate.  It points out that the main effect of the mandate is to shift risk around, and concentrate it in CCPs.  The risk doesn’t go away.  It moves.

Let me think.  Who was pointing this out five years ago?  Modesty prevents me from naming names.

Clearing was sold-most notably by my bêtes noire Geithner and Gensler*-as a magic box that made counterparty risk disappear.  This was a false claim, and arguably a dishonest one.  I find it hard to believe that Gensler, for instance, really believed what he said.  And the alternatives are ugly.  He (and other advocates of the clearing mandate) either made arguments he (they) knew to be untrue, or was (were) utterly ignorant of the implications of the policies that he (they) was (were) implementing and supporting.  Choices: (A) Idiot. (B) Liar. (C) There is no choice (C).

In reality, clearing mainly shifts around counterparty risk, and creates new risks, most notably liquidity risks.

All of these things were foreseeable, and foreseen-by some. Who were ignored, and at times reviled.

Why did this happen? It seems to me that in the heated days of the crisis, there was a desperation to find a solution.  For a variety of reasons, most notably the fact that the major cleared markets dealt with the Lehman situation without much problem, policymakers seized on clearing as the panacea.  And once they had done that, getting the clearing mandate passed became an end in itself.  The decision had been made, all doubts had to be suppressed.

But where does that leave us? With the growing recognition that the alleged panacea was nothing of the sort.  With the creeping recognition that the mandate has created a new set of risks.  A new set of potential sources of systemic instability.  So now policymakers are scrambling to address and to mitigate these problems.

It would have been so much better had these problems been anticipated, in advance, and the law drafted accordingly.

This is not Monday morning quarterbacking. I and others anticipated these problems at noon on Sunday.  But we were left on the sidelines, while the geniuses called and ran the plays. We are going to be dealing with the consequences of that for years to come.

*One blessedly departed from government “service”, and the other blessedly about to do so.

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November 27, 2013

Some of Cassandra’s (AKA SWP’s) Warnings on Clearing Begin to Take Hold

Filed under: Clearing,Derivatives,Financial crisis,Regulation — The Professor @ 9:49 pm

I’ve been hammering on the theme of the systemic risks of central clearing-especially mandated central clearing-for around five years.  And now those concerns are being expressed with greater frequency.  Fed Governor Jerome Powell gave a speech focusing on the most straightforward source of systemic risk in mandated clearing: the concentration of risk in the clearinghouse, which becomes a single point of failure whose collapse could jeopardize the broader financial system.   Bernanke made a similar argument a couple of years back.

Some articles from the last several days highlight more subtle, but in my view more important, concerns.  This Reuters piece mentions several things I’ve focused on over the years: the strains that clearing can put on the liquidity of individual firms, and the system at large; margin pro-cyclicality;  and crucially, the fact that self-preserving actions taken by CCPs may have destabilizing effects elsewhere in the financial system.

This last point demonstrates a danger in the Powell approach which focuses on making CCPs invulnerable, which I’ve referred to as the levee effect.  Just as making the levee higher at one point does not reduce flooding risk throughout a river system, but redistributes it, strengthening a CCP can redistribute shocks elsewhere in the system in a highly destabilizing way.  CCP managers focus on CCP survival, not on the survival of the entire system, and this is quite dangerous when as is almost certainly the case, their decisions have external effects.  Indeed, greater reliance on CCPs increases the tightness of the coupling of the financial system, which can be highly problematic under stressed conditions.  Liquidity and funding are the primary channels by which CCP decisions will have external effects on the broader financial markets.

These considerations are related to a broader point, which is that CCPs are merely parts, albeit important ones, of a broader financial system, and they must be evaluated in the context of the entire system.  An article in the International Financing Review by Christopher Whittall provides another illustration of this, again related to liquidity.  He notes that Basel III’s leverage ratio clashes with the tremendous thirst of CCPs for liquidity:

“The move towards central clearing creates a focus on how to fund margin requirements, which should dictate an increase in repo activity from banks. The problem is repo becomes very unappealing for banks under the leverage ratio.”

So sayeth the head of fixed income at a major bank.  CCPs create tremendous funding needs, and particularly contingent funding needs that are especially large in stressed conditions when liquidity is hard to come by.  These needs are hard enough to address in the absence of a leverage ratio, but as the fixed income guy notes, this is an even bigger problem when it is present.  As he says: “Viewed as a whole, we can start to start to see how these different regulations don’t quite hang together from a macro-prudential perspective.”

Exactly.  Illustrating another theme: Regulatory responses to the crisis have tended to focus on the individual pieces with too little attention paid to how regulations of one piece affect the other pieces.  The interaction between the leverage ratio and clearing mandates is a particularly worrisome example.  In any complex system, it is the interaction between interconnected pieces of the system that can lead to abrupt collapses.  Making each piece of the system more robust doesn’t necessarily make the system more robust.  Indeed, the opposite can be true.

Yes, I’ve been a Cassandra on these issues.  So in some sense, it’s good to see that the concerns that prompted my prophesies are now getting more widespread attention.  But methinks that the post-crisis regulatory juggernaut is impossible to reverse, and that although some of the problems in clearing and the interactions between clearing and other aspects of financial regulation can be ameliorated, the basic sources of systemic risk inherent in the new financial and regulatory structure will persist.

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November 22, 2013

All Pain, No Gain: The CFTC’s Rule on CCP Qualifying Liquid Resources

Matt Leising had a nice article a few days back about the CFTC’s rule that does not treat US Treasury securities as “qualifying” liquid resources for CCPs.  Instead, under new regulation 33-33 they must obtain “prearranged and highly reliable funding.” Based on Fed rules, this means that a CCP must get  committed line of credit from banks.   This imposes a substantial cost on CCPs, because under new Basel III rules, committed lines impose a large capital charge on the issuing banks.  For purposes of calculating capital, the banks have to assume that the lines are fully drawn.  This capital cost will be passed onto CCPs.

It is ironic that outgoing (resisting the great urge to snark) Chairman Gary Gensler repeatedly argued that one of the main benefits of the Frankendodd clearing mandate is that it would reduce the interconnectedness of the financial markets, especially interconnectedness through derivatives contracts.  Now he has pushed through a regulation that mandates an interconnection among major financial institutions via a derivatives channel: the lines connect derivatives CCPs to major banks.   I have long pointed out that Gensler’s claim that clearing would reduce interconnectedness was grossly exaggerated, and arguably deceptive.  Instead, I pointed out that the mandate would reconfigure-and is reconfiguring-the topology of the network of connections between financial firms.  What the CFTC has done is dictate what that form of interconnection will be.  This particular dictate is extremely problematic.

A CCP needs access to liquidity in the event of a default of a clearing member.  The CCP needs to pay obligations to the winning side of the market, in cash, in a very tight time window.  Failing to make these variation margin payments could impose financial distress on those expecting the cash inflow, and more disturbingly, call into question the solvency of the clearinghouse.  This could spark a run in which parties try to close positions in order to reduce exposure to the CCP.  Given that this is likely to occur in highly unsettled market conditions, such fire sales (and purchases) will inevitably inject substantial additional volatility into price that can exacerbate pressures on the clearing mechanism.

A CCP holding Treasuries posted as IM by the defaulting CM can sell them to raise the cash.  Alternatively, it could repo them out.  During most periods of financial turbulence-and financial crisis-which is likely to be either the cause or effect of the default of one or more large CMs, there is a “flight to quality” and Treasury security prices rise and there is a rush to buy them by investors seeking a safe haven.  Moreover, under such circumstances the Fed will perform its lender of last resort function, and readily accept Treasuries as collateral: even if CCPs could not access the Fed directly*, they could access it indirectly.   Thus, in “normal” crises, Treasuries should be highly liquid, and a ready source of cash that can be used to meet variation margin obligations.

Put differently, from a liquidity perspective, Treasuries are a negative beta asset: they become more liquid when overall market liquidity declines-or verges on collapse.  This is a highly desirable attribute.  Another way to characterize it is that from a liquidity perspective, Treasuries have right way risk.

Bank lines are very different.  Banks become stressed during crisis situations, and face a higher risk of being unable to perform on credit lines under these circumstances.  (Indeed, what if the defaulter is one of the suppliers of a committed line?) Banks fighting for survival but which can perform might try to evade this performance during stressed market conditions, which in a tightly coupled system (and clearing is a source of tight coupling) can be extremely disruptive: a few minutes delay in performing could cause a huge problem.  And if the banks do perform, doing so poses the substantial risk of increasing their risk of financial distress.  That is, committed lines are positive beta from a liquidity perspective: that is, they pose wrong way risks.   If drawn upon, these lines can be an interconnection that is a source of contagion from a derivatives default to systemically important banks, precisely at the time that they are least able to withstand the shock.

In the event, a CCP that does collect Treasuries as IM can likely use these right way assets to raise the cash need to meet its obligations, and can avoid drawing down on its committed line.  But that would mean that the committed line is superfluous, and imposes unnecessary costs on the CCP, and hence on the users of the clearing system.

I also conjecture that having met its liquidity requirements with a committed line, pursuant to the CFTC reg, CCPs would  have a weaker incentive to take Treasuries as collateral, and a stronger incentive to permit the posting of lower quality assets (or incentivizing such posting by reducing haircuts assessed to such collateral) for IM. This would mitigate the cost impact to users that results from the CCP having to secure the committed line, and pay for it (the cost being passed onto the users), thereby reducing the loss of trading/clearing volume and the associated revenues.  This would increase the odds that the line will be drawn on (because the lower quality assets pose a substantial risk of becoming illiquid during a crisis situation-they embed wrong way risk too).  I’ll have to think this through more, because the situation is somewhat complex: it depends on the pricing of the line, which will depend on the likelihood it will be drawn against, and the market conditions at the time it is.  This will depend in part on the quality of collateral that the CCP collects.  I’m not sure of what the equilibrium outcome will be, but I suspect that mandating the obtaining of lines will undermine incentives to demand the posting of high quality collateral.  If it does, this is a bad outcome that increases wrong way and systemic risks.  If it doesn’t, then the cost of the lines is superfluous and a burden on clearing and derivatives trading.

There is one scenario in which Treasuries would not be good collateral: if the financial crisis (and default of a CM or CMs) was the result of a fiscal crisis in the US, or a default (real or technical)  of the kind feared during the last (but the last, most likely) debt ceiling standoff.  But that’s an Armageddon scenario in which banks are likely to be highly stressed and unable to perform, or in which they would incur exceptional and arguably existential costs if they did.  Put differently, there’s likely no good source of liquidity in this scenario, and the CFTC rule will hardly make a difference.

In sum, it is highly unlikely that bank lines are a better source of liquidity, especially under crisis situations, than Treasuries.  Indeed, they are plausibly worse, and actually create an interconnection that can transmit a shock to the derivatives market (and the CCP that clears it) to systemically important banks: this is the exact opposite of what clearing was supposed to achieve. The cost of the lines, which is likely to be substantial, particularly given their necessary size, is a deadweight burden on the markets: all pain, no gain.

Other than that, the rule is great.  And a fitting parting shot from Gensler.

* Frankendodd makes it difficult for US CCPs to obtain Fed liquidity support.  This is a serious mistake that could come back to haunt us in some future crisis.  To work effectively, the LOLR must be able to direct liquidity to where it’s needed,  quickly and efficiently.  CCPs could be a major source of liquidity demand in future crises, which makes isolating them from the Fed highly dangerous, and the invitation to an ad hoc response in some future crisis.

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