Streetwise Professor

HSBC’s Gary Dunn said something at the ISDA AGM that I think is very important:

Dunn pointed out the risk characteristics of a CCP are very similar to that of collateralised debt obligations, the tranched credit products that were prevalent in the run-up to the 2008 financial crisis.

In the CCPs default waterfall, the initial margin payments from clients and default fund contributions from clearing members are comparable to the equity or first loss and mezzanine tranches of a CDO. In other words, these are the first sources of funds that get eaten into to cover any losses.

According to Dunn, the super senior tranche (which in the case of CDOs tended to attract Triple A ratings, but often subsequently sustained losses during the credit crisis) is the additional steps the clearing house might take when all other funds are exhausted, whether it is haircutting, asking for more capitalisation from clearing members of possibly even a government bailout.

“If you start modelling the risks of a CCP as a CDO, you realise the correlation risks in a CCP aren’t at the moment fully appreciated, very much like they weren’t when we had CDOs and CDO squareds,” said Dunn.

“The probability of a CCP failing is still relatively low, but there is a reasonable probability that people or banks lose money even if a CCP doesn’t fail,” he added.

I can hear you saying: “Where have I read that before?”  Or: “When have you said that before?”  In January, 2011, now that you ask

Let’s see how this relates to CCPs, and in particular to the default funds of CCPs that are the ultimate backstop of cleared contracts.  Default funds are analogous to protection written on supersenior tranches.  The collateral (margin) that firms must post to CCPs when they hold derivatives positions absorbs most of the losses due to movements in market prices.  Indeed, margins are usually set to absorb 95-99 percent of market moves.  Beyond margin, CCPs often have their own financial resources to cover the losses associated with the default of any member firm not covered by margin.  If the margin and CCP-resource elements of the CCP “waterfall” (note the similarity of terminology used to describe tranched structures and CCPs) are breached, then the members must absorb the remaining default losses, up to some pre-established commitment level.

This means that CCP members must cover defaults only in extreme circumstances, just like writers of protection on supersenior tranches must cover defaults only under extreme circumstances.  Indeed, the oft-touted features of CCPs, such as collateralization create the seniority/out-of-the-moneyness that gives rise to wrong way risk if the pre-requisite dependencies also exist.

So it seems that CCPs are potentially vulnerable to wrong way risk.  They are effectively financial structures of a type that can, given the right (or wrong, depending on your perspective) dependence, give rise to a serious wrong way risk problem.  Which raises the question: are the dangerous dependencies likely to be present?  That is, are the contributors to a CCP default fund likely to be in bad financial straits just when their contributions are needed to absorb default losses? Are those that are insuring default losses (through mutualization) likely to be in dodgy condition precisely when they are most likely to have to pay off on that insurance?

This is a big deal. Wrong way risk is particularly poisonous, and a source of systemic risk in systemically important institutions like big CCPs. Policymakers have been largely oblivious to this very important problem.  I’ve been on about it for over two years, but we see how that matters.  Maybe if people like Gary Dunn start raising the alarm this issue will get the attention it deserves.

But, of course, Anat Admati, etc., will dismiss this as self-interested scaremongering by banks, and will criticize me as being some sort of tool (which she has, by the way).

I understand perfectly that such self-interested scaremongering occurs.  But I also understand that sometimes there is a wolf.  This is one of those times.

Pre-Crisis, there was very little academic writing on clearing.  Post-Crisis, with questions about the role of derivatives in creating systemic risk, and the mandating of clearing of derivatives as a means of mitigating this problem, this is changing.  This is a good thing, but unfortunately, this burgeoning academic literature is at risk of irrelevance, and worse, of being misleading, because the theoretical models of clearing are nothing like clearing as it actually is.  These models tend to focus on the mutualization of risk within CCPs.  That’s important, but as I’ll discuss in more detail below, mutualization is not the most important feature of CCPs.  Collateralization is.

I’ll just talk about a couple of papers in detail, Adam Zawadowski’s Entangled Financial Systems in the most recent RFS, and Clearing, Counterparty Risk, and Aggregate Risk by Biais, Heider, and Hoerova.

These papers have some important insights, and I don’t want to seem overly critical.  I just want to persuade scholars that the focus of these papers, and many others, is misdirected, and to suggest where they should direct their attention.

“Entangled Financial Systems” presents a model of the periodic collapse of the financial system through the channel of inter-bank derivatives exposures.  The paper is rough sledding, in part because it tackles a complicated issue, and in part because the exposition and especially the proofs are hardly paragons of clarity: I have my doubts about some of the proofs.  That said, the story is a plausible one.  Banks use fragile capital structures (short maturity debt to fund long-lived assets) to solve an agency problem.  They use derivatives to manage risk in order to protect non-pledgeable income.  Banks are at risk of blowing up due to an idiosyncratic, exogenous shock: perhaps an operational risk, like a rogue trader.  If a bank blows up, its counterparties don’t get paid in full on their derivatives.  If these counterparties don’t insure against this risk, they may fail, and so on, with the result being a daisy chain of failures.  Thus, one idiosyncratic failure can lead to the collapse of the entire system.

In the model, the original risk of a blowup is idiosyncratic and insurable.  But in equilibrium, banks don’t buy insurance against a counterparty failing because they don’t internalize the impact of their failure on their other counterparties.  Thus, there is a “market failure”: the system blows up periodically because it is privately efficient but socially inefficient not to buy counterparty insurance.

One crucial issue with the paper is that most things are, laudably, endogenized, but one crucial thing is not: each bank can trade with only two counterparties located adjacently on a circle.  The choice of counterparties is exogenously specified. This concentration of counterparty exposure is crucial in making the system vulnerable to collapse.

Zawadowski recognizes that greater diversification of exposures across counterparties reduces the fragility of the system.  Although the externality may induce insufficient diversification across counterparties (because the systemic benefits of this aren’t internalized), market participants in reality have a variety of reasons to spread their trades across many counterparties.  Meaning that real financial systems may be less fragile than in the model, with its exogenously imposed concentration of exposures.

I’m also skeptical that an idiosyncratic risk at a single institution can bring down the entire financial system.  Look at some of the rogue trader losses-Kerviel at SocGen, Adoboli at UBS.  These guys cost their banks billions-but even such huge losses didn’t lead to a financial system meltdown via any channel, including a derivatives channel.  Instead, the 2007-2008 Crisis was related to a systemic shock-a decline in US real estate prices-that hit multiple financial institutions and investors.  It’s hard to identify an actual episode where the channel analyzed in the model-an idiosyncratic shock at a single financial institution-led to a financial meltdown.  The idiosyncratic nature of the risk is important: that’s what makes the risk insurable.  The paper therefore has little to say about non-insurable risks.

Where does clearing come in?  In the paper, clearing is a form of counterparty insurance.  Mandating clearing internalizes the externality.

There are several problems here.  The first is that in the model, counterparty insurance is supplied by a continuum of investors who can diversify away the risk.  A CCP in theory can also diversify the idiosyncratic risk by mutualizing it.  But note that CCPs are voluntary cooperative arrangements among financial institutions.  If there is a gain from collective action-internalizing the externality through cooperation-why don’t financial institutions voluntarily cooperate to form CCPs?   (Though in the context of the model, sharing the risk among financial institutions is more costly than passing the risk to investors.  Still, there is a collective benefit from cooperation among the financial institutions.)  Such cooperation increases joint wealth: why don’t market participants cooperate to internalize the externality?  What stands in the way of consummating such mutually beneficial bargains?   Moreover, why does it happen in some markets, not in others?

But the mutualization issue generally is the bigger problem, and the root of my qualms about the developing literature on CCPs.  Most of the models, including the Biais et al paper, formalize CCPs as a mutual risk sharing/insurance mechanism.  (Hell, I’ve done that myself.)

But mutualization is only one of the functions of CCPs As We Know Them.  Indeed, I am increasingly leaning to the view that it is the most problematic of their functions.

CCPs operate on the “defaulter pays” principle.  That is, real world CCPs attempt to choose margins (collateral) and default fund contributions so that they almost always cover a defaulter’s losses, and that non-defaulters’ default fund contributions are seldom used to make good a defaulter’s losses.  That is, default funds are tapped-and risk mutualized-only in rare, and arguably extreme, situations.

Put differently, only tail risk is mutualized in real world CCPs, and the primary function of CCPs is to set margins so that default losses are NOT mutualized, except in extreme circumstances.  CCPs are like monoline insurance of supersenior positions well down on the default waterfall.

In the context of the _ paper, this is particularly problematic, as he shows that collateralization is an inefficient way to address the externality problem.  It ties up valuable resources that could be used to fund positive NPV projects.   This is just one problem with collateral: the “initial margin problem”, if you will.  There’s also the variation margin problem that I’ve written about over the years.

I consider the tail-risk mutualization aspect of CCPs highly problematic because of the wrong way risk problem.  Like super-senior tranches of a CDO, losses hit the default fund during systemic episodes when those exposed to the default fund (the members of the CCP) are under stress.

This all means that the academic literature, which is modeling CCPs as mutual insurers, has two big problems.

The first problem is one of positive economics.  Existing models are not able to predict (a) why clearinghouses form, and (b) why they are primarily mechanisms to net and collateralize exposures, and only mutualize extreme risks.  They do not predict why market participants sometimes cooperate to implement a “defaulter pays” model, and sometimes don’t-and why they have never implemented a fully mutualized insurance scheme.

We need models that help us understand why market participants sometimes cooperate to implement a defaulter pays mechanism, supplemented by mutualization of the extreme risks; why they sometimes don’t; and why they never fully mutualize.  That is, we need to understand why so few risks are mutualized, even when market participants choose to form CCPs.

With all due modesty, I think the answers will will be found in my original analysis from the 90s: that the usual bugbears of insurance-adverse selection and moral hazard-make it uneconomically costly to mutualize risk, and that these problems also make centralized/delegated setting of collateral levels more costly than bilateral arrangements for doing so, depending on the characteristics of the traded instruments and those trading them.

The second problem is one of normative economics and policy prescriptions derived from models.  Policy recommendations based on models of CCPs that are flatly contrary to the way CCPs really operate are highly misleading, and dangerous.  Eliding from a model that says “mutualization of risk is socially efficient but privately unprofitable” to prescribing a policy of mandating CCPs is deeply flawed, when in practice CCPs won’t mutualize risk as in the models, but will instead implement a defaulter pays model.  (NB: of late regulators are telling CCPs that their main source of concern is that CCPs will set margins too low.  That is, regulators want to make sure that CCPs really make defaulters pay.  So in practice, mandated CCPs will mutualize only extreme risks, and collateralize the rest.  Nothing like what’s in the models.)   It’s a sort of bait-and-switch.

Prudent normative policy recommendations need to be based on a model with good positive content. We need to understand much better why market participants eschew implementing the defaulter pay model before mandating it.  For that’s what clearing mandates do: they impose the implementation of defaulter pays, NOT the implementation of the kinds of mutualization in many formal models of clearing.   Given the costliness of collateral (IM-not to mention the destabilizing effects of VM), it is particularly misleading to advocate policy measures that will lead to increased collateralization based on models in which collateral plays no role whatsoever.  Again-a bait-and-switch.

In sum, I’m pleased that many talented scholars are turning their attention to clearing. Especially when they cite me But it will be a shame if these scholars go on a wild goose chase, and construct models of CCPs that are completely disjoint from real world CCPs.  This goes double when they make policy prescriptions based on their models.

We need to understand the costs and benefits of defaulter pays, with the mutualization of only extreme risks.  For that’s what CCPs are really about.  We need models that are based on an understanding of collective action issues-because non-mandated CCPs are institutions that arise from collective action.  Only when we understand these issues should we have much confidence about making policy recommendations.

I was invited to participate in a panel on clearing at ISDA’s Annual General Meeting in Singapore, but unfortunately I had to decline on account of my teaching obligations.  I therefore have to nod (vigorously0 in agreement from afar, because much of the discussion there has focused on the unintended consequences of the clearing and collateral mandates.  Consequences that I have been warning about for over four years.

One of the things that infuriated me about the advocacy for clearing (and yeah, I’m looking at you GiGi) was the claim that clearing would reduce the interconnectedness of the financial system.  I said this was patently false.  Clearing mandates would reconfigure the topology of the network of connections among financial institutions, but they would remain interconnected.  I noted that: CCPs would be vital interconnecting nodes in this new network: failure of these nodes would be catastrophic: and perhaps most importantly, CCPs could be vectors of contagion precisely during periods of financial stress.  I pointed out very early on that CCPs were repositories of wrong way risk because losses would hit default funds precisely during periods of extreme financial stress, and via that channel would bring that stress right back to the balance sheets of the banks with exposure to the default funds.  You know, when they were least able to stand the shock.  The CCP circuit connecting banks would be closed precisely when they were least able to stand the shock.

In retrospect, I seem like a Pollyanna.  Compared to people like HSBC’s Gary Dunn, anyways (Risk link-requires a subscription).  Gary went all Jeremiah at the AGM, warning of an apocalypse emanating from the clearing system.  Actually, his word was “Armageddon”:

Mandatory clearing of over-the-counter derivatives could jeopardise policy-makers’ hopes of a no-bailout financial system, according to Gary Dunn, senior manager for regulatory and risk analytics at HSBC.

Speaking at the annual general meeting of the International Swaps and Derivatives Association in Singapore today, Dunn sketched out an “Armageddon scenario” resulting from the fact that the same group of international banks are all members of the majority of central counterparties (CCPs) – so, a big bank default would simultaneously hit all CCPs of which it is a member.

“What happens when one bank defaults across six CCPs? The remaining members will have to pick up the bill. Given that they are almost certainly members of the other CCPs, this will result in a default contribution bill so large it could potentially lead to their failure also,” he said.

Given the key role CCPs will play in the future financial system, Dunn argued this would ultimately result in a taxpayer bailout amounting to trillions of dollars. In his Armageddon scenario, that bailout would be preceded by the complete liquidation of CCP initial margin stocks – much of which would likely be held in the form of government debt.

“The wrong-way risk in the current CCP system is so large it could potentially lead to a sovereign default,” he said. [Emphasis added.]

Interconnections between SIFIs via clearinghouses, with the fragility of these connections perhaps exacerbated by the fragmentation of CCPs (due to fragmentation along jurisdictional lines, perhaps).  Where have you seen that before?  Hint: Not in a Gensler speech.

The clearing panel also fretted abou the possibility that in its attempt to eliminate TBTF, the G-20 has just created new TBTF institutions.  Too big, and too interconnected:

Central counterparty clearers stand to be the next “too-big-to-fail” institutions and could pose an acute threat to the financial system if regulators stall on plans to manage the potential failure of a clearing entity.

At the annual general meeting of the International Swaps and Derivatives Association in Singapore today, a group of panelists highlighted the lack of clarity over resolution for failed CCPs as a significant concern for the G20 objectives of eliminating systemic risk.

“There are still no resolution plans for CCPs and it is murkier now that clearing houses have moved away from the utility model,” said Athanassios Diplas, senior adviser to the ISDA board, speaking at the event earlier today.

The G20 objectives agreed in 2009 deem that no financial institution should be considered too big to fail and that taxpayers should not bear the costs of resolution for any institution that does fail

While regulators have been busy penning rules to deal with the problem of too-big-to-fail banks, concerns are shifting to clearing houses, and the increased concentration of risk held in them as the Dodd-Frank Act in the US and the European Market Infrastructure Regulation push an increasing number of standardised over-the-counter swaps through central counterparties.

“We’re getting very close to solving too big to fail globally for banks, but I worry that this risk could move to CCPs. I’m not convinced that we have made CCPs deeply resolvable yet – we have to do that to address systemic risk issue in a thorough way,” Wilson Ervin, vice-chairman of the group executive office at Credit Suisse told IFR.

All of which was perfectly foreseeable in 2009 when the G-20 blessed clearing as the silver bullet solution.  Foreseeable-and foreseen by some.

And the late start on addressing this issue before CCP mandates went into effect has left the world financial system in highly exposed:

While the Financial Stability Board addressed basic principals for clearing house resolution in June 2012, the issue remains on the back burner with many regulators as they continue to get to grips with a workable bank resolution regime

CCPs are the solution.  So in their wisdom governments decided to load risk onto them.  But dealing with the failure of these government-mandated SIFIs “remains on the back burner.”

Great.  That will turn out well.

Fools rush in where angels fear to tread.  Governments have rushed into prescribing the Clearinghouse Cure, but have relegated addressing the very dangerous potential side-effect of that cure “to the back burner.”

But we’re not done!  The panel also fretted about the potentially destabilizing effects of increasing collateral and margins-both initial and variation margin (can’t find a link to this Mary Childs story: I think it is only available on Bloomberg terminals):

The numbers are large enough to be very worrisome,” Athanassios Diplas, principal at Diplas Advisors LLC and a senior adviser to the ISDA board, said on the panel. “I don’t

think anyone has trillions lying around the couch cushions.” Regulators should be careful in setting the collateral requirements given that margin calls contributed to the escalation of the financial crisis in 2008, according to Kim Taylor, president of CME Group Inc.’s clearinghouse.

Spiraling Losses

“Margin calls triggered liquidation of assets for positions, which triggered mark to market losses for other parties. It contributed to the spiral, and I think there’s the  potential for threshold-based margin” to help avoid a repeat, she said on the panel.

Margin calls exacerbating a crisis.  Whoever heard of such a thing?  Only anyone who has studied past financial panics and market crashes.  But Gensler and Timmy! and so many others assured us that collateral is only good: the more collateral the better.  Just another item on the bill of goods they sold the world-and for which we may have to pay dearly later.

Scary addendum.  At a recent Chicago Fed conference, I told someone from a major central bank that although the initial margin issue was important, it worried me that central banks and regulators seemed to be ignoring how variation margin could destabilize the system, especially with an expansion of clearing, which creates a very tightly coupled system of margin payments that must operate on a very tight and rigid time schedule.  He told me that there wasn’t as much concern about variation margin because it netted out to zero.

Seriously.  I kid you not.   It’s as stupid as the Krugman “we owe national debt to ourselves” mantra.  The payers have to find the liquidity to make the payment to the receivers.  In stress situations, they have to find a lot of liquidity precisely when liquidity dries up.  In response, they do things that impose additional stress on the system, and can break it.  Money is not transferred instantaneously and frictionlessly between those who owe and those who receive.  Those frictions-and just the timing required to recycle the payments-can cause the system to freeze up during periods of stress.

The “what, me worry?” approach to variation margin is very worrisome indeed.

But don’t worry!  Regulators will ensure that CCPs don’t engage in a race to the bottom when setting margins:

Britain’s new regulator for market operators warned clearers of tougher policing of fees to stamp out cut-throat competition that risks undermining financial stability.

. . . .

“We are not in the business of preventing competition but what’s important is the terms of that competition,” Britain’s new clearing supervisor, Edwin Schooling Latter, told Reuters in an interview.

The Bank of England became the regulator for clearing houses this month and Schooling Latter said in his first media interview he will not tolerate “a race to the bottom” such as clearers allowing banks to post too low margins against trades.

Margins refer to traders of derivatives posting government bonds or other high quality collateral to help cover any losses and the level of margins is determined by the clearing house.

“We want a world where the clearing houses compete on the quality of their risk management and not on how low their margins are,” Schooling Latter said.

Because regulators, of course, are so skilled at pricing risks.  They did such a bang-up job of it when setting capital requirements under Basel.  And by “bang-up” I mean like a train wreck.

The Sorcerer’s Apprentice metaphor seems more apt by the day.  Regulators and legislators have cast the spell to bring massive CCPs to life, but cannot control the consequences-which can be dangerous indeed.  They intended to solve one problem, but they have created others, and are scrambling to deal with them.

The clearing and reporting requirements of Frankendodd have barely gone into effect, and the unintended consequences are already beginning to pile up.  Who coulda seen that coming, eh?

Even I couldn’t have made up the bestest of them.  Namely, as a result of the SEC’s bizarre portfolio margining rule, ICE has said that it will not clear single-name CDS.  You know, the weapons of financial mass destruction that were supposed to be the reason for needing a clearing mandate in the first place.  So ICE won’t clear the poster children for the clearing mandate.  Like I say: you cannot make up this stuff.

From Risk:

Ice Clear Credit has shelved plans to clear single-name credit default swaps (CDSs) for clients of its member firms, as a result of a new Securities and Exchange Commission (SEC) policy on portfolio margining. Under the terms of that policy, circulated late on March 8 – the last working day before the start of mandatory clearing for CDX index trades in the US – clients would be able to benefit from risk offsets between cleared index and single-name contracts, but the vast majority would be charged twice the margin calculated by a central counterparty (CCP).

The move sparked a furious response from some buy-side firms and has now dissuaded Ice’s CDS clearing house from offering the service at all.

“Last Friday, the SEC issued a temporary approval requiring broker-dealer futures commission merchants (FCMs) to charge two times the initial margin requirement of the CCPs. This was unfortunate, so we made a decision, based upon that unexpected development – news of which we received very late in the day on Friday – and based upon input from many clients, that it would be better not to offer single-name clearing under those conditions than to make single names available,” Peter Barsoom, chief operating officer of Ice Clear Credit, told attendees at the Futures Industry Association (FIA) annual conference in Florida last week.

The SEC policy gives temporary approval for an FCM to allow cross-margining if it collects 150% of the margin required by a CCP, but only if the client has “virtually no credit risk”. For all other clients, 200% must be collected on positions held in the portfolio margin account, which participants say would apply to most buy-side firms.

Portfolio margining across asset classes is theoretically beneficial, but practically dicey due to the instability of correlations, which often result in positions being undermargined during conditions of market stress.  And yes, individual name CDS and indices can diverge, again particularly during periods of financial stress.  But a portfolio consisting of a position in an index and offsetting positions in single names (especially names in the index) is less risky than either leg on its own.  This means that it is possible to improve capital efficiency while holding risk level constant by giving margining offsets for portfolio benefits.  But noooooooooooo.  In its infinite wisdom, SEC has decided to punitively margin these portfolios.  This reduces substantially the benefits of clearing individual name CDS, so ICE says to hell with it.

Again, the irony is almost too much.  The risks of single-name CDS were constantly invoked to justify the clearing mandate.  Those arguments were largely bogus, but regardless, due to regulations adopted to implement the mandate, single-name CDS will not be cleared for the foreseeable future.  Yay!

This is yet another example of the perverse effects of regulatory setting of margin levels.  I’ve been saying this so much I’m blue in the face: you could call me the smurfwiseprofessor.   For the zillionth time: regulatory margin setting is a form of price control, risk price control specifically.  Price controls never work.  Worse than that, price controls always lead to distortions.  First with futurization and now with portfolio margining, we are seeing these distortions appearing, big time.  And they’ll likely only get worse, when margins on non-cleared swaps are finalized.

Regulators have neither the information or incentives to set these prices right.  They bewail regulatory arbitrage, but their attempts at price control are the destined to set off a regulatory arbitrage land rush.

Sheesh.

But it gets better!  Even the seemingly banal task of reporting swap trades is overwhelming the CFTC.  According to Scott O’Malia, they cannot find a London Whale in a phone booth:

Dodd-Frank Act derivatives rules are failing to give regulators a full picture of the swaps market and wouldn’t help them detect a loss similar to JPMorgan Chase & Co. (JPM)’s London Whale trades, according to Commodity Futures Trading Commission member Scott O’Malia.

Swap-trade data the agency has been receiving since the end of last year from repositories including the Depository Trust and Clearing Corp. is inadequate to identify large positions and have overwhelmed government computer systems, O’Malia said in a speech prepared for a Securities Industry and Financial Markets Association conference in Phoenix.

The data “is not usable in its current form,” said O’Malia, 45, one of the agency’s five commissioners. “The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files.”

. . . .

Different swap dealers and trading counter-parties are using their own reporting formats because the government failed to specify standards, O’Malia said.

“It means that for each category of swap identified by the 70-plus reporting swap dealers, those swaps will be reported in 70-plus different data formats because each swap dealer has its own proprietary data format it uses in its internal systems,” he said. “The permutations of data language are staggering. Doesn’t that sound like a reporting nightmare?”

The CFTC’s computer systems are failing to handle the incoming data. “None of our computer programs load this data without crashing,” O’Malia said.

This should be no surprise.  The issues with CFTC computers particularly.  The GAO issued reports in the ’80s ripping the agency for its IT dysfunctions.

Frankendodd has barely come to life, and it is already wreaking havoc.  I am sure there are more good times to come!

And I am totally, totally sure that Obamacare will work just as well.  No prospect for unintended consequences there!

I laughed out loud when I read this paragraph from a Risk Magazine article about futurisation in the energy markets:

Top CFTC officials [GiGi? Is that you?] as well as members of Congress who supported Dodd-Frank [that's Frankendodd around here, buddy] have repeatedly said the law was not aimed at physical end users of derivatives.  But if the the flight towards futures causes liquidity elsewhere in the market to dry up, end-users might have no choice but to fall in line.

Look: Elvis Costello’s “My aim is true” is definitely not the theme song of regulators and legislators in the US, or anywhere for that matter.  A 16 year old, hopped up, Afghan jihadi sprayin’ and prayin’ with his AK on full auto is more discriminating in his targeting than most regulators, and regulations.  Unintended consequences-AKA collateral damage-are the rule, rather than the exception with regulations.  This goes N-fold for monstrosities like Frankendodd.

Frankendodd is just starting its rampage.  The energy derivatives markets-and end-users in them-are only the first victims.

So when a regulator or legislator says that a particular reg or law isn’t aimed at you, don’t take comfort: take cover; there will be incoming.   We’re not talking Sergeant York or Annie Oakley behind the trigger here. More like Blind Lemon Jefferson.

Frankendodd runs hundreds of pages.  The regulations written to bring it to life run to thousands more.  Every word on every page has the potential to wreak havoc: hell, apropos the position limit case, even the commas matter.

Case in point, the CFTC’s proposed rule on protection of customer funds, most particularly Section 1.22.  Some of the relevant language:

The Commission proposes to amend § 1.22 by clarifying that the prohibition on the FCM’s use of one futures customer’s funds to margin or secure the positions of another futures customer, or to extend credit to another person, applies at all times.

. . . .

Further, the Commission is proposing language providing a clear mechanism to ensure compliance with this prohibition, which is to require an FCM to maintain residual interest in segregated accounts in an amount which exceeds the sum of all margin deficits for futures customers.

This is very inside baseball, but has seismic implications.

The basic thing is that some customers are late in meeting margin calls.  This gives rise to margin deficits.  Under the traditional omnibus model used in futures markets for donkey years, futures commission merchants (brokers-”FCMs”) can cover customers’ margin deficits with the margins of other customers.  Effectively, customers lend one another money to address the timing issues that the rigorous mark-to-market and variation margin processes inevitably create.  Moreover, the FCM is ultimately on the hook to cover the losses of a defaulted customer.  The FCM’s customers can lose only if there is a default by a customer that the FCM can’t cover (resulting in an FCM default).

That is, customers effectively lend to one another, and thus there is “fellow customer risk”-a solvent customer can lose as a result of the default of another customer. The CFTC rule is intended to eliminate this risk.

Problem: the risk can’t really be eliminated, merely shifted around.  Related problem: the likely reaction to this attempt to shift risk.

The CFTC seems to want to shift the risk to the FCMs: the “residual interest” language means that the FCM has to have enough of its own money on hand to cover any margin deficits.  This will require the FCM to hold substantial precautionary balances, because (a) the magnitude of margin deficits is likely to be quite variable, and particularly will be large in the aftermath of a big price move (that can’t be predicted in advance), and (b) there are serious penalties to being undersegregated.  Alternatively, FCMs are likely to require customers to post margins far in excess of exchange margin levels, thereby reducing the likelihood that any customer’s account will have a margin deficit, and the amount of residual interest the FCM must hold to cover any such deficits.

Either way, there will be a substantial increase in the amount of cash tied up, and the needs for customers and FCMs to have access to contingent liquidity.  The omnibus model was an effective way for customers to supply liquidity to, and obtain liquidity from, other customers.  Yes, there are risks, but there are corresponding benefits: the near universality of the omnibus model in futures markets, and its survival for decades, provides compelling evidence that the benefits far exceed the costs.

But apparently that’s not good enough for GiGi and the Gang.

The clearing and collateral mandates-combined with Basel III and other regulatory measures-are already requiring substantial increases in the amount of collateral-liquid assets-that will be tied up to support derivatives trades.  This will just add to that.  And insofar as being a customer protection mechanism: uhm, customers will pay for it.  Don’t act as if your are doing them a big favor. (Raising the question if its so valued by customers, why hasn’t some FCM adopted voluntarily what the CFTC wants to impose by fiat?  If it’s so great, customers would flock to firms offering that model.)

It also comes at a terrible time for the FCM industry.  The economics of the business are terrible.  ZIRP has blown a hole in a major source of revenue, volume is down sharply, and competition is intense.  A recent Celent study details the carnage:

“The leading FCMs in the US are struggling with falling revenues and profits,” saysAnshuman Jaswal, PhD, Senior Analyst with Celent’s Securities & Investments Group and author of the report. “This puts them in an unenviable position, especially when we consider the overall impact and related costs of various regulatory implementations taking place in the next couple of years.”

Another data point: SocGen just wrote down its investment in big FCM Newedge.  This is not a thriving industry, and ladling more costs onto it won’t help it one bit.

The ostensible purpose of this new regulation is to prevent another MF Global or Peregrine situation.

Seriously?

MF Global broke every rule in the book about segregation and the treatment of customer money.  Peregrine’s owner ran a huge fraud for 20 years. So creating more rules for troubled or criminal FCMs to break will help?  If the CFTC or SROs couldn’t enforce the old rules and thereby prevent losses of customer funds, why should we expect they’ll do any better with the new ones?

It’s also hard to see how these rules, if they had been in place, would have prevented either the Peregrine or MFG situations.  Furthermore, there are other ways of attacking the exceptional-and MFG and Peregrine were exceptional-without imposing crushing burdens on the ordinary day-to-day operation of the markets, FCMs and their customers.  For instance, the Peregrine fraud could not have continued if Peregrines regulator (the NFA) had direct electronic access to the firm’s accounts, thereby preventing Wasendorf from altering the paper statements he sent on to regulators to cover up his fraud.  Hell, in the MFG case, having more excess margin in customer accounts would have just increased the money that Corzine could have tapped to cover the company’s losses and own margin calls: it is just that excess margin that disappeared somewhere, somehow.  I would further note that since an FCM is most likely to be tempted to get at customer funds when it is in financial jeopardy (which is what happened with MF), adding to its financial burdens could create more problems than it solves.

The cost-benefit analysis the CFTC advanced in support of the rule is just the kind of joke I’ve come to expect.  This is actually a problem that is amenable to calculation.  Collect data on the distribution of customer margin deficits under current rules.  Figure out the 99.9th percentile of this distribution.  (Importantly, condition this distribution on market conditions-find out what that percentile is during very volatile periods.)    Given the rigor of the rule, it is plausible to assume that additional funds equal to this 99.9th percentile will have to be held by customers, FCMs, or both will be held to ensure compliance.  Calculate the return on this sum lost because customers and FCMs are required to hold low-yielding assets in order to comply with the rule.  That’s one component of the cost.

Another cost is the additional operational cost required to ensure compliance.  This will not be trivial: indeed, one reason FCMs might require substantial increases in customer margins is to reduce the operational burdens required to maintain compliance.

One cost that is important is hard to quantify.  As I’ve written repeatedly, spikes in liquidity needs during periods of market stress can be systemically destabilizing.  This rule will: (a) restrict one vital source of liquidity, namely, intracustomer loans; (b) result in far more liquid assets being tied up in brokerage accounts; (c) lead to increases in liquidity demand during periods of high volatility, as FCMs will either have to hold more liquid assets, or will force customers to hold more excess margin, during high volatility periods in order to maintain compliance (i.e., the 99.9 percentile is much bigger during high volatility periods, requiring more margin to meet this threshold-the distribution of liquidity demand spikes caused by this could be calculated); and (d) result in position unwinds by those unwilling to incur the cost of the elevated margins.  All of these effects are pro-cyclical, and tend to exacerbate market instability/volatility.  Liquidity problems are what create or exacerbate crises.  Derivatives market “reforms” have already imposed substantial liquidity burdens: this will only add another.  That is systemically risky.

Benefits?  Uhm, hard to ascertain.  As noted above, the rule is ill-suited to address either a Peregrine or MFG problem, even though those are the examples the CFTC repeatedly invokes in their support.  Moreover, it must be noted that reducing the amount of loss arising from the default of fellow customers is not necessarily a benefit.  This is primarily a transfer of wealth from one party to another.  The relevant issue is whether one risk sharing rule is better than another.

This is another example of the pernicious effects of attempts to “fix” high profile problems such as MF Global and Peregrine.  In response to truly extraordinary episodes, we get “fixes” that (a) don’t really do anything to address the problems they are supposed to be fixing, and (b) impose substantial burdens on the ordinary operations of the markets, operations that have gone on swimmingly for decades under the old way of doing business, thank you very much.

As a rule of thumb, I think it wise to be very suspicious of rules designed to prevent recurrence of an extreme event or events.  That is especially true in this case.   Another example of all pain, no gain.

Is that the CFTC’s motto now?

Hint: collateral crunches are not an ab exercise.  Instead, regulators and legislators around the world are waking up to the reality of what they have wrought: that the regulations that they blithely decided to impose on the derivatives markets are likely to have severe adverse consequences.  Specifically, Europeans have awakened to the fact that clearing and collateral mandates will be extremely burdensome on firms that use derivatives to manage risk, but who pose no real systemic threat.  Thus, a committee of the European Parliament has voted to send clearing regulations back to the European Commission for reconsideration.  There is a realization that a “collateral crunch” is impending as a result of these various regulations:

This has led to talk of a “collateral crunch”, with most central counterparties accepting only government bonds or cash as collateral, assets that may not be readily available. This is more restrictive than at present, with corporate bonds and even equities often accepted as collateral in uncleared bilateral deals, if lodged in sufficient quantity.

The problem may be particularly acute for mutual funds, as an equity or corporate bond fund will simply not possess anything it can use as collateral. Instead it may have to use the securities lending or repo markets to secure suitable assets.

But many pension funds will also be hit. As Mr Haines points out, even the index-linked government bonds that pension funds do tend to hold in abundance are not generally accepted as collateral by central counterparties, even if conventional bonds issued by the same governments are.

Estimates of the cost of using the repo market to access the necessary collateral range from 50 basis points of a pension fund’s assets to several hundred basis points, Mr Haines adds. Alternatively, pension funds may feel pressured to alter their asset allocation so they do have sufficient in-house collateral.

Totally unpredictable, right?  Uhm, not really.

I find it particularly amusing that virtually every article on the effects of Frankendodd and Emir bewail the “unintended consequences.”  A million pardons, but that was a theme here on SWP, and in various presentations I made, before Frankendodd and Emir were actually adopted.  Unintended, but eminently foreseeable-and totally ignored.

The recent angst focuses on initial margin: the amount of capital that has to be tied up to support derivatives positions from the moment they are initiated.  Given that collateral is costly, the large increases in initial margin will require derivatives users to choose between continuing to use them to manage risk, but obtain lower returns, or to eschew derivatives and live with greater risk.

The benefit received in exchange for this very real cost?  Given that many entities so affected pose no systemic risk, it’s quite difficult to identify any gain.

Not that initial margin is unimportant, but the focus on it distracts attention from what I believe to be the true systemic risk inherent in clearing and collateral mandates: the contingent needs for liquidity to make variation margin payments.  Big price moves lead to big variation margin flows.  These will tend to occur when markets are stressed and liquidity becomes scarce.  Thus, the need to make variation margin payments will exacerbate stresses on the market, especially will stress liquidity supply mechanisms.  Given that financial crises are, typically, liquidity crises, this is a major systemic problem.

So by all means pay attention to the drag that the dramatic increase in initial margin requirements will impose.  This is a drag that will be experienced day after weary day.  But do not overlook the truly dangerous unintended consequence of the clearing and collateral mandates in Frankendodd and Emir.  The stress that these mandates will put on liquidity supply mechanisms at the precise instant that these mechanisms are at risk of failure.

What could go wrong?

I say again: regulate/legislate in haste, repent at leisure. The seeds for the next crisis are being sown in the alleged attempts to prevent a recurrence of the last one.  Legislative and regulatory generals fighting the last war.

This week’s big derivatives story was about a public workshop at the CFTC on the issue of futurization.  I was one of the first people to comment on this issue, last year when ICE announced it was converting all of its energy swaps into energy futures.

That was Futurization 1.0. The conversion merely consisted of renaming “swaps” “futures”.  In all economic dimensions (contract specs, execution, clearing) the contracts remained identical.  But the renaming allowed some energy swap users to escape the dreaded Swap Dealer designation.

Futurization 1.1 was the CME’s conversion.  This illustrates some of the silly impacts of Frankendodd.  The CME has cleared energy swaps for going on 10 years now.  The parties would execute a swap, and submit the swap for clearing through an Exchange of Futures for Swaps (EFS) trade.  So the originally executed swap existed only until it was submitted for clearing, when it was replaced with economically equivalent futures contracts.  But no matter how short the swap’s life, the fact that it was born a swap meant that it counted towards the volume of swaps activity used to determine whether someone was a swap dealer.  So the process has now changed, and market participants use (mainly) block trades of futures to create the positions they want, thereby cutting out the interim swap step.

The transformation of the energy derivatives landscape, and the launch of swap futures by CME and Eris are now raising the question of whether futurization will spread beyond energy.

One motive to eschew swaps in favor of futures is unlikely to exist in interest rates, credit and other financial derivatives: the biggest market participants are likely to trade enough bespoke swaps for which there are no futures equivalents, meaning that they will be treated as swap dealers regardless: this reduces their incentive to substitute futures for swaps.

The main driver of futurization outside of energy will be CFTC regulatory treatment of futures and swaps.  Differential treatment will affect the economics of futures vis a vis swaps, and the prospect of such differential treatment was the center of controversy at the CFTC meeting, and in the larger debate in the industry.

The main sources of differential treatment are execution and margining.  Swaps will have to be executed subject to (allegedly) soon-to-be announced SEF rules, and are subject to immediate reporting.  Most market participants who will substitute futures for swaps will execute these deals via privately negotiated block trades subject to exchange rules.  Crucially, reporting of block futures trades is delayed 15 minutes, a concession to fears that immediate reporting would impair liquidity because block positioners (those supplying liquidity to the block futures market) could find it difficult to lay off their risk if the fact they had just done a big trade was announced immediately.  This would induce them to require larger price concessions for doing block trades.

Which raises the question: why the difference between the futures goose and the swaps gander?  Similar considerations obtain for swaps.

Thus, this rule difference is likely to favor futures executed via block trades as opposed to swaps executed via traditional means (but with immediate post-trade transparency) or via SEFs.  (Economically material differences between the rules governing block trades and SEF trades could also affect the relative costs of trading in these disparate ways, and hence affect the choice between them.)

Margining will be different for swaps and futures.  Futures will be margined assuming a one- or two-day liquidation period (i.e., margins will be based on something analogous to a one- or two-day value at risk).  However, swaps-even cleared swaps-will require a minimum liquidation period of 5 days for calculating initial margin.

This substantially higher margin for swaps results in a substantial economic disadvantage to these contracts compared to futures contracts that generate the exact same cash flows (in the absence of default).   This will likely be another factor pushing the market towards futures-which is a major reason for the fury of swaps dealers.

This differential treatment of economically equivalent contracts just because one is called a “swap” (BAD!) and the other is called a “future” (GOOD!) makes little-or no-economic sense-and reflects the swap-o-phobia that pervades DC, and which was an animating principle behind Frankendodd.

The reason to set margins based on a liquidation period reflects the purchase of IM: it is intended to cover potential losses on a defaulted position before that position can be liquidated by the clearinghouse (i.e., the position can be assumed by another solvent market participant).  The less liquid an instrument,  the longer it takes the CCP to work out of the position, the more it is exposed to potential adverse price moves and hence the more margin cover it needs.

This liquidation period depends on the economic characteristics of the contract, how widely it is traded in the marketplace, the identity, number and capitalization of the firms that trade it, and market conditions at the time of liquidation. All of these conditions should be pretty much the same for two contracts that specify the same contingent cash flows, one of which is called a swap and the other a future.  Consider say a 10 year vanilla IRS and economically equivalent futures contracts that offer the same contingent cash flows.  Abstracting from margining differences, these contracts have identical price risks, and should attract the same kinds of users.  Why should liquidity of one differ from the liquidity of the other in the event of the default of the holder of a big position?

And don’t tell me that futures are traded in light markets and swaps are traded in dark ones.  As already noted, futures traded as substitutes for swaps are and will be typically traded in blocks outside the limit order book.

More importantly: in the event of the default of a big FCM or dealer that should be the reason to be concerned, the CCP is going to try to get rid of the defaulted portfolio in big chunks through some sort of auction process.  The firm winning the auction will then trade out of the position, likely using the central market and block trades.

This isn’t much different than how a swap CCP will handle the default process.  Indeed, LCH obligates its members to assume portions of a defaulted portfolio, and one reason for having stringent CCP membership requirements is to ensure that the members have the capital and trading expertise to manage big pieces of defaulted portfolios.

We actually have a case study of futures and swap default management processes.  When Lehman defaulted, CME auctioned off its interest rate, equity, currency, commodity, and energy positions.  These trades were done at differentials from market prices, to reflect the risk that those taking over the positions would assume and have to work off.  A couple of the positions were under-margined: the firms taking over the positions required the CME to provide more funds than the Lehman margin it had against those positions.  As it turned out, the other positions were over-margined, and across all positions the over-margining exceeded the under-margining, meaning that the CME clearinghouse did not suffer any loss as the result of the default.  But this illustrates the possibility that futures can be under-margined, and that even the putatively more liquid futures contracts can require substantial price concessions to get someone to assume them.

LCH.Clearnet handled the default of the Lehman IRS positions. These totaled $9 trillion in notional-bigger than the Lehman futures positions at CME, and arguably far larger in terms of risk.  ($1 trillion in notional of a 10 year IRS poses substantially more risk than $1 trillion in notional of Eurodollar futures.)  90 percent of the position was hedged within a week.  According to LCH.Clearnet, the costs of trading out of the defaulted position were “well within” the Lehman margins it held.

It’s hard to see much of an economic difference between the CME and LCH experiences.  It doesn’t appear that it was materially more difficult to manage the default of “swaps” than it was “futures.”   The Lehman default does not provide any evidence that swap-o-phobia is anything but a mental illness.

Further, this case study illustrates that there is no reason to believe that absent government regulation, swaps will be under-margined and futures will not.  Indeed, had the Lehman positions been held at 5 separate CCPs, two of them would have been under margined.

Indeed, there are serious reasons to be concerned that government regulations of the margining of economically similar (and in some respects identical) contracts will create systemic risks, rather than mitigate them.

The margin regulations-with larger IM imposed on swaps than futures-are a form of price control, in this case default risk price control.  And we know that price controls work out swell, especially when applied by regulators in a two-sizes-fits-all fashion across all different kinds of instruments posing different risks and cleared by CCPs with potentially disparate financial strength.

Moreover, this price control will tend to induce activity to move towards futures CCPs.  Whereas in the absence of the margin differential clearing activity in, say, interest rate derivatives would be split between futures CCPs and swap CCPs, under the differential regulation, business will tend to tip to the futures CCPs-most notably, CME.  This will tend to lead to greater concentration of credit risk.

Wasn’t the whole point of Frankendodd to reduce concentration? Just asking.

The whole conceit that regulators can set risk prices is quite dangerous, and is likely to be a source of systemic risk because these prices are set on the basis of highly limited information in a politicized process, and because mistakes in setting risk prices (especially price differences between similar products) tend to lead to crowded trades and risk concentration that is highly destabilizing during crisis periods (cf. Basel II).

The case for setting different margins (default risk prices) on very similar-and in some cases identical-derivatives contracts is particularly weak.  It is the characteristics of the products and those who trade them that will drive liquidity and liquidation periods: products called “futures” that share the same economic characteristics as products called “swaps” will pose virtually the same challenges to liquidate in the event of a large default.  Given this, the economics suggest that imposing differential margins based on a name difference-rather than economic differences-can’t make things better, and could well make them worse.

But the Sorcerer’s Apprentices know better. So futures are likely to get an artificial advantage, and swaps an artificial burden. Such distortions are quite dangerous.  My conclusion? Futurize in haste, repent at leisure.

I’m sure you would never peg me as a green type, but I have decided to join the recycling movement!

I am doing so in response to the call by Barney Frank (the Frank of Frankendodd) to merge the SEC and the CFTC.  This idea has itself been recycled many times, dating back to the 1980s and the birth of stock index futures.

One of the recycling efforts was by Hank Paulson, in the spring of 2008, in his proposal to reform the financial markets.  A centerpiece of this proposal was the org chart shuffling.  What I said then holds true today, so I’ll conserve scarce resources (mainly my time), and merely recycle:

The biggest headline was that the recommendation for the merger of the SEC and the CFTC. This puts in me in mind of two quotes. The first is by Churchill: “A fanatic is one who can’t change his mind and won’t change the subject.” Whenever anything happens in the financial markets, the cry immediately goes up to merge the SEC and the CFTC. Many people are apparently fanatical, because they never change about their minds about the desirability of the merger, and the subject always seems to return to it.

The second quote is by somebody slightly–well, a lot actually–less famous; that would be me. In a 2001 Regulation Magazine piece on the Clinton regulatory legacy, I wrote that the SEC-CFTC combination was a solution in search of a problem.

I am always somewhat mystified by the substance of the arguments for the merger. The most commonly mentioned benefit is a harmonization of margins between stocks and stock index futures. What, it’s not possible to harmonize without going merging the two bodies? Moreover, given the myriad other more important issues facing the two agencies, this seems like a very thin reed on which to rest a major reshaping of the regulatory structure.

In reality, there is very little overlap between the regulatory responsibilities of the two agencies. What’s more, there are huge swathes of the trading landscape that fall outside the jurisdiction of either agency. So merger will hardly reduce that much duplicative or contradictory regulation, and will not fill any regulatory gaps. So what’s the point?

Indeed, there are many sources of potential danger in a merger. One, very underappreciated in my view, is that it sacrifices the advantages of specialization. There are issues unique to securities markets and derivatives markets. Specialized agencies can develop the expertise needed for each market space. Of course the staff at a merged agency could specialize, but major policy, rulemaking, and interpretive decisions are made at the commissioner level. Right now SEC commissioners, for example, need to deal with arcane issues of accounting, disclosure, securities intermediation, and securities trading practices in stock, option, and fixed income markets. This is an already daunting task. Adding new areas of responsibility involving different markets and different instruments with different issues will further tax the already limited expertise of the commissioners of the merged agency.

The inevitable outcome of this dilution of expertise and specialization will be to enhance the power of staff, and degrade the quality of commission decision making. Neither outcome is desirable.

Indeed, I would argue that the SEC is already underspecialized. The agency operates subject to three statutes, the Securities Act of 1933, the Exchange Act of 1934, which focus on primary and secondary markets for securities, respectively; and the Investment Company Act of 1940, which focuses on mutual funds and the like. The agency has responsibility over the issuers of securities, and the markets and intermediaries that trade securities. There is little overlap between these areas. Issues of disclosure and accounting can be conceptually and operationally distinguished from issues of market structure and organization.

A second area of concern is that a unified agency will provide a mechanism to reduce and distort competition between different sectors of the financial markets. There are many on Wall Street that would love to throttle the futures exchanges in order to reduce competition for the securities business. (The margin issue is a perfect example of this. The securities firms would love to force an increase in margins on futures to drive some business from the futures exchanges to the stock market.) The regulatory autonomy of the CFTC has largely precluded such an outcome. The SEC has indeed tried in the past to impede the development and introduction of futures products that compete closely with securities markets but has largely failed in these endeavors because it does not have the necessary authority or jurisdiction.

Now, of course, a merger would change agency politics. Under the current framework, the SEC is largely responsive to securities firms and exchanges, and the CFTC is responsive to the futures exchanges and the FCMs. A merged entity would be responsive to the interests of all of these parties. But that is not necessarily a good thing, as one very likely outcome is that the merged entity would implement regulations that would reduce competition between the varying constituencies.

A more sensible, but still problematic, regulatory reorganization would involve (1) stripping out the primary market, accounting, and disclosure responsibilities from the SEC and putting them in a separate agency focusing on these corporate finance issues, and (2) creating a separate agency responsible for trading and market structure issues in securities and derivatives markets. This second agency, call it the “Commission for Financial Trading and Markets” (“CFTM”) would focus on issues relating to manipulation; fraud; the financial adequacy of intermediaries (securities and derivatives brokerages); and facilitating competitive market structures in financial markets. Arguably the manipulation, fraud and competition responsibilities should give the CFTM some authority in the OTC markets.

This approach would be far preferable to mashing together two disparate agencies with very different histories and cultures in the hope that something beneficial will come out of the unnatural coupling. It would permit the development of some specialization, and many issues of fraud, manipulation, and market structure are common across securities and derivatives markets, so the specialization could be applied to a variety of related markets. This alternative is still problematic, however, because the CFTM could easily become a mechanism for stifling competition between different methods of allocating risks and discovering prices.

All that said, there is little likelihood that the merger (or the creation of a CFTM) will come to pass in any event. The idea has been around for decades, and has never even come close to implementation. This is no surprise. There are powerful political forces in the way. Most notably, the futures exchanges, their members, and the FCMs have fought the SEC’s loving embrace vociferously, and found vocal support in Congress. Moreover, whereas the SEC falls under the congressional banking committees (e.g., the Senate Banking Committee and the Securities, Insurance and Investment Subcomittee), the CFTC is under the ag committees. Neither is about to readily cede jurisdiction over a large, well-heeled, and generous industry.

What he, er I, said.

Expecting miracles from mashing together org charts is insane.  At best, it has no effect.  The more likely outcome is to make things worse.  (Want an example?  Look at the effects of the reorganization of the intelligence community post-911.)   The point about specialization is particularly apposite, IMO (naturally, since I brought it up!)  The five commissioners of the CFTC and the five commissioners of the SEC are already overwhelmed by their complex responsibilities, and can devote relatively little time to becoming expert in any one particular area.  Extending the scope of the commissioners’ responsibilities is supposed to make that problem better?

In the end, nothing is likely to happen.  This is a lame duck kerfuffle.  The people who will have skin in the game in the next Congress will want nothing to do with this, as has been the case for about the last 15 Congresses.

November saw a mini-drama involving the CME, CFTC, and DTCC about the issue of SDRs.  (Acronym overload!)  SDRs being Swap Data Repositories, a spawn of Frankendodd-arguably the only good thing in the Title VII litter.

CME had filed to become an SDR, and wanted to require anyone who cleared swaps through CME to report the trade to its SDR.  The CFTC didn’t like the idea of tying clearing and reporting, and held things up: it had stated that the choice of SDR should be up to the customer.  So CME sued.  DTCC-which has its own SDR and would benefit if some CME swap deals were reported to it-filed as an intervenor in the suit.

Lo and behold, the CFTC approved the CME application, including the provision that tied clearing and reporting.  CME dropped its suit, and DTCC is stomping its little feet:

“The Commission’s action late yesterday was an unexplained and an abrupt reversal of course,” the DTCC, which runs a rival swaps data repository, said in a statement.

“This action is inconsistent with the Commission’s previous actions, and will cause market participants to question the finality of any Commission rule or interpretation.”

Two comments.

First, issues of tying and vertical integration are cropping up all over in trading and exchanges.  I just presented a paper at a conference honoring Oliver Williamson that looks at vertical integration between execution and clearing and settlement.  But the issues are also present in things like data centers and reporting and likely will be present in any service exchanges offer.  Regulators are hostile to these sorts of arrangements.  The lesson of my paper is that there can be-and in my view, typically are-good, transactions cost economics-based reasons for these sorts of vertical arrangements.  Regulators should take a deep dive into TCE and learn something about the potential benefits of vertical restrictions or vertical integration rather than continuing to indulge in their reflexive hostility to it.  What’s the transaction at issue?  What are the potential contractual hazards?  Are the contracting and governance methods chosen to implement the transaction well-adapted to the contracting hazards?

IOW, as if (40 plus years after Coase made an observation on the subject) it is rather astounding that regulators look at every vertical restriction with a jaundiced eye.

Second, in some respects this is like Groundhog Day for me.  I’ve seen this before.  I came across a similar controversy in my failed attempt to create a predecessor to SDRs-an “energy data hub”-back in 2003.  It was obvious then, and is obvious now, that there are substantial scale and scope economies in creating and operating an SDR, and that an SDR is a natural, multi-product monopoly.  It is highly likely that the efficient form of organization would be an industry utility/cooperative, likely a non-profit.

But as I experienced in ‘03, industry players see this as a great commercial opportunity, and there is intense competition to establish for-profit data hubs and regulators will not mandate the creation of a single hub or pick a winner.  Hence, it is likely that in the end, in each jurisdiction there will be one dominant hub that could be quite lucrative.  Hence the intense competition to be the winner in a winner-take-all contest.  This competition is typically dissipative.  Moreover, if multiple SDRs do survive (because, for instance, the firms play some sort of oligopoly pricing game), there will be excessive costs due to incomplete exploitation of scale and scope economies (i.e., fragmentation is costly).

Which all means that although mandatory reporting to a data hub/SDR is a good idea, as a result of political economy considerations it will be implemented in a highly inefficient way.

Go figure.