cheap genric cialis buy viagra online canada buy viagra mexico buy cheap generic cialis compare prices cialis professional canadian healthcare cialis viagra and cream get cialis cialis no prescription approved viagra buy generic cialis generic cialis us cialis sales

Streetwise Professor

October 19, 2014

It *Was* Too Quiet Out There

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

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

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

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

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

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

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

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

So it turns out it was too quiet out there.

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

Print Friendly

October 13, 2014

You Might Have Read This Somewhere Before. Like Here.

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

Where have I read that before?

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

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

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

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

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

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

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

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

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

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

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

Print Friendly

September 29, 2014

McNamara on Pirrong & Clearing: Serious, Fair, But Ultimately Unpersuasive

Stephen Lubben passed along this paper on central clearing mandates to me. It would only be a modest overstatement to say that it is primarily a rebuttal to me. At the very least, I am the representative agent of the anti-clearing mandate crowd (and a very small crowd it is!) in Steven McNamara’s critique of opposition to clearing mandates.

McNamara’s arguments are fair, and respectfully presented. He criticizes my work, but in an oddly complimentary way.

I consider it something of a victory that he feels that it’s necessary to go outside of economics, and to appeal to Rawlsian Political Theory and Rawls’s Theory of Justice to counter my criticisms of clearing mandates.

There are actually some points of commonality between McNamara and me, which he fairly acknowledges. Specifically, we both emphasize the incredible complexity of the financial markets generally, and the derivatives markets in particular. Despite this commonality, we reach diametrically opposed conclusions.

Where I think McNamara is off-base is that he thinks I don’t pay adequate attention to the costs of financial crises and systemic risk. I firmly disagree. I definitely am very cognizant of these costs, and support measures to control them. My position is that CCPs do not necessarily reduce systemic risk, and may increase it. I’ve written several papers on that very issue. The fact that I believe that freely chosen clearing arrangements are more efficient than mandated ones in “peacetime” (i.e., normal, non-crisis periods) (something McNamara focuses on) only strengthens my doubts about the prudence of mandates.

McNamara addresses some of the arguments I make about systemic risk  in his paper, but it does not cite my most recent article that sets them out in a more comprehensive way.  (Here’s an ungated working paper version: the final version is only slightly different.) Consequently, he does not address some of my arguments, and gets some wrong: at least, in my opinion, he doesn’t come close to rebutting them.

Consider, for instance, my argument about multilateral netting. Netting gives derivatives priority in bankruptcy. This means that derivatives counterparties are less likely to run and thereby bring down a major financial institution. McNamara emphasizes this, and claims that this is actually a point in favor of mandating clearing (and the consequent multilateral netting). My take is far more equivocal: the reordering of priorities makes other claimants more likely to run, and on balance, it’s not clear whether multilateral netting  reduces systemic risk. I point to the example of money market funds that invested in Lehman corporate paper. There were runs on MMFs when they broke the buck. Multilateral netting of derivatives would make such runs more likely by reducing the value of this corporate paper (due to its lower position in the bankruptcy queue). Not at all clear how this cuts.

McNamara mentions my concerns about collateral transformation services, and gives them some credence, but not quite enough in my view.

He views mutualization of risk as a good thing, and doesn’t address my mutualization is like CDO trenching point (which means that default funds load up on systemic/systematic risk). Given his emphasis on the risks associated with interconnections, I don’t think he pays sufficient concern to the fact that default funds are a source of interconnection, especially during times of crisis.

Most importantly, although he does discuss some of my analysis of margins, he doesn’t address my biggest systemic risk concern: the tight coupling and liquidity strains that variation margining creates during crises. This is also an important source of interconnection in financial markets.

I have long acknowledged-and McNamara acknowledges my acknowledgement-that we can’t have any great certainty about how whether clearing mandates will increase or reduce systemic risk. I have argued that the arguments that it will reduce it are unpersuasive, and often flatly wrong, but are made confidently nonetheless: hence the “bill of goods” title of my clearing and systemic risk paper (which the editor of JFMI found provocative/tendentious, but which I insisted on retaining).

From this “radical” uncertainty, arguing in a Rawlsian vein, McNamara argues that regulation is the right approach, given the huge costs of a systemic crisis, and especially their devastating impact on the least among us. But this presumes that the clearing mandate will have its intended effect of reducing this risk. My point is that this presumption is wholly unfounded, and that on balance, systemic risks are likely to increase as the result of a mandate, especially (and perhaps paradoxically) given the widespread confidence among regulators that clearing will reduce it.

McNamara identifies me has a hard core utilitarian, but that’s not quite right. Yes, I think I have decent formal economics chops, but I bring a Hayekian eye to this problem. Specifically, I believe that in a complex, emergent system like the financial markets (and derivatives are just a piece of that complex emergent system), top down, engineered, one-size-fits-all solutions are the true sources of system risk. (In fairness, I have made this argument most frequently here on the blog, rather than my more formal writings, so I understand if McNamara isn’t aware of it.) Attempts to design such systems usually result in major unintended consequences, many of them quite nasty. In some of my first remarks on clearing mandates at a public forum (a Columbia Law School event in 2009), I quoted Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

I’ve used the analogy of the Sorcerer’s Apprentice to make this point before, and I think it is apt. Those intending to “fix” something can unleash forces they don’t understand, with devastating consequences.

At the end of his piece, McNamara makes another Rawlsian argument, a political one. Derivatives dealer banks are too big, to politically influential, corrupt the regulatory process, and exacerbate income inequality. Anything that reduces their size and influence is therefore beneficial. As McNamara puts it: clearing mandates are “therefore a roundabout way to achieve a reduction in their status as ‘Too Big to Fail,’ and also their economic and political influence.”

But as I’ve written often on the blog, this hope is chimerical. Regulation tends to create large fixed costs, which tends to increase scale economies and therefore lead to greater concentration. That clearly appears to be the case with clearing members, and post-Frankendodd there’s little evidence that the regulations have reduced the dominance of big banks and TBTF. Moreover, more expansive regulation actually increases the incentive to exercise political influence, so color me skeptical that Dodd-Frank will contribute anything to the cleaning of the Augean Stables of the American political system. I would bet the exact opposite, actually.

So to sum up, I am flattered but unpersuaded by Steven McNamara’s serious, evenhanded, and thorough effort to rebut my arguments against clearing mandates, and to justify them on the merits. Whether it is on “utilitarian” (i.e., economic) or Rawlsian grounds, I continue to believe that arguments and evidence weigh heavily against clearing mandates as prudent policy.  But I am game to continue the debate, and Steve McNamara has proved himself to be a worthy opponent, and a gentleman to boot.

Print Friendly

September 8, 2014

Cleaning Up After the Dodd, Frank & Gensler Circus

A lot of CFTC news lately. Much of it involves the agency, under new chairman Timothy Massad, dealing with the consequences of Frankendodd and the overzealous efforts of his predecessor Gary Gensler to implement it.

One of Massad’s priorities relates to clearinghouses (CCPs):

CFTC Chairman Timothy Massad said in a Sept. 5 interview that his agency will bolster examinations of clearinghouses, which process trillions of dollars in transactions and are potentially vulnerable to market shocks or cyber attacks. The agency is working with the Federal Reserve on the effort, he said.

New rules requiring banks and other firms to use clearinghouses owned by LCH.Clearnet Group Ltd., CME Group Inc. (CME) and Intercontinental Exchange Inc. (ICE) have been “a great thing” and have helped regulators “monitor and mitigate risks, but it doesn’t eliminate risk,” according to Massad.

“We’ve got to be very focused on the health of clearinghouses,” he said.

It’s nice to see that the CFTC, as well as prudential regulators, recognize that CCPs are of vital systemic importance. But as I’ve said many times, on four continents: In a complex, interconnected financial system, making CCPs less likely to default  does not necessarily increase the safety of the financial system. Making one part of the system safer does not make the system safer. It can prevent one Armageddon scenario, but increase the likelihood of others.

Gensler babbled repeatedly about the clearing mandate reducing the interconnectedness of the financial system. In fact, it just reconfigures the interconnections. The very measures that are intended to ensure CCPs get paid what they are owed even in periods of crisis can redirect crushing stresses to other vulnerable parts of the financial system. CCPs may end up standing, surrounded by the rubble of the rest of the financial system.

CCPs are deeply enmeshed in a complex web of credit and payment relationships. Mechanisms intended to reduce CCP credit exposure-multilateral netting, high initial margins, rigorous variation margining-feed back into other parts of that web.

There are so many interconnected parts. Today Risk ran an article about how LCH relies heavily on two settlement banks, JPM and Citi. Although LCH will not confirm it, it appears that these two banks process  about 85 percent of the payments between clearing members and LCH. This process involves the extension of intraday credit. This creates exposures for these two big SIFIs, and makes the LCH’s viability dependent on the health of these two banks: if one of them went down, this could cause extreme difficulties for LCH and for the clearing members. That is, OTC derivatives clearing adds a new way in which the financial system’s health and stability depend on the health of big banks, and creates new risks that can jeopardize the health of the big banks.

So much for eliminating interconnectedness, Gary. It’s just been moved around, and not necessarily in a good way.

Again, mitigating systemic risk requires taking a systemic perspective. The fallacy of composition is a major danger, and a very alluring one. The idea that the system gets safer when you make a major part of it safer is just plain wrong. The system is more than just the sum of its parts. Moreover, it can actually be the case that making one part of the system stronger, but more rigid, as clearing arguably does, makes the system more vulnerable to catastrophic failure. Or at least creates new ways that it can fail.

Another issue on Massad’s plate is addressing the conflict between his agency and Europe on giving regulatory approval to each other’s CCPs. It looks like this issue will not get resolved by the drop dead date in December. This will result in substantially higher costs (primarily in the form of higher capital requirements and higher margins), the fragmentation of OTC derivatives markets, and greater counterparty concentration (as US firms avoid European CCPs and vice versa).

The CFTC is also trying to fix its fundamentally flawed position limit proposal, and particularly the defective, overly restrictive, and at times clueless hedging exemptions. Mencken defined Puritanism as “The haunting fear that someone, somewhere, may be happy.” The CFTC’s hedging exemption, as currently constituted, reflects a sort of financial Puritanism: “The haunting fear that someone, somewhere, may be speculating.” To avoid this dread possibility, the exemptions are so narrow that they eliminate some very reasonable risk management strategies, such as using gas forwards to hedge electricity price exposures.

This has caused an uproar among end users, including firms like Cargill that have been hedging since the end of the freaking Civil War. Perhaps their survival suggests they might know something about the subject.

In the “be careful what you ask for” category, the CFTC is wrestling with a very predictable consequence of one of its decisions. In an attempt to wall off the US from major shocks originating overseas, the Gensler CFTC adopted rules that would have subjected foreign firms dealing with foreign affiliates of US banks to US regulations if the parents provided guarantees for those affiliates. Foreign firms definitely didn’t want to be subjected to the tender mercies of the CFTC and Frankendodd regs. So to maintain this business, the parents stripped away the guarantees.

Problem solved, right? The elimination of the guarantee would eliminate a major potential channel of contagion between the dodgy furriners and the US financial system, right? That was the point, right?

Apparently not. The CFTC has major agida over this:

Timothy Massad, the new CFTC chairman, said in an interview he is concerned aboutrecent moves by several large Wall Street firms to sidestep CFTC oversight by changing the terms of some swap agreements made by foreign affiliates.

“The concern has always been that activity that takes place abroad can result in the importation of risk into the U.S.,” Mr. Massad said. He said there is a concern that a U.S. bank’s foreign losses would ultimately find their way to U.S. shores, infecting the parent company in possibly destabilizing ways.

. . . .

The moves mean any liability for those swaps lies solely with the offshore operation, which the banks have said will protect the U.S. parent from contagion. Yet without that tie to the U.S. parent, the contracts won’t fall under U.S. jurisdiction and so won’t be subject to strict rules set by the 2010 Dodd-Frank financial-overhaul law, including requirements that contracts historically traded over the telephone be traded publicly on U.S. electronic platforms [i.e., the SEF mandate].

By de-guaranteeing, the US banks have eliminated the most direct channel of contagion from over there to over here. But apparently the CFTC is worried that unless its regulations are followed overseas, there will be other, albeit more indirect, backdoors into the US.

In essence, then, the CFTC believes its regulations are by far superior to those in Europe and elsewhere, and that unless its regulations are implemented everywhere, the US is at risk.

Not too arrogant, eh?

A few observations should make you question this arrogance, and in a  big way.

First, note that the most likely effect of the CFTC getting its way of exporting its regulations into any transaction and any entity involving any affiliate of a US financial institution is that foreign entities will just avoid dealing with any such affiliate. This will balkanize the global derivatives market: ‘mericans will deal with ‘mericans, and Euros with Euros, and never the twain shall meet. This will likely result in greater counterparty concentration. Such developments would create systemic vulnerabilities, and even though the direct counterparty credit channel could not bring that risk back to US banks, the myriad other connections between foreign banks and American ones would.

Second, note the last sentence of the quoted paragraph: “including requirements that contracts historically traded over the telephone be traded publicly on U.S. electronic platforms.” So apparently attempts to avoid the SEF mandate infuriate the CFTC. But the SEF mandate has nothing to do with systemic risk. For this reason, and others, I named this mandate “The Worst of Frankendodd.” But so intent is the CFTC on pursuing this systemically irrelevant unicorn that it is questioning moves by US banks that actually reduce their exposure to problems in foreign markets.

Timothy Massad has the unwelcome task of cleaning up after the elephant parade at the Dodd, Frank & Gensler Circus. Clearing mandates, coordinating with overseas regulators, position limits, and the elimination of affiliate guarantees are only some of the things that he has to clean up. I hope he’s got a big shovel and a lot of patience.

 

Print Friendly

July 30, 2014

ISDA Should Stay Its Hand, Not Derivatives In Bankruptcy

Filed under: Derivatives,Economics,Financial crisis,Regulation — The Professor @ 8:39 pm

I’ve been meaning to write about how derivatives are treated in bankruptcy, but it’s a big topic and I haven’t been able to get my hands around it. But this article from Bloomberg merits some comment, because it suggests that market participants, led by ISDA, are moving to a partial change that could make things worse if the bankruptcy code treatment of derivatives remains the same.

Derivatives benefit from a variety of “safe harbors” in bankruptcy. They are treated very differently than other financial contracts. If a firm goes bankrupt, its derivatives counterparties can offset winning against losing trades, and determine a net amount. In contrast, with normal debts, such offsets are not permitted, and the bankruptcy trustee can “cherry pick” by not performing on losing contracts and insisting on performance on winning ones. Derivatives counterparties can immediately access the collateral posted by a bankrupt counterparty. Other secured debtors do not have immediate access to collateral. Derivatives counterparties are not subject to preference or fraudulent conveyance rules: the bankruptcy trustee can claw back cash taken out of a firm up to 90 days prior to its bankruptcy, except in the case of cash taken by derivatives (and repo) counterparties. Derivatives counterparties can immediately terminate their trades upon the bankruptcy of a trading partner, collect collateral to cover the bankrupt’s obligations, and become an unsecured creditor on the remainder.

It is this ability to terminate and grab collateral that proved so devastating to Lehman in 2008. Cash is a vital asset for a financial firm, and any chance Lehman had to survive or be reorganized disappeared with the cash that went out the door when derivatives were terminated and collateral seized. It is this problem that ISDA is trying to fix, by writing a temporary stay on the ability of derivatives counterparties to terminate derivatives contracts of a failed firm into standard derivatives contract terms.

That sounds wonderful, until you go back to previous steps in the game tree. The new contract term affects the calculations of derivatives counterparties before a tottering firm actually declares bankruptcy. Indeed, as long as preference/fraudulent conveyance safe harbor remains, the new rule actually increases the incentives of the derivatives counterparties to run on a financially distressed, but not yet bankrupt, firm. This increases the likelihood that a distressed firm actually fails.

The logic is this. If the counterparties keep their positions open until the firm is bankrupt, the stay prevents them from terminating their positions, and they are at the mercy of the resolution authority. They are at risk of not being able to get their collateral immediately. However, if they use some of the methods that Duffie describes in How Big Banks Fail, derivatives counterparties can reduce their exposures to the distressed firm before it declares bankruptcy, and crucially, get their hands on their collateral without having to worry about a stay, or having the money clawed back as a preference or fraudulent conveyance.

Thus, staying derivatives in a bankrupt firm, but retaining the safe harbor from preference/fraudulent conveyance claims, gives derivatives counterparties an incentive to run earlier. Under the contracts with the stay, they are in a weaker position if they wait until a formal insolvency than they are under the current way of doing business. They therefore are more likely to run early if derivatives are stayed.

This means that this unbalanced change in the terms of derivatives contracts actually increases the likelihood that a financial firm with a large derivatives book will implode due to a run by its counterparties. The stay may make things better conditional on being in bankruptcy, but increase the likelihood that a firm will default. This is almost certainly a bad trade-off. We want rules that reduce the likelihood of runs. This combination of contract terms and bankruptcy rules increases the likelihood of runs.

This illustrates the dangers of piecemeal changes to complex financial systems. Strengthening one part can make the entire system more vulnerable to failure. Changing one part effects how the other parts work, and not always for the better.

Rather than fixing single parts one at a time, it is essential to recognize the interdependencies between the pieces. The bankruptcy rules have a lot of interdependencies. Indeed, the rules on preferences/fraudulent conveyance are necessary precisely because of the perverse incentives that would exist prior to bankruptcy if claims are stayed in bankruptcy, but creditors can get their money out of a firm before bankruptcy. Stays alone can make things worse if the behavior of creditors prior to a formal filing is not constrained. All the pieces have to fit together.

The Bloomberg article notes that the international nature of the derivatives business complicates the job of devising a comprehensive treatment of derivatives in bankruptcy: harmonizing bankruptcy laws across many countries is a nightmare. But the inability to change the entire set of derivatives-related bankruptcy rules doesn’t mean that fixing one aspect of them by a contractual change makes things better. It can actually make things worse.  It is highly likely that imposing a stay in bankruptcy, but leaving the rest of the safe harbors intact, will do exactly that.

ISDA appears to want to address in the worst way the problems that derivatives can cause in bankruptcy. And unfortunately, it just might succeed. ISDA should stay its hand, and not derivatives in bankruptcy, unless other parts of the bankruptcy code are adjusted in response to the new contract term.

Print Friendly

July 25, 2014

Benchmark Blues

Pricing benchmarks have been one of the casualties of the financial crisis. Not because the benchmarks-like Libor, Platts’ Brent window, ISDA Fix, the Reuters FX window or the gold fix-contributed in an material way to the crisis. Instead, the post-crisis scrutiny of the financial sector turned over a lot of rocks, and among the vermin crawling underneath were abuses of benchmarks.

Every major benchmark has fallen under deep suspicion, and has been the subject of regulatory action or class action lawsuits. Generalizations are difficult because every benchmark has its own problems. It is sort of like what Tolstoy said about unhappy families: every flawed benchmark is flawed in its own way. Some, like Libor, are vulnerable to abuse because they are constructed from the estimates/reports of interested parties. Others, like the precious metals fixes, are problematic due to a lack of transparency and limited participation. Declining production and large parcel sizes bedevil Brent.

But some basic conclusions can be drawn.

First-and this should have been apparent in the immediate aftermath of the natural gas price reporting scandals of the early-2000s-benchmarks based on the reports of self-interested parties, rather than actual transactions, are fundamentally flawed. In my energy derivatives class I tell the story of AEP, which the government discovered kept a file called “Bogus IFERC.xls” (IFERC being an abbreviation for Inside Ferc, the main price reporting publication for gas and electricity) that included thousands of fake transactions that the utility reported to Platts.

Second, and somewhat depressingly, although benchmarks based on actual transactions are preferable to those based on reports, in many markets the number of transactions is small. Even if transactors do not attempt to manipulate, the limited number of transactions tends to inject some noise into the benchmark value. What’s more, benchmarks based on a small number of transactions can be influenced by a single trade or a small number of trades, thereby creating the potential for manipulation.

I refer to this as the bricks without straw problem. Just like the Jews in Egypt were confounded by Pharoh’s command to make bricks without straw, modern market participants are stymied in their attempts to create benchmarks without trades. This is a major problem in some big markets, notably Libor (where there are few interbank unsecured loans) and Brent (where large parcel sizes and declining Brent production mean that there are relatively few trades: Platts has attempted to address this problem by expanding the eligible cargoes to include Ekofisk, Oseberg, and Forties, and some baroque adjustments based on CFD and spread trades and monthly forward trades). This problem is not amenable to an easy fix.

Third, and perhaps even more depressingly, even transaction-based benchmarks derived from markets with a decent amount of trading activity are vulnerable to manipulation, and the incentive to manipulate is strong. Some changes can be made to mitigate these problems, but they can’t be eliminated through benchmark design alone. Some deterrence mechanism is necessary.

The precious metals fixes provide a good example of this. The silver and gold fixes have historically been based on transactions prices from an auction that Walras would recognize. But participation was limited, and some participants had the market power and the incentive to use it, and have evidently pushed prices to benefit related positions. For instance, in the recent allegation against Barclays, the bank could trade in sufficient volume to move the fix price sufficiently to benefit related positions in digital options. When there is a large enough amount of derivatives positions with payoffs tied to a benchmark, someone has the incentive to manipulate that benchmark, and many have the market power to carry out those manipulations.

The problems with the precious metals fixes have led to their redesign: a new silver fix method has been established and will go into effect next month, and the gold fix will be modified, probably along similar lines. The silver fix will replace the old telephone auction that operated via a few members trading on their own account and representing customer orders with a more transparent electronic auction operated by CME and Reuters. This will address some of the problems with the old fix. In particular, it will reduce the information advantage that the fixing dealers had that allowed them to trade profitably on other markets (e.g.,. gold futures and OTC forwards and options) based on the order flow information they could observe during the auction. Now everyone will be able to observe the auction via a screen, and will be less vulnerable to being picked off in other markets. It is unlikely, however, that the new mechanism will mitigate the market power problem. Big trades will move markets in the new auction, and firms with positions that have payoffs that depend on the auction price may have an incentive to make those big trades to advantage those positions.

Along these lines, it is important to note that many liquid and deep futures markets have been plagued by “bang the close” problems. For instance, Amaranth traded large volumes in the settlement period of expiring natural gas futures during three months of 2006 in order to move prices in ways that benefited its OTC swaps positions. The CFTC recently settled with the trading firm Optiver that allegedly banged the close in crude, gasoline, and heating oil in March, 2007. These are all liquid and deep markets, but are still vulnerable to “bullying” (as one Optiver trader characterized it) by large traders.

The incentives to cause an artificial price for any major benchmark will always exist, because one of the main purposes of benchmarks is to provide a mechanisms for determining cash flows for derivatives. The benchmark-derivatives market situation resembles an inverted pyramid, with large amounts cash flows from derivatives trades resting on a relatively small number of spot transactions used to set the benchmark value.

One way to try to ameliorate this problem is to expand the number of transactions at the point of the pyramid by expanding the window of time over which transactions are collected for the purpose of calculating the benchmark value: this has been suggested for the Platts Brent market, and for the FX fix. A couple of remarks. First, although this would tend to mitigate market power, it may not be sufficient to eliminate the problem: Amaranth manipulated a price that was based on a VWAP over a relatively long 30 minute interval. In contrast, in the Moore case (a manipulation case involving platinum and palladium brought by the CFTC) and Optiver, the windows were only two minutes long. Second, there are some disadvantages of widening the window. Some market participants prefer a benchmark that reflects a snapshot of the market at a point in time, rather than an average over a period of time. This is why Platts vociferously resists calls to extend the duration of its pricing window. There is a tradeoff in sources of noise. A short window is more affected by the larger sampling error inherent in the smaller number of transactions that occurs in a shorter interval, and the noise resulting from greater susceptibility to manipulation when a benchmark is based on smaller number of trades. However, an average taken over a time interval is a noisy estimate of the price at any point of time during that interval due to the random fluctuations in the “true” price driven by information flow. I’ve done some numerical experiments, and either the sampling error/manipulation noise has to be pretty large, or the volatility of the “true” price must be pretty low for it to be desirable to move to a longer interval.

Other suggestions include encouraging diversity in benchmarks. The other FSB-the Financial Stability Board-recommends this. Darrel Duffie and Jeremy Stein lay out the case here (which is a lot easier read than the 750+ pages of the longer FSB report).

Color me skeptical. Duffie and Stein recognize that the market has a tendency to concentrate on a single benchmark. It is easier to get into and out of positions in a contract which is similar to what everyone else is trading. This leads to what Duffie and Stein call “the agglomeration effect,” which I would refer to as a “tipping” effect: the market tends to tip to a single benchmark. This is what happened in Libor. Diversity is therefore unlikely in equilibrium, and the benchmark that survives is likely to be susceptible to either manipulation, or the bricks without straw problem.

Of course not all potential benchmarks are equally susceptible. So it would be good if market participants coordinated on the best of the possible alternatives. As Duffie and Stein note, there is no guarantee that this will be the case. This brings to mind the as yet unresolved debate over standard setting generally, in which some argue that the market’s choice of VHS over the allegedly superior Betamax technology, or the dominance of QWERTY over the purportedly better Dvorak keyboard (or Word vs. Word Perfect) demonstrate that the selection of a standard by a market process routinely results in a suboptimal outcome, but where others (notably Stan Lebowitz and Stephen Margolis) argue that  these stories of market failure are fairy tales that do not comport with the actual histories. So the relevance of the “bad standard (benchmark) market failure” is very much an open question.

Darrel and Jeremy suggest that a wise government can make things better:

This is where national policy makers come in. By speaking publicly about the advantages of reform — or, if necessary, by using their power to regulate — they can guide markets in the desired direction. In financial benchmarks as in tap water, markets might not reach the best solution on their own.

Putting aside whether government regulators are indeed so wise in their judgments, there is  the issue of how “better” is measured. Put differently: governments may desire a different direction than market participants.

Take one of the suggestions that Duffie and Stein raise as an alternative to Libor: short term Treasuries. It is almost certainly true that there is more straw in the Treasury markets than in any other rates market. Thus, a Treasury bill-based benchmark is likely to be less susceptible to manipulation than any other market. (Though not immune altogether, as the Pimco episode in June ’05 10 Year T-notes, the squeezes in the long bond in the mid-to-late-80s, the Salomon 2 year squeeze in 92, and the chronic specialness in some Treasury issues prove.)

But that’s not of much help if the non-manipulated benchmark is not representative of the rates that market participants want to hedge. Indeed, when swap markets started in the mid-80s, many contracts used Treasury rates to set the floating leg. But the basis between Treasury rates, and the rates at which banks borrowed and lent, was fairly variable. So a Treasury-based swap contract had more basis risk than Libor-based contracts. This is precisely why the market moved to Libor, and when the tipping process was done, Libor was the dominant benchmark not just for derivatives but floating rate loans, mortgages, etc.

Thus, there may be a trade-off between basis risk and susceptibility to manipulation (or to noise arising from sampling error due to a small number of transactions or averaging over a wide time window). Manipulation can lead to basis risk, but it can be smaller than the basis risk arising from a quality mismatch (e.g., a credit risk mismatch between default risk-free Treasury rates and a defaultable rate that private borrowers pay). I would wager that regulators would prefer a standard that is less subject to manipulation, even if it has more basis risk, because they don’t internalize the costs associated with basis risk. Market participants may have a very different opinion. Therefore, the “desired direction” may depend very much on whom you ask.

Putting all this together, I conclude we live in a fallen world. There is no benchmark Eden. Benchmark problems are likely to be chronic for the foreseeable future. And beyond. Some improvements are definitely possible, but benchmarks will always be subject to abuse. Their very source of utility-that they are a visible price that can be used to determine payoffs on vast sums of other contracts-always provides a temptation to manipulate.

Moving to transactions-based mechanisms eliminates outright lying as a manipulation strategy, but it does not eliminate the the potential for market power abuses. The benchmarks that would be least vulnerable to market power abuses are not necessarily the ones that best reflect the exposures that market participants face.

Thus, we cannot depend on benchmark design alone to address manipulation problems. The means, motive, and opportunity to manipulate even transactions-based benchmarks will endure. This means that reducing the frequency of manipulation requires some sort of deterrence mechanism, either through government action (as in the Libor, Optiver, Moore, and Amaranth cases) or private litigation (examples of which include all the aforementioned cases, plus some more, like Brent).  It will not be possible to “solve” the benchmark problems by designing better mechanisms, then riding off into the sunset like the Lone Ranger. Our work here will never be done, Kimo Sabe.*

* Stream of consciousness/biographical detail of the day. The phrase “Kimo Sabe” was immortalized by Jay Silverheels-Tonto in the original Lone Ranger TV series. My GGGGF, Abel Sherman, was slain and scalped by an Indian warrior named Silverheels during the Indian War in Ohio in 1794. Silverheels made the mistake of bragging about his feat to a group of lumbermen, who just happened to include Abel’s son. Silverheels was found dead on a trail in the woods the next day, shot through the heart. Abel (a Revolutionary War vet) was reputedly the last white man slain by Indians in Washington County, OH. His tombstone is on display in the Campus Martius museum in Marietta. The carving on the headstone is very un-PC. It reads:

Here lyes the body of Abel Sherman who fell by the hand of the Savage on the 15th of August 1794, and in the 50th year of  his age.

Here’s a picture of it:

OLYMPUS DIGITAL CAMERA

The stream by which Abel was killed is still known as Dead Run, or Dead Man’s Run.

Print Friendly

July 1, 2014

What Gary Gensler, the Igor of Frankendodd, Hath Wrought

I’ve spent quite a bit of time in Europe lately, and this gives a rather interesting perspective on US derivatives regulatory policy. (I’m in London now for Camp Alphaville.)

Specifically, on the efforts of Frankdodd’s Igor, Gary Gensler, to make US regulation extraterritorial (read: imperialist).

Things came to a head when the head of the CFTC’s Clearing and Risk  division, Ananda K. Radhakrishnan, said that ICE and LCH, both of which clear US-traded futures contracts out of the UK, could avoid cross-border issues arising from inconsistencies between EU and US regulation (relating mainly to collateral segregation rules) by moving to the US:

Striking a marked contrast with European regulators calling for a collaborative cross-border approach to regulation, a senior CFTC official said he was “tired” of providing exemptions, referring in particular to discrepancies between the US Dodd-Frank framework and the European Market Infrastructure Regulation on clearing futures and the protection of related client collateral.

“To me, the first response cannot be: ‘CFTC, you’ve got to provide an exemption’,” said Ananda Radhakrishnan, the director of the clearing and risk division at the CFTC.

Radhakrishnan singled out LCH.Clearnet and the InterContinental Exchange as two firms affected by the inconsistent regulatory frameworks on listed derivatives as a result of clearing US business through European-based derivatives clearing organisations (DCOs).

“ICE and LCH have a choice. They both have clearing organisations in the United States. If they move the clearing of these futures contracts… back to a US only DCO I believe this conflict doesn’t exist,” said Radhakrishnan.

“These two entities can engage in some self-help. If they do that, neither [regulator] will have to provide an exemption.”

It was not just what he said, but how he said it. The “I’m tired” rhetoric, and his general mien, was quite grating to Europeans.

The issue is whether the US will accept EU clearing rules as equivalent, and whether the EU will reciprocate. Things are pressing, because there is a December deadline for the EU to recognize US CCPs as equivalent. If this doesn’t happen, European banks that use a US CCP (e.g., Barclays holding a Eurodollar futures position cleared through the CME) will face a substantially increased capital charge on the cleared positions.

Right now there is a huge game of chicken going on between the EU and the US. In response to what Europe views as US obduracy, the Europeans approved five Asian/Australasian CCPs as operating under rules equivalent to Europe’s, allowing European banks to clear though them without incurring the punitive capital charges. To emphasize the point, the EU’s head of financial services, Michael Barnier, said the US could get the same treatment if it deferred to EU rules (something which Radhakrishnan basically said he was tired of talking about):

“If the CFTC also gives effective equivalence to third country CCPs, deferring to strong and rigorous rules in jurisdictions such as the EU, we will be able to adopt equivalence decisions very soon,” Barnier said.

Read this as a giant one finger salute from the EU to the CFTC.

So we have a Mexican standoff, and the clock is ticking. If the EU and the US don’t resolve matters, the world derivatives markets will become even more fragmented. This will make them less competitive, which is cruelly ironic given that one of Gensler’s claims was that his regulatory agenda would make the markets more competitive. This was predictably wrong-and some predicted this unintended perverse outcome.

Another part of Gensler’s agenda was to extend US regulatory reach to entities operating overseas whose failure could threaten US financial institutions. One of his major criteria for identifying such entities was whether they are guaranteed by a US institution. Those who are so guaranteed are considered “US persons,” and hence subject to the entire panoply of Frankendodd requirements, including notably the SEF mandate. The SEF mandate is loathed by European corporates, so this would further fragment the swaps market. (And as I have said often before, since end users are the alleged beneficiaries of the SEF mandate-Gary oft’ told us so!-it is passing strange that they are hell-bent on escaping it.)

European US bank affiliates with guarantees from US parents have responded by terminating the guarantees. Problem solved, right? The dreaded guarantees that could spread contagion from Europe to the US are gone, after all.

But US regulators and legislators view this as a means of evading Frankendodd. Which illustrates the insanity of it all. The SEF mandate has nothing to do with systemic risk or contagion. Since the ostensible purpose of the DFA was to reduce systemic risk, it was totally unnecessary to include the SEF mandate. But in its wisdom, the US Congress did, and Igor pursued this mandate with relish.

The attempts to dictate the mode of trade execution even by entities that cannot directly spread contagion to the US via guarantees epitomizes the overreach of the US. Any coherent systemic risk rationale is totally absent. The mode of execution is of no systemic importance. The elimination of guarantees eliminates the ability of failing foreign affiliates to impact directly US financial institutions. If anything, the US should be happy, because some of the dread interconnections that Igor Gensler inveighed against have been severed.

But the only logic that matters her is that of control. And the US and the Europeans are fighting over control. The ultimate outcome will be a more fragmented, less competitive, and likely less robust financial system.

This is just one of the things that Gensler hath wrought. I could go on. And in the future I will.

Print Friendly

June 18, 2014

The Klearing Kool Aid Hangover

Back in Houston after a long trip to Turkey, France, Switzerland, and the Netherlands speaking about various commodity and clearing related issues, plus some R&R. Last stop on the tour was Chicago, where the Chicago Fed put on a great event on Law and Finance. Clearing was at the center of the discussion. Trying to be objective as possible, I think I can say that my critiques of clearing have had an influence on how scholars and practitioners (both groups being well-represented in Chicago) view clearing, and clearing mandates in particular. There is a deep  skepticism, and a growing awareness that CCPs are not the systemic risk safeguard that most had believed in the period surrounding the adoption of Frankendodd. Ruben Lee’s lunch talk summarized the skeptical view well, and recognized my role in making the skeptic’s case. His remarks were echoed by others at the workshop. If only this had penetrated the skulls of legislators and regulators when it could have made a major difference.

And the hits keep on coming. Since about April 2010 in particular, the focus of my criticism of clearing mandates has been on the destabilizing effects of rigid marking-to-market and variation margin by CCPs. I emphasized this in several SWP posts, and also my forthcoming article (in the Journal of Financial Market Infrastructure, a Risk publication) titled “A Bill of Goods.” So it was gratifying to read today that two scholars at the LSE, Ron Anderson and Karin Joeveer, used my analysis as the springboard for a more formal analysis of the issue.

The Anderson-Joeveer paper investigates collateral generally. It concludes that the liquidity implications of increased need for initial margin resulting from clearing mandates are not as concerning as the liquidity implications of greater variation margin flows that will result from a dramatic expansion of clearing.

Some of their conclusions are worth quoting in detail:

In addition, our analysis shows that moving toward central clearing with product specialized CCPs can greatly increase the numbers of margin movements which will place greater demands on a participant’s operational capacity and liquidity. This can be interpreted as tipping the balance of benefits and costs in favor of retaining bilateral OTC markets for a wider range of products and participants. Alternatively, assuming a full commitment to centralized clearing, it points out the importance of achieving consolidation and effective integration across infrastructures for a wider range of financial products. [Emphasis added.]

Furthermore:

A system relying principally on centralized clearing to mitigate counter-party risks creates increased demand for liquidity to service frequent margin calls. This can be met by opening up larger liquidity facilities, but indirectly this requires more collateral. To economize on the use of collateral, agents will try to limit liquidity usage, but this implies increased frequency of margin calls. This increases operational risks faced by CCPs which, given the concentration of risk in CCPs, raises the possibility that an idiosyncratic event could spill over into a system-wide event.

We have emphasized that collateral is only one of the tools used to control and manage credit risk. The notion that greater reliance on collateral will eliminate credit risk is illusory. Changing patterns in the use of collateral may not eliminate risk, but it will have implications for who will bear risks and on the costs of shifting risks. [Emphasis added.]

The G-20 stampede to impose clearing focused obsessively on counterparty credit risk, and ignored liquidity issues altogether. The effects of clearing on counterparty risk are vastly overstated (because the risk is mainly shifted, rather than reduced) and the liquidity effects have first-order systemic implications. Moving to a system which could increase margin flows by a factor of 10 (as estimated by Anderson-Joeveer), and which does so by increasing the tightness of the coupling of the system, is extremely worrisome. There will be large increases in the demand for liquidity in stressed market conditions that cause liquidity to dry up. Failures to get this liquidity in a timely fashion can cause the entire tightly-coupled system to break down.

As Ruben pointed out in his talk, the clearing stampede was based on superficial analysis and intended to achieve a political objective, namely, the desire to be seen as doing something. Pretty much everyone in DC and Brussels drank the Klearing Kool Aid, and now we are suffering the consequences.

Samuel Johnson said “Marry in haste, repent at leisure.” The same thing can be said of legislation and regulation.

Print Friendly

June 6, 2014

A Model Solution?

Filed under: Economics,Financial crisis,Regulation — The Professor @ 5:55 am

Europe and the US have diverged in significant ways on post-crisis financial regulation. This has had myriad consequences, including fragmentation of liquidity (especially in the swaps market), which in turn leads to less competition as it is harder for US banks to compete for the business of European clients and vice versa; greater cost; and greater complexity.

One area where there was some prospect of a unified global framework was capital rules for banks, where it was hoped that the US would adopt Basel III. But evidently the Fed is resisting that, and will move forward with its own stress test-based framework, rather than the Basel III framework which permits banks to utilize their own models to evaluate risk and hence capital.

Not that Basel III is perfect, by any means, but this approach creates the problems mentioned above, plus some more in the bargain. One is mentioned in the article: a one-model-fits all approach creates a monoculture problem that is vulnerable to catastrophic failure. I wrote about this problem quite a bit in 2009.

There is another problem as well. Although the stress test has some merits as a way of periodically evaluating capital adequacy, it  is not immediately clear how banks can evaluate the capital implications of particular transactions on a day-to-day basis in this system. If you can’t do that, you can’t price deals right or make capital allocation decisions. This is especially true if the details of the Fed model are kept secret, as will almost certainly be the case.

If you have a Basel III compliant capital model you can calculate the impact on capital due to an incremental change in a portfolio, and can hence price deals rationally and structure portfolios to achieve capital efficiency. This will be harder to do in a black-box stress test model. Not impossible but not easy either.

Print Friendly

May 19, 2014

Deja Dit: Clearing My Spindle on . . . Clearing

Filed under: Clearing,Financial crisis,Politics,Regulation — The Professor @ 7:47 pm

Several clearing related stories, each of which gives me a sense of deja vu. Or deja dit, to be more accurate.

The Bank of England just released a paper warning about the potential pro-cyclicality of CCP initial margin methodologies. I have expressed concern about this for some time.

BofE expresses concern that pro-cyclicality threatens to cause a measure intended to reduce credit risk create liquidity risk instead. This is another Clearing Cassandra theme. (Speaking of Cassandra, I will be returning to the old stomping grounds of Troy next week. And I don’t mean a city in upstate NY.)

BofE recommends that CCPs make public their margin methodologies, something that sends the clearinghouses into paroxysms of rage. But it makes sense to do that. And not just to reveal to the marketplace the potential liquidity demands that these methodologies can create, thereby allowing them to prepare accordingly. But to permit clearing participants to estimate their exposure to CCPs.

Clearing member exposure to CCPs depends on the likelihood that initial margins are sufficient to cover losses. Estimation of this exposure requires CMs to be able to evaluate margin calculations under a variety of market scenarios. If CCPs keep their methodologies secret, this is not possible. Discriminating choice among CCPs also requires market participants to understand margin costs and exposure under different scenarios. Such choice is not possible if CCPs keep secret their calculations.

CCPs are the beneficiaries of clearing mandates. Due to margin spirals and other feedback effects, margin calculations have external effects. There is therefore a strong efficiency case favoring disclosure to mitigate the externality, and any commercial/competitive inconvenience CCPs suffer as a result is more than compensated for by the fact that government mandates force huge quantities of business their way.

Another story that has come to my attention is that RBS is cutting back its rate clearing business, in large part due to the substantial capital commitment required, and the operational overhead.

This is another long-time SWP theme. The regulatory burdens of being a clearing member create scale economies that will result-and is resulting-in substantial consolidation of the clearing business. Thus, the systemic risks associated with clearing arise not only because of concentration of risk in CCPs, but in concentration of risks in a dwindling number of clearing firms who participate in multiple CCPs. Concentration of risks in a small number of CMs is, in my view, actually more systemically worrisome than concentration of risks in a small number of CCPs. Indeed, it is precisely the concentration of risks in CMs that makes failure of a systemically important CCP more likely.

Recall the good old days, when Gensler fought to reduce the minimum capital requirement for CMs to $25 million in order to spur competition in the supply of clearing services? Good times, good times. Little did he recognize that the other myriad burdens of Franendodd and Emir would inevitably lead to consolidation, making the minimum capital requirement irrelevant.

But this was only one of Gensler’s delusions (or was it lies?) about clearing. I was therefore pleased, and admittedly somewhat shocked, to see his (interim) replacement, Mark Wetjen, (implicitly) call bull on Gensler’s Panglossian propaganda on clearing:

He made an interesting and refreshingly blunt departure from the superseded Gensler script, by referring to Clearing Houses as potential sources of systemic risk.

“A clearinghouse’s failure to adhere to rigorous risk management practices established by the Commission’s regulations, now more than ever, could have significant economic consequences.”

His predecessor’s evangelical belief in CCPs as universal risk-mitigants, refused to countenance the heresy that central clearing may at best merely transfer credit risk, and may actually result in concentration of and increase in systemic risk. Fundamentalism should have no place in regulation, especially the more fundamental reforms; Wetjen’s implied recognition that a central pillar of the Dodd-Frank reforms is open for objective discussion, represents an important and consequential change in the Agency’s culture and governance.

That last part is the opinion of Nick Railton-Edwards (a somewhat Pythonesque handle, eh?), who wrote the piece, rather than Wetjen. (He sounds like a like-minded, not to say right-minded, bloke.) But it is a realistic characterization of the implications of Wetjen’s remarks. I would add that this evangelism is exactly what I hammered Gensler for repeatedly in 2009-2013: Indeed, I repeatedly used the term evangelist to refer to Gensler and his allies. (And that hammering is why he banned me from the CFTC building-something that I have on unimpeachable authority.)

The sad thing about all this is that all of these things were foreseeable before legislators and regulators* went all in on clearing as The Solution. Certain Cassandras did foresee it. But now this is where we are, and some adults like the BofE and Wetjen are trying to mitigate the dangers that this rash and thoughtless plunge created.

Would that this had occurred at the front end of the process rather than the back. Better late than never, perhaps. But better early than late.

*Timmah! was Gensler’s partner in crime on this. Geithner has just released his memoirs, and is flogging the book. I will give him another flogging in due course. For old times’ sake.

Print Friendly

Next Page »

Powered by WordPress